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Ukraine energy 2018: Historic victory over Gazprom and tariff hike

The year of 2018 brought Ukrainians a rise in gas prices, new central heating tariffs, and swings in petrol prices, while we also witnessed Naftogaz’s historic victory over Russia's Gazprom. In 2019, no less fateful events are expected as a new competitive electricity market will be launched.

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The past year has shown that Ukraine can, and must, secure wins over Russia on all fronts, both military and economic. The triumph of NJSC Naftogaz over the Russian gas monopoly Gazprom in the Stockholm arbitration became an unprecedented event not only in the history of relations between the two countries, but also for the whole of Europe.

Ukraine, represented by Naftogaz, sued Gazprom over the two contracts concluded in 2009: for Russian gas transit to the EU and own purchase of Russian gas.

First, the arbitration rejected the demands of the Russian side in accordance with the “take or pay” principle in the amount of $56 billion, and also reduced the price of gas that was bought from Gazprom in the second quarter of 2014. So, the first arbitration award said Naftogaz had to pay Gazprom about $2 billion for the gas supplied in 2014.

The second award concerned the transit contract, according to which Gazprom had to transport via Ukraine 110 billion cubic meters per year. In this dispute, the court sided with Ukraine and ordered that Gazprom pay Naftogaz $4.63 billion.

Thus, based on both cases, Gazprom owes the Ukrainian company $2.56 billion. At the same time, daily interest in the amount of $500,000 keeps accumulating – that's until the Russian company executes the arbitration award.

Following a fiasco of such a scale, Russia decided not to comply with the binding decision of the Stockholm arbitration.

Ukraine’s response step was not long in coming. Naftogaz began seizing the Russian monopoly's assets in Europe, in particular the shares of companies that own Nord Stream, Nord Stream 2, and Blue Stream.

However, this victory has all chances to become only the first in a series of equally prominent ones. In July 2018, Naftogaz filed a new lawsuit against Gazprom with the Stockholm Arbitration claiming to revise the tariff for the transit of natural gas in 2018-2019 under a contract with the Russian monopoly and compensate for the underpayment some $12 billion.

The new lawsuit has emerged due to the fact that the issue was never raised in previous proceedings.

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The Ukrainian side is demanding compensation for losses due to Gazprom’s failure to fulfill the gas supply contract (as amended by the previous arbitration). The difference between the revised contract price (whose formula was changed by the previous arbitration award) and the price at which Naftogaz is forced to replace gas supplies from Gazprom with those from Europe is subject to compensation.

At the same time, the new arbitration proceeding does not in any way cancel Gazprom's obligation to pay the Ukrainian side $2.6 billion in line with the previous arbitration award.

Bedides, Naftogaz in international courts demands compensation from Gazprom for the assets of the Ukrainian company that Russian troops seized in Crimea. Ukraine is demanding compensation of about $5 billion in losses ($8 billion with interest).

The Arbitration Tribunal in The Hague The will hold the first round of hearings in the case in the spring of this year.

Fight for transit

Another war that Ukraine is waging in the international arena is to preserve the country’s status as a transit state for Russian gas flows to the EU. The current transit contract between Naftogaz and Gazprom expires at the end of 2019, and the Russian side has not yet shown any will to conclude a new one. Despite the lack of economic feasibility, the Russian monopoly continues building gas pipelines bypassing Ukraine.

The main threat to transit via Ukraine is the Nord Stream-2 pipe, several hundred kilometers of which have already been laid along the bottom of the Baltic Sea. Gazprom assures that the gas pipeline will be completed in early 2020.

In the most pessimistic scenario, this would mean zero transit via Ukraine, or a loss of $2-3 billion in annual revenues, which practically corresponds to the country's gas imports.

In the fight against this move by Russia, Ukraine is seeing support of the United States and many European countries, who know firsthand how Russia is able to use its natural resources as political tools of pressure.

However, Ukraine is yet to do its homework – complete the unbundling process in Naftogaz and separate from the company the country's gas transmission system.

In 2019, the authorities will have to decide on the unbundling model, which would be consistent with Ukraine’s international obligations and not jeopardize Naftogaz’s disputes with Gazprom.

It is advisable to complete the process as soon as possible, so that in the second half of the year Ukraine could attract international partners from among large European companies to manage the GTS, which should increase the country's chances of preserving Russian gas transit and minimizing losses from the possible launch of Nord Stream-2.

Renaissance of Ukrainian gas production

This is hard to believe, but as early as the middle of the last century, Russia was firmly seated on the Ukrainian gas needle. In fact, there were times when Ukraine was a net exporter of gas, while its production was several times higher than today's figures. The decline of domestic gas production coincided with its rise in Western Siberia. Officials in the Kremlin offices decided to throw all resources into that region, while Ukraine faded into the background, to eventually turn from an exporter into a chronic importer.

However, Ukraine has impressive gas reserves estimated at 600-900 billion cubic meters. According to this figure, Ukraine is in Europe's TOP-3, but it is significantly inferior in terms of production to countries with even scarcer reserves.

After gaining independence, Ukraine has repeatedly declared plans to increase gas output, but the only major achievement was the development of the Black Sea shelf. Besides, success in this direction was reset to zero after Russia occupied Crimea.

At the same time, it was the aggression of the northern neighbor that prompted the authorities to take revolutionary steps to ensure independence from external suppliers by increasing own production.

According to the "Concept of development of the gas industry", approved in 2016, Ukrainian enterprises by 2020 were set to reach production levels of 27 billion cubic meters, which, subject to the simultaneous reduction of gas consumption in the country would fully cover the country's demand.

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At the same time, production figures are not yet encouraging. At the end of 2018, Ukraine produced 20.9 billion cubic meters of gas, which is only 0.4% more than in 2017.

Ukraine's largest state-owned gas producer Ukrgazvydobuvannya produced 15.42 bcm, which is only 1.2% more than in 2017, while the country's largest oil producing company, Ukrnafta, as well as private enterprises, showed a decline of 2%, to 1 bcm and 4.4 bcm, respectively.

Such low rates are explained by the fact that the major decisions to facilitate the extraction were made as late as in 2018. The most important innovation was the lifting of an opaque and corrupt mechanism for issuing special permits for subsoil use. Now companies will participate in competitive bidding for the right to develop the fields, while the practice of issuing permits to someone's cronies or those who make some "extra payments" is becoming a thing of the past.

It is worth noting though that some masterminds behind old corruption schemes might be able to find gaps in new rules, so at least in the first couple of biddings, law enforcers and media should keep a close eye on the developments.

The first open auction over the recent years was held in October 2018, where licenses for several sites were sold.

For example, the starting price of a special permit on Lypovetsky Site was set at UAH 3.537 million, eventually rising to UAH 15.087 million, which is 4.27 times higher.

In 2019, the State Service of Geology and Minerals plans to issue special permits via the Prozorro.Sales electronic platform. Already on March 6, 2019, a tender is scheduled for the sale of 10 licenses for sites with expected reserves of 90 billion cubic meters of gas and and 16 million tonnes of oil.

The agency prepared a total of 30 sites for auctioning off via Prozorro.Sales.

Thus, the last corruption obstacle that prevented domestic gas production from developing should fall.

Ukraine may not get rid of import dependence in 2020, as the government program expected, but this will definitely happen in the foreseeable future. All the prerequisites have been created to this end..

Today, Ukraine is forced to import about a third of the gas consumed (in 2018, fuel imports amounted to 10.6 billion cubic meters), which has a negative effect on the price for domestic consumers.

Swings in gasoline prices and tariff hike

One of the most anticipated events of the past year was the government’s decision to raise gas prices for the households from November 1 by 23.5% to UAH 8,550 per 1,000 cubic meters, which led to an increase in heating tariffs, where gas takes up about 86% of the cost.

In December of last year, the National Energy and Utilities Regulation Commission (NEURC) approved new heating tariffs for a number of heat generating companies. From January 1, the tariff has increased by 10-24%. For example, for Kyiv residents, heating bills will rise 22%. 

At the same time, a difficult decision for the Cabinet to raise gas prices has allowed Ukraine to resume cooperation with the International Monetary Fund and agree on a new program worth $3.9 billion.

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At the end of December, Ukraine secured a first $1.4 billion tranche; however, to receive the remaining amount, Ukraine will have to fulfill a number of obligations, in particular, on bringing gas prices to import parity, which means a possible further increase in gas prices depending on changes in the value of goods in world markets.

And as the events of 2018 showed, the world market remains unpredictable.

From mid-August to early October, Brent prices rose by almost 20%, to $84.8 per barrel, also pulling prices at Ukrainian gas stations, which almost daily overcame psychological marks, getting close to UAH 36 per liter at some gas stations.

The forecasts of world analysts were disappointing – by the end of this year, oil could have risen to $100 per barrel.

However, since the second half of October, global oil prices started dropping. For example, by the beginning of 2019, Brent fell to $53 per barrel, against which petrol at Ukrainian retail networks became significantly cheaper, although its price decline is somewhat slower than the rise was.

New year with new electricity market

Starting this year, consumers will be able to choose their electricity supplier, focusing on quality and price, which will not be regulated by the state, but by the market.

Accordingly, there should be competition between energy companies, which has never been in place in Ukraine. The introduction of a new market model is divided into two phases: for businesses, it will start working in the middle of summer 2019, and for household consumers – no earlier than 2020.

At the same time, consumers in the first days of the new year will already feel some innovations brought by the new market.

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From January 1, 2019, two different companies will provide energy services to customers – the distribution system operator and the electricity supplier company.

The distribution system operator will deal exclusively with electricity distribution and maintaining electrical networks. The electricity supplier company will deal with the supply of electricity to consumers and be responsible for charging payments and settlements. Accordingly, customers will have 2 contracts – on the provision of distribution services and on the supply of electricity.

At the same time, the cost of services for residential consumers will not change so far.

The new market should bring competition and market mechanisms into one of the country's main sectors – energy, which could give an additional impetus to economic growth.

However, such large-scale changes will certainly come across the interests of a wide range of people whose actions can easily roll back the effect of reforms that have been launched. Such risks will be most noticeable this year, full of uncertainty in the wake of elections.

Top performance on renewables

For years, renewable energy has shown the best development pace in Ukraine. In 2018 alone, 742.5 MW of new “green” capacities were introduced, which is 2.8 times more than in the record year of 2017.

Thus, the total installed capacity of renewable energy sources in 2018 reached 2.117 MW. The leader in commissioning green energy facilities in 2018 was Kherson region with 227.2 MW.

However, the success story has a downside. Today, renewable energy (without major hydropower plants) accounts for about 2% in the structure of the country's electricity production, while the share of this electricity in the cost of all electricity produced is already reaching 9%.

The thing is that the main mechanism for stimulating the development of alternative energy in Ukraine is via so-called “green” tariffs, which are deliberately set high (higher than in other types of generation, and in many ways higher than in the EU).

Thus, the current pace of a "green" generation buildup in a few years could have made the Ukrainian electricity golden and simply unaffordable for the national economy.

However, the situation that Ukraine is facing is not unique. All countries that began to develop renewable energy much earlier than Ukraine faced the same issue.

In the end, after reaching a certain share of renewable generation in production, many European countries rejected the “green” tariff and switched to the auction mechanism. Ukraine is now following this path.

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At the end of December 2018, the Verkhovna Rada of Ukraine supported in first reading a bill that provides for the transition from the "green" tariff to the auction mechanism for new renewable energy facilities starting 2020.

The mechanism proposed provides for the participation in auctions of wind power stations (WPP) with a capacity of more than 20 MW, and for other types of renewable sources – more than 10 MW – from January 1, 2020.

In 2021 and 2022, it will be WPP projects with a capacity of 20 MW and other energy producers using renewable sources – from 5 MW. From 2023, it will be wind farm projects with a capacity of 3 MW and projects using other types of renewables with a capacity of more than 1 MW.

The difference from the current conditions of the "green" tariff, which is valid until 2030, is that after the auction, support is guaranteed for 20 years from the date of commissioning.

Thus, Ukraine does not plan to abandon the development of "green" energy and its international obligations, but is moving in this direction in step with the entire civilized world, albeit with a slight delay.

In 2019, Ukraine will continue to fight for energy independence by increasing its own gas production, simultaneously punishing Russia in international courts for its long-term "fraternal" attitude towards its neighbor. In 2019, the struggle for justice will continue, and in the end, the aggressor state will be forced to answer for their perfidious actions. So far, only financial-wise…

Ihor Orel

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