Ukraine’s Energy Challenges: Some Homegrown; Some Russian

US-Ukraine Energy Dialogue III:
Securing Ukraine’s Energy Independence

Ukraine’s Energy Challenges: Some Homegrown; Some Russian

Keith C. Smith

Featured remarks by CSIS Senior Associate Keith Smith, delivered at “US-Ukraine Energy Dialogue III”, Capitol Hill/Hart SOB Ninth Floor Forum Room, Washington, D.C., April 15, 2008.


A dynamic, efficient energy sector is a major prerequisite for Ukraine’s development into a vibrant market economy that will rapidly improve living standards. Because of the corruption that has characterized much of the energy sector, Ukraine will need to make the industry much more transparent if Ukraine is to develop a Western-style democracy capable of protecting its national security interests, and which cements closer ties with the European Union. It will also make these changes in order to more effectively resist Russian efforts to control Ukraine’s energy transportation routes and production facilities.

Ukraine is a highly inefficient user of energy. In fact, Ukraine has the highest ratio of energy use to per capita GDP in the world, giving the country the world’s most energy intensive economy. Ukraine has extensive reserves of coal and remains a significant producer of coal. It also has a large nuclear power industry. However, it relies heavily on imports of oil and especially gas for its energy needs, all of which is controlled by Russian companies.

Most of Ukraine’s oil comes from Russia, domestic production is quite small. Ukraine has six major refineries, almost of all of which are controlled by Russian firms. TNK-BP, Lukoil, Taftneft, and Alliance all own refineries. Refinery operators have been in a difficult position on the Ukrainian market. On the one hand, Russian refineries receive cheaper crude oil because they do not have to pay the high export tariffs the Russian government imposes on crude exports. On the other hand, Ukrainian refineries are relatively unsophisticated and inefficient, so they have a hard time competing with cheaper imported gasoline and diesel fuel from Central Europe.

Natural gas is more important than oil for Ukraine. The country consumes five times more natural gas than oil in energy equivalent terms. Although Ukraine covers about a quarter of its natural gas consumption from domestic production, like crude oil, most of the natural gas consumed in Ukraine comes from imports from Russia, Kazakhstan, Turkmenistan, and Uzbekistan. All of these imports are routed via Russia.

Ukraine’s energy sector is complicated by the country’s role as a transit country for the vast majority of Russian exports of oil and gas to the European Union. More oil and gas traverses Ukraine than any other country in the world. The gas transit trade is particularly opaque, leading to speculation concerning corruption by the companies involved. In contrast to oil where a number of Russian exporters compete with suppliers from the Middle East, a single state-controlled company. Russia’s Gazprom, the state natural gas export monopoly, controls all the gas exports to Ukraine and the company and its partners sell gas at different prices and through different arrangements throughout Europe, including Ukraine. In the case of Ukraine, Gazprom channels exports through an intermediary company, jointly owned by itself and two Ukrainian citizens. This arrangement is presently opposed by the Ukrainian Government, but is strongly backed by Russia.

Within Ukraine, Gazprom collaborates with powerful groups of business interests to create a non-transparent system that keeps out more transparent Western competitors, thereby threatening Ukraine’s security interests. The opaque system of energy imports and sales has until recently had the strong support of much of the country’s political leadership. Nevertheless, Ukraine remains highly dependent on decisions made in Moscow and by off-shore companies. This has lessened the incentive to make progress in improving energy efficiency or to develop competing supplies of gas and oil.

These vested interests, both political and business, have actively discouraged Western investment in the energy sector, leaving Ukraine with one of the lowest levels of foreign direct investment in energy in the region. Too many powerful individuals in Ukraine view foreign investment as a win-lose proposition, firmly believing that they and Ukraine would lose financially if Western firms were to increase their presence in the country’s energy sector.

Ukraine is the key energy corridor bringing oil and gas shipments to Europe from Russia and Central Asia and could play an even more significant role in Europe’s attempt to achieve greater energy security. Wide ranging improvements in economic transparency, in the rule of law, in setting realistic energy tariff systems and in diversification of import sources would strengthen Ukraine’s economic and political links with Europe. If Ukraine were to open up its energy sector by using market prices and reducing barriers to foreign investment, it would increase its own influence over energy policy decision and might even induce Russia to introduce additional reforms into its own energy sector.

Maintaining Some Ukrainian Control

In spite of continued Russian pressure, much of Ukraine’s political elite is determined to retain control of its major gas pipeline system rather than allow it to be controlled by Gazprom. There is growing support in the parliament for identifying additional sources of revenue that can be earmarked for the much needed renovation of the main gas and oil pipelines. Up until recently, pipeline explosions caused by poor maintenance and a lack of modernization have only reinforced Moscow’s claims that only Russia has the technical and financial ability to keep the pipelines in sufficiently good shape to guarantee gas supplies to Europe.

The off-shore production sharing agreement between the American company, Vanco Energy, and the Ukrainian Government, signed in mid-October 2007, was the culmination of the country’s first off-shore energy production and development tender. Encouraged in part by Vanco’s apparent success, Shell Oil Company has tentatively agreed to commit at least $100 million for joint exploration and development activities, with the prospect of a considerably larger commitment once some of the present political and legal hurdles are overcome. However, foreign firms are generally required to bring in a politically-connected “business partner” in order to cement a production deal.

USAID, the World Bank, the EBRD and the European Commission are anxious to help Ukraine modernize its energy infrastructure, develop a progressive tariff system and integrate the country’s energy sector with those of Western Europe. To have a major impact on Ukraine’s energy sector, this assistance will require a greater degree of business and governmental transparency than is currently desired by some key elements of the political elite and domestic firms that have benefited from close ties with Russian companies.

There is a greater awareness in Ukraine of the need to diversify the country’s sources of oil and gas and to reduce domestic consumption through increased efficiency. Ukraine is fortunate in that the country contains significant reserves of oil and gas, both on and off shore, massive coal deposits, Europe’s best coal-bed methane prospects, and at least six functioning nuclear reactors, backed by a sophisticated nuclear industry.

With more enlightened energy policies and stronger rule of law to support contracts, Ukraine has the capability to cut in half its import dependency over the next 15 years. Reform would also strengthen Ukraine’s position when negotiating energy import prices with Russia and the Central Asian suppliers of natural gas. These steps would significantly bolster Ukraine’s national security interests which are under threat by Russia. Recent comments at the NATO Bucharest summit by President Putin and Foreign Minister Lavrov challenged Ukraine’s right to exist as a sovereign nation. Reports by NATO officials charge that President Putin even threatened to dismantle Ukraine if it pursued NATO membership. This followed Putin’s warning that Russian nuclear missiles would target Ukraine if it joined the Alliance.

Gazprom, acting through alleged joint stock companies, and with the acquiescence of Naftogaz Ukrainy, has over the past two years increased its control of Ukraine’s domestic gas market. Indirectly, this has given Russia greater control over large parts of the Ukrainian economy, adding to the disincentives for Western competitors to invest in energy development in Ukraine. The Tymoshenko Government, however, is determined to limit the control of Gazprom to 25% of Ukraine’s domestic market, but there is a constant struggle between Russia and Ukraine over this issue. Some of Ukraine’s political and business interests, however, may benefit financially from promoting Russian domination of Ukraine’s domestic markets. Breaking up the symbiotic relationship between non-transparent Russian and Ukrainian interests is a difficult task, particularly when 80% of Ukraine’s gas imports are controlled by Russia –even if they originate in Turkmenistan.

Recommendations for Ukraine:

The Ukrainian government should quickly set in train a program to use markets to set energy prices or, in the case of gas and electric power to move to full-cost recovery levels. Energy tariffs (prices) in both the industrial and consumer sectors should reflect real import and domestic production costs. Only with appropriate price signals will Ukrainian producers, importers, and consumers make the decisions that will result in the efficient utilization and production of energy in Ukraine. All consumers except households should be charged the full cost of power. The government should set up a schedule to move households to prices that completely cover costs, supplemented with policies to cushion the impact of higher prices on the most vulnerable families. Domestic producers of gas and oil should receive the same prices as foreign suppliers.

Naftogaz Ukrainy should be restructured so that production, pipelines, and distribution are handled by independent subsidiaries. Internal transfer pricing between these subsidiaries should be made at market or full-cost recovery prices. Transit and other prices should be set high enough to cover the cost of modernizing and renovating the existing pipeline system.

Ukraine should eliminate its contracts with intermediate companies and negotiate gas purchase contracts directly with Gazprom. This move would weaken the hold over the market of Ukrainian business groups and politicians who benefit financially through their collaboration with Russian state-controlled energy entities.

Ukraine should attempt to negotiate the construction of new transit pipelines with Gazprom. Alternative pipelines, such as Nord Stream and South Stream, both officially supported by the European Union, will weaken Ukraine’s bargaining power with Russia and reduce transit fees now paid to the Ukrainian treasury. Ukraine’s energy security and future transit fee income will be greater, if Russia’s oil and gas exports to the EU continue to traverse Ukraine.

Ukraine should restart the privatization of the remaining assets in the energy sector through open tenders for all assets. Such a program should draw the interest of European and American companies, thereby bringing more diversified ownership of Ukraine’s energy infrastructure.

Ukraine should adopt energy efficiency standards similar to those in the EU.

Taxes on exploration and development projects should be reduced to bring them more in line with Western levels. The law should also make it easier for holders of exploration licenses to also secure production licenses, thereby encouraging more foreign direct investment (FDI) in the energy sector.

Ukraine should implement the transit protocol of the European Energy Charter that stipulates the creation of a “common carrier” system. Ukraine should also sign and implement the Athens Energy Treaty to encourage more FDI in the energy sector.

Recommendations for the EU and United States

The U.S. and EU should provide technical assistance to Ukraine to meet goals for transparency set by the IEA, World Bank, EBRD and EU. The U.S. and EU can help draw up open tenders in line with international standards and that contain provisions for Stockholm arbitration of disputes in the awarding of exploration, development and distribution rights.

Western assistance agencies and development banks should fund and support twinning programs and open audits involving representatives from the above organizations working alongside Ukrainians in the Energy and Industry ministries, in the state oil and gas companies, in Ukrtransnafta and Naftohaz Ukrainy, and in the oversight committees in the Rada. The presence of foreign specialists should stimulate progress in implementing best business practices concerning energy imports, domestic production, energy transportation, refining and marketing.

Countries with efficient central residential heating systems, such as Finland and Sweden, should be encouraged to provide technical assistance to Ukraine. This assistance should include help in upgrading and metering all multi-unit residential systems and small businesses tied into the energy system. Assistance from the World Bank and the EU, including supervised metering systems, should be used to ensure that the illegal diversion of oil and gas supplies from existing pipelines be stopped. The costs of diversion are ultimately paid for by Ukrainian and European consumers.

The United States and the EU should encourage the World Bank and the IEA to help the Ukrainian Government formulate a long-term energy strategy that would increase domestic production of oil, gas, nuclear energy, clean coal and alternative fuels, as long as the production process are competitive with oil and gas imports. They should encourage the IAEA to help Ukraine develop a more robust program to increase efficiency and safety at all its nuclear plants. Inefficient coal mining and processing should be gradually phased out and funding put into more environmentally friendly and cost effective technology.

The EU and U.S. should support Ukrainian efforts to negotiate direct purchase contracts with in Turkmenistan, Kazakhstan and Azerbaijan. Ukraine should not have to pay prices that are set by the Kremlin for non-Russian energy.

Due to the complex and non-transparent energy market in Ukraine, reforms in this sector can have multiplier effects; for example in breaking the hold of non-transparent business Russian and Ukrainian business groups over the country’s political system. It would also speed Ukraine’s economic and political integration into the West.

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