What’s next for Ukraine’s energy sector?

While Ukrainian government, legislature, business and taxpayers are appropriately focused on the coming winter heating season, international stakeholders have the luxury of looking ahead and encouraging reflection on the medium-term direction of the Ukrainian economy.

Ukraine’s frequently voiced desire for greater U.S. investment in the energy sector has yet to translate into rules that are more attractive and reliable than those offered in other countries, particularly in the energy sector, to judge by the analysis offered by  Robert Bensh, senior managing partner at Pelicourt LLC.  Given the particularly long-term horizon of energy investors, it is important to envisage how Ukraine may structure its energy balance sheet and the entire sector for the next 25 years. How will it conduct the promised privatization of state-owned enterprises and ensure a competitive business environment among domestic and international firms? What types of energy sources will be used to produce stable electricity? Can Ukraine afford effective incentives for renewable energy sources? How does Ukraine plan to distribute its energy sources to its consumers given an aging and inefficient power grid? To engage better with the international and domestic investors and donors, Ukraine may need to develop a vision for its energy consumption culture for both households and businesses.

In 2014, Ukraine produced 47 percent of its natural gas needs, or approximately 700 billion cubic feet. Ukrainian Officials have expressed a desire to reduce their country’s dependence on Russian gas, and given the rich subsoil reserves, this could theoretically be achieved in the near future. Recently, Minister of Finance Natalie Jaresko proposed a new tax regime for energy producers in Ukraine, which cuts gas royalties as an incentive for increased private investment.

Although this would typically be viewed as a timely step in the right direction, the plan also introduces a “surcharge tax” of 30 percent on profits. In fact, theFinancial Times confirms a statement that companies represented at the U.S. Chamber of Commerce’s U.S. – Ukraine Business Forum voiced in July, “that this is the government giving with one hand, but taking away with the other.” In other words, Ukrainian officials should return to the drawing board and finalize a tax regime that makes sense for investors.

Traditionally, Ukraine has relied on its abundance of nuclear and coal resources for production of electricity. However, nuclear generation is running close to full capacity, and several coal stations have closed as a result of the violent unrest in eastern Ukraine. Neither coal production nor nuclear is likely to expand substantially any time soon. It is therefore in Ukraine’s best interest to diversify its energy sources used to produce electricity. The World Bank also sees a benefit to diversification and has allocated over $60 million to increase Ukraine’s capacity of hydropower through renovations to the Dnipro and Dniester hydroelectric plants. In addition, the International Finance Corporation is exploring renewable energy investment for Ukraine. Even with these investments in additional generation capacity, the role of energy efficiency cannot be overestimated. The country’s place in the European markets will not be secure unless its industry makes a transition to a more sustainable use of all resources, including energy.

Fortunately, Ukraine has already adopted or tabled a range of legislative and regulatory acts facilitating investments in energy efficiency in the public sector, industry and households, including energy performance contracting and Energy Service Companies (ESCOs). However, the overall creditworthiness of both the banks and borrowers casts a shadow over this fledgling sector. While Ukraine has encouraged renewable investment through high feed-in tariffs, the concessions and licensing process is still viewed by many as opaque while Ukraine’s ability to afford such high level of incentives for wind and solar energy is far from certain. The Institute for Energy Efficiency in Ukraineadvocates for the introduction of renewable energy sources. The group believes that a government target of 9 percent energy savings through renewables by 2020 is too modest, and that legislators should be more ambitious with their target goals. Overall, there is a clear understanding that without drastic energy efficiency gains, the economy will not be viable in the mid to long-term. The Paris Climate negotiations can yet prove to be the action-forcing event to nudge Ukraine to revisit its strategy and reach a final internal agreement on its Greenhouse Gas Emissions targets and energy efficiency goals. On Sept. 30, Ukraine submitted its so called Intended Nationally Determined Contributions, or INDC, which commits it to reduce greenhouse emissions by 2030 to under  60% of 1990 GHG emissions levels.

For Ukraine’s economy, energy efficiency is so essential that it is part of the International Monetary Fund’s (IMF) review in offering the country a financial lifeline.  Last month, IMF produced its first review of Ukraine’s Extended Arrangement under the Extended Fund Facility (EFF), and is now working on its second review. The Government of Ukraine confirmed its commitment to meeting the policies and objectives of the EFF, which include a variety of anti-corruption, transparency strengthening, and energy efficiency measures. On Oct. 1, one of the most important commitments, the “Gas Market Law” was supposed to take effect, and separate the state-owned Naftogaz from its transportation subsidiary Ukrtransgaz. This arrangement could theoretically produce an investment opportunity for U.S. companies with experience in energy transmission systems. Unfortunately, the deadline for the Gas Market Law has been missed, which prompts investors to question the validity and future of Ukraine’s gas distribution reform.

Ukraine’s antiquated power grid leaves businesses and consumers susceptible to rolling blackouts. This is a result of underinvestment and poor management. Businesses have to compensate for an unreliable national grid by investing more in their own energy supply systems. The World Bank is currently addressing this problem with a commitment of over $300 million to improve the reliability of power transmission systems, while supporting the implementation of a wholesale electricity market for Ukraine. This project could be the start of improved quality of electricity supply for consumers and businesses, but more investment and initiative must occur to address this issue.

Lastly, Ukraine must communicate to investors her vision for future patterns of energy consumption, and particularly heating sources. On April 1, the government increased heating prices for consumers by 285 percent in accordance with its IMF agreement. Still, these prices remain under 75 percent of real market value, and government subsidies, which should be allocated as social assistance for vulnerable households, reportedly enrich corrupt officials and oligarchs. According to a studypublished by VoxUkraine that analyzes the pros and cons of increased tariffs on the population, gas hikes can incentivize households to pursue energy savings and overall efficiency through structural investments to their property which increase insulation. Nevertheless, given the difficult economic environment and limited work opportunities in Ukraine, some households simply cannot afford to insulate their homes and have relied on subsidies for heating. For the time being, it should be in the interest of officials to offer low-income subsidies for these households, while simultaneously curbing tariff arbitrage.

It is time for international donors, politicians, and businesses to coordinate their plans to address Ukraine’s immediate energy problems, while developing a synthesized vision for the future. This plan must be comprehensive enough to include Ukraine’s own resources, its domestic transmission and distributions systems, and trade links with partner nations and companies. Finally, Ukrainian officials have to prove to international investors that an improved political environment will be sustained for the duration of this transition from status quo business practices to a next generation national energy model.

This article is published in collaboration with Above the Fold. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Gary Litman is Vice President of International Strategic Initiatives at the U.S. Chamber of Commerce.

Image: An employee stands near gas pipes at Oparivske gas underground storage in Lviv region September 30, 2014. REUTERS/Valentyn Ogirenko