How (Not) to Save Ukraine
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The energy sector of Ukraine needs to be reformed and made competitive. However, efforts to achieve this goal should not exacerbate Ukraine’s biggest problem on the path to economic prosperity, namely the population’s impoverishment. Shock therapy, used by the Ukrainian government, represents an all too abrupt and hasty step, albeit in a good direction. Dr. Anders Aslund’s issue brief “Securing Ukraine’s Energy Sector” published by the Atlantic Council in April 2016 is a well-timed attempt to restart the debate on Ukraine and the measures the latter has taken to improve its energy sector.
Throughout 2015, developments in Ukraine were at the center of attention of world politics, but at this point in time, the events in Kiev have somewhat lost their urgency. The change of A. Yatsenyuk’s government, the epic concerning N. Savchenko’s extradition to Ukraine, and provocations on the border with the Donetsk People’s Republic still excite public opinion in the former Soviet Union, but have been overshadowed in Western media by other topics, such as the coming presidential election in the US, the settlement of the Syrian crisis and the need to eliminate the Islamic State. Dr. Anders Aslund’s issue brief “Securing Ukraine’s Energy Sector” published by the Atlantic Council in April 2016 is a well-timed attempt to restart the debate on Ukraine and the measures the latter has taken to improve its energy sector.
According to Dr. Aslund, in 2015 the Ukrainian authorities carried out a number of far-reaching reforms in the energy sector. He believes, in particular, that Kiev has become more independent from the Kremlin, which has used energy as a weapon to exert leverage over the Ukrainian domestic agenda and exercise control over the political leadership and key power players. Although the issue brief fails to give the names of these “pro-Kremlin traders,” it should be recalled that one of the most successful traders in the 1990s was Yulia Tymoshenko, who headed Unified Energy Systems of Ukraine in 1995-1996. Paradoxically, Dr. Aslund happened to be President Leonid Kuchma’s economic adviser exactly at that particular time.
Setting the pernicious influence of the pro-Russian traders aside, today the energy sector of Ukraine is in a deplorable state. Its lack of competitiveness has been exacerbated by subsidized prices throughout the modern history of Ukraine: as the author indicates, in 2014 energy subsidies amounted to 10 percent of GDP. Imports of energy carriers, primarily oil and gas, made about the same share of the Ukrainian GDP. In 1990-2010, the development of primary energy resources fell by 47 percent, and for the time being the recovery of these losses looks less than probable.
The gas segment appears to be the most problem-plagued energy sector, which triggered in the past regular conflicts between Russia and Ukraine. The decline in gas consumption, starting in 2008, resulted in the fall of the latter by 40 percent (to 36 billion cubic meters) in 2011-2015. Only in 2015, gas consumption in Ukraine fell by 25 percent, which A. Yatsenyuk regarded as a clear proof of “Kiev’s adherence to its policy of energy effectiveness.” However, the real cause of the Ukrainian energy sector’s decline is the general weakening of the economy, which continued throughout 2015.
Nord Stream 2: Pros and Cons
After a 10 percent drop in 2014, the industrial production index fell by 13 percent in 2015. There is little doubt that destabilized political situation in the country is the root cause behind the weakening of Ukrainian industry, but the fall in prices of the main export commodities of Ukraine, namely chemical products, fertilizers, steel, etc., made the situation even worse. Thus, industrial gas demand fell last year by 21 percent to 11,2 billion cubic meters. Of course, Crimea’s accession to Russia and unresolved military conflict in Donetsk and Lugansk regions of Ukraine have also cast a shadow over this decline. However, only Odessa region saw an increase in gas demand in 2015, even allowing for the “problem” regions of Ukraine.
In 2000-2015, industry accounted for an approximately 75 percent drop in gas consumption in Ukraine. Due to fuel switching from gas to coal by a number of enterprises and, in part, to enhanced energy efficiency, the decline in gas consumption took place before the Maidan, but in the past two years it reached distressing proportions. Gas consumption in the household sphere fell by 25 percent in 2015, which was particularly noticeable after consumer prices had quadrupled. Moreover, a 43.3 percent rate of inflation and decline in GDP by 9.9 percent in 2015 have resulted in reduced real income of the population by 22,2 percent.
This course of events ran counter to the rules under which the gas market of Ukraine had operated before 2014. Until recently, gas for household consumption cost significantly less than its market price, and the difference was covered at the expense of domestic production. Thus, the gas price for households in Ukraine was about 85 dollars for one thousand cubic meters, nearly half as much as in Russia. In addition, due to subsidies, the final price for pensioners was less than 1 dollar.
As a state-controlled company, Naftogaz of Ukraine had to provide service to this segment of the market, and eventually faced chronic insolvency. Imported gas was used to supply the needs of industry and partly of regional companies producing and marketing thermal energy. In terms of market development, making tariffs correspond to the market is definitely a timely measure; however, against the backdrop of the general decline in well-being, it may force the population to reduce consumption to the lowest level or to find ways to escape payment.
The future of $17.01 billion IMF loan depends largely on the success of the energy reforms. The Ukrainian political elite that has put the country’s economy on the brink of default, having managed to blunder through forming a new government, has decided to increase the price of gas in the country to 6879 hryvnia for one thousand cubic meters in order to unlock the IMF loan. Populist promises that it “will be the last change within the compass of a lifetime” of the people only testifies to the fact that consolidating public finances in Ukraine will take place mainly at the expense of the Ukrainians. Dr. Aslund welcomes the “radical” and “stunning” reforms of the Ukrainian authorities in the energy sector. In his view, the decline in gas consumption in all spheres of the Ukrainian society is “large-scale and highly desirable.”
Dr. Anders Aslund’s support for Kiev’s aforementioned decisions is not accidental. From November 1991 to January 1994, Aslund worked as a senior advisor to the Russian government under President Boris Yeltsin on the country’s transformation into a market economy. In his works he keeps revealing his adherence to shock regulating measures in the post-Soviet space. According to him, “it is much more important that enterprises were privatized than how they were privatized”, adding that “the owners who make them succeed are more often than not the second or third owners following privatization.” And it is this that puts the current leaders of Ukraine in a tight corner, since the likelihood of their ability to make the country prosperous is minimal.
Ukraine’s Energy Future Lies in Good
Governance, Not in Diversification
Anders Aslund anticipates the expected drop in gas consumption in 2016 to be 29 billion cubic meters in the same spirit: he considers it to be for the benefit of Kiev, because the country would have to import only 9 billion cubic meters. The author believes that the remaining amount will be produced in Ukraine. However, this may be a problem, since the volume of production by state-owned UkrGazVidobuvannya and Ukrnafta fell in 2015 by 0.8 billion cubic meters, let alone the fact that Chernomornaftagaz, which consistently recovered 1.2-1.3 billion cubic meters, now falls within Russia’s jurisdiction. The volume drops off in Ukraine were mitigated to some extent by the growth of independent producers, namely Burisma Holdings, which is a member of R. Akhmetov’s holding Naftogazvidobuvannya. Burisma Holdings is registered in Cyprus, and in 2014 Joe Biden’s son Hunter Biden and former President of Poland Aleksander Kwasniewski were appointed to its Board of Directors.
Dr. Aslund puts forward a number of recommendations for both the Ukrainian government and the transatlantic community. According to the author of the issue brief, it is advisable for Kiev to create an electricity market on an arm’s length basis, to establish an independent energy regulator to achieve more transparency in the energy sector, to optimize the tax regime, and to split Naftogaz into separate structures for production and transportation. Most of these measures are included in the list of the reforms that the IMF insists on and in one way or another are carried out by the current government of Ukraine. For example, after a 7-month delay, Naftogaz published a plan of the company’s split. At that, the dispute between the company and the state over the ownership of the Public Joint Stock Company “UkrGasVydobuvannya” (UGV) is still underway: Kiev insists on the transfer of control to the Ministry of Energy.
Last, but not least, A. Aslund recommends avoiding any kind of cooperation with Russia. In his opinion, the achievement of this goal is a matter of national security. The author urges Kiev to cancel the 10-year gas contract with Russia, signed in 2009 by Yulia Tymoshenko and Vladimir Putin (in 2011, the second year of Viktor Yanukovych’s Presidency of Ukraine, Tymoshenko was sentenced to imprisonment for abuse of power after signing this contract). A. Aslund also argues against purchases of Russian gas (it should be added “directly”, since most of the supplied reverse gas was produced in Russia).
The report calls on the Ukrainian authorities to “facilitate orderly transit” of Russian gas through the Ukrainian territory against the backdrop of Gazprom’s declared intention to put an end to this practice by 2019. The seriousness of this goal is supported by the fact that even during the crisis years of 2014-2015, after the share of Ukraine in the Russian natural gas transit had dropped within two decades from 90 to 39 percent, Kiev received about 2 billion dollars annually for the transit. Given this, writes A. Aslund, Naftogaz decided to increase the transit tariff to the “normal market level” ($4.5 dollars per 100 km, which is several times higher than the ones for the countries of Central and Eastern Europe), while the Antimonopoly Committee of Ukraine punished Gazprom for distortion of competition in Ukraine. Gazprom didn’t need any further incentive to speed up the construction of Nord Stream 2.
The prices for gas that Gazprom charged Ukraine were indeed in some cases higher that the pan-European average. However, unauthorized withdrawals of gas in Ukraine were insanely out of proportion, let alone chronic non-payment by Naftogaz for gas supplies. Therefore, given the peculiarities of the Ukrainian market, the charges of unfair practice appear to be extremely unfounded and have pronounced political overtones. Even the complete removal of Russia from the energy sector of Ukraine will fail to solve a number of domestic problems: for example, by early 2016, the total volume of arrears in payment for gas reached 1 billion dollars, mainly due to the regional distribution companies.
Ukraine between West and East
The author’s Recommendations for the Transatlantic Community cause only bewilderment. Urging the leaders of the transatlantic ideas to “help Ukraine become free from Gazprom’s monopolistic and corrupt practices,” to “pursue EU competition policy against Gazprom” for the alleged violation of antitrust rules and to “investigate Gazprom as a criminal organization,” as well as to “support Ukraine against Russia in international governance institutions,” A. Aslund at the same time calls upon actors to “facilitate orderly gas transit to European countries through Ukraine.” Why Gazprom should stick to Ukraine as a transit country, given all the above-mentioned oppressive measures, remains outside the analysis of Dr. Aslund.
It is worth noting that in speaking about Gazprom “as a criminal organization” the author of the issue brief refers to an article published by Vladimir Milov and Boris Nemtsov in the Novaya Gazeta paper in 2010, as well as to the report of the NGO Global Witness (according to the latest available Financial Statement for 2013/2014, its main sponsor is the Open Society Foundations of George Soros). Impartiality and purely scientific approach are in all their glory.
Indisputably, the energy sector of Ukraine needs to be reformed and made competitive. However, efforts to achieve this goal should not exacerbate Ukraine’s biggest problem on the path to economic prosperity, namely the population’s impoverishment (the current gross domestic product of Ukraine does not exceed 60 percent of GDP in 1990). Shock therapy, used by the Ukrainian government (and recommended by international financial institutions supervising putting the reforms in Ukraine into practice), represents an all too abrupt and hasty step, albeit in a good direction.
Blaming Russia for all the ills of Ukraine could have made sense as long as the former was present in the Ukrainian market. It turned out that corruption and oligarchic conflicts in Ukraine blend in with the country’s landscape without any trace of Russian influence. Unless there is a leader who can rectify the situation both in Ukraine and in its energy sector, oligarchic rivalries for influence and control are inevitable. Although one can only welcome the initial intention of the author to substantiate the need to reform Ukraine, the major drawback of Dr. Aslund’s issue brief is its praising and defending those who use the reforms as a smokescreen for oligarchic interests.