The Ukrainian gas market has changed a lot in the last five years. First of all, due to the conflict with Gazprom and the fact that Naftogaz is developing gas purchase practices in the West. Consumption of industrial consumers has fallen sharply in recent years due to various reasons – the economic crisis and the conflict in the East. Consumption of households and consumers also declined, primarily due to economic factors, more efficient consumption and rising prices. Rising natural gas prices have increased interest in Ukraine’s gas production. However, not everything is so cloudless in this market. Public authorities ignore court decisions, the fuel market is still not demonopolized, corruption is flourishing at all levels, and Russia continues to wage a gas war with Ukraine. In fact, gas wars between Ukraine and Russia have not stopped since the very first day of independence. The gas crisis of 2009, which was accompanied by a transit halt and accusations of gas theft, proved to be the largest and most damaging for Ukraine. Then Romania, Hungary, Bulgaria, Croatia, Austria and Greece were left without fuel. All of this ended with the signing of ten-year gas supply and transit contracts, through which Ukraine, according to various estimates, lost $ 10-20 billion and was forced to apply to the Stockholm Arbitration with a request to review certain points of the agreements. Therefore, there are a number of challenges facing the Zelensky team in the gas sector that need to be addressed adequately.
- Transit contract
The current transit contract between Naftogaz and Gazprom will end on December 31, 2019. By the end of 2019, the process of unbundling- the separation of the GTS operator – should be completed. The new operator must sign the new agreement. Negotiations on this issue have been going on for several years, but the parties cannot agree yet.
For Ukraine, stopping the transit means losing $ 3 billion in annual revenue, which is about 3% of GDP. Russia seeks to completely abandon Ukrainian transit services. To do this, it builds gas pipelines bypassing Ukraine: “Nord Stream-2” and “Turkish Stream”. Putting them into operation will allow the Russian monopolist to supply the same volumes of gas to Europe as it does now without using Ukrainian gas pipelines.
Gazprom is currently facing some difficulties in constructing North Stream-2. It is difficult to predict how things will go in the future. Recent calculations by Naftogaz have shown that the Russian side has the technical ability in 2020 not to use Ukrainian transit, even if the Nord Stream-2 is not built.
Negotiations on the new contract are in tripartite format. They are attended by Ukraine, Russia and the European Commission. Until recently, there was not clearly stated position of Gazprom. On the Russian side, it was announced first of all by Vladimir Putin and Alexei Miller. The official proposal from the Russian monopoly was received on November 18. Gazprom’s petition stated that the key condition for the continuation of a valid contract or the conclusion of a new contract was the refusal of both parties to mutual claims in international arbitration and termination of all court proceedings.
In simple words, the Kremlin proposes to forget about the won arbitrations, the current arbitration ($ 12 billion) and the AMC fine. The total amount of concessions the Russians wish is about $ 22 billion. Among other requirements of Russia, which Naftogaz previously disclosed, is harmonization of Ukrainian legislation with EU legislation and guaranteeing the independence of the regulator, which is also important for Ukraine.
Ukraine insists on a ten-year agreement based on European legislation. The minimum volume of transit should be 60 billion cubic meters of gas and another 30 billion cubic meters of gas – an additional option, which is reserved in case of demand growth in the European market.
Gazprom also expects the Ukrainian side’s position on its readiness to buy Russian gas directly from 2020. Naftogaz has repeatedly made it clear that it is ready for it. The main requirement is fair prices.
Possible scenarios for 2020:
- The first is that in early January, the Russian side, according to the 2009 model, announces that Ukraine is stealing gas from a transit pipe and is conducting an exemplary-twisting valve. After that, according to Gazprom’s plan, urgent consultations should start and under pressure from the EU, Ukraine, as in 2009, must agree to some compromise option.
- The second is that after January 1, the parties simply do not notice the new year and continue to work under the old contract. Ukraine will receive the same transit fee as before. In this case, the government rejects this scenario. The current agreement will allow Gazprom to completely refuse transit in a year or two without any penalties, since under the current agreement Gazprom pays the transported volumes and has no obligations either in terms or in terms of volumes.
- Third – after the New Year, due to the lack of a contract, the Ukrainian side is suspending the transit because there are no grounds for its implementation.
It is possible that a new round of gas war with Russia will be protracted. However, Energy and Environment Minister Olexiy Orzhel repeatedly made it clear that the country would do without gas transit. At present, Ukraine has record gas reserves in underground storage facilities – 21.7 billion cubic meters. The biggest risks may arise in February-March when the reserves in storage facilities become smaller. However, stress tests conducted by the GTS operator show that even in peak days, Ukrainian gas consumers will be enough.
The strength of Moscow’s negotiating position is that the EU cannot yet refuse to supply gas from Russia. The Kremlin will try to replicate the 2009 scenario and look forward to Kyiv’s concessions Gazprom may not sign the contract and try to blackmail both Ukraine and EU consumers. However, large reserves in Ukrainian and EU underground gas storage facilities make it difficult to implement such a scenario. It is currently unknown how long Gazprom will be willing to lose its European market share and face penalties from its customers. The last time Gazprom did this – in the winter of 2014-2015 – it lost more than $ 5 billion. However, the decision is ultimately political and is made by Putin.
- Naftogaz unbundling
Naftogaz unbundling is one of the EU’s key requirements for Ukraine and is a necessary prerequisite for concluding a new transit contract. Within the framework of the agreements with the European Energy Community, Ukraine several years ago committed itself to separate the transportation, storage, production and sale of gas. Now all these functions are performed by Naftogaz and its subsidiary Ukrtransgaz.
The key difference in this issue is the control of the gas transportation system, which gives the right to manage billions of dollars. It is about the revenue from gas transit and the ability to influence the tenders of the operator through procurement.A different view of the banding has further cooled the relationship between Naftogaz head Andrei Kobolev and Vladimir Groisman. The Cabinet proposed a scenario under which the control of the “pipe” would be obtained by the government, and “Naftogaz” considered the optimal model with ISO (Independent system operator) – an independent operator to use the GTS on concession rights.
Former Prime Minister Groisman has said that unbundling should be completed by the end of 2019. After the change in power, Naftogaz and the Cabinet reached a consensus.
On October 31, Parliament passed a law establishing a company that would be responsible for transit of Russian gas through Ukraine and supplying natural gas to consumers. According to Orzhel, unbundling will take place on an ISO model with the transition to OU. This was done to eliminate the contradictions that existed in the positions of Naftogaz and the Groisman Government
The document envisages the creation of a separate company – “GTS Operator”. The new operator must gain independence not only from the former owner – Naftogaz, but also from any other influences from the producers and suppliers of gas and electricity, in particular through the vertical of the state authorities. According to the ISO model, the assets of GTS should remain the property of Naftogaz by January 1, 2020, and the management of these assets will become the competence of the independent operator – LLC “GTSU Operator”, “daughter” of “Ukrtransgas” from November 1. The GTS operator will be transferred to PJSC “Trunk Gas Pipelines of Ukraine”, which will be transferred to the corporate management of the Ministry of Finance. After the separation, the ISO model has to become OU since January 1, 2020: Naftogaz will lose ownership of the gas transportation system, and the state (MoF) will become the legal owner.
Ukrainian officials say the adoption of the law will improve Kyiv’s negotiation position in the upcoming gas talks with Gazprom on a transit contract. The fact is that Ukraine insists on signing a contract based on European rules, and for this it is necessary to create an independent operator, who will sign an agreement with the Russian monopolist. However, many experts consider that unbundling is unlikely to improve Ukraine’s position in negotiations with Russia, even if all technical problems are resolved. Russia will still look for elements of non-compliance.
But, even if Russian gas will bypass Ukraine, unbundling is still needed, as it is a requirement of an association agreement with the EU and an agreement on accession to the Energy Community. After completion of the process, Naftogaz will cease to be a monopolist in the main gas transportation. From January 1, 2020, the Naftogaz should lose influence on the operational activities of the new independent operator.
An important issue is attracting a foreign investor. Talks about this lasts for years. A year ago, Kobolev estimated the value of the GTS $ 14 billion. However, he admitted that European partners have no desire to buy a share of the “pipe” at such a price. At different times, dozens of European gas consortia were interested in the Ukrainian GTS. Consortia from Slovakia and Italy – Eustream and Snam, the Netherlands and France – Gazunie and GRTgaz, companies from Poland – GAZsystem, Greece – Desfa, Spain – Reganosa, Germany – Verbunddnelz Gaz AG, Belgium – Fluxys, Romania – Transgaz. For this moment, the probability of attracting a foreign investor seems extremely doubtful.
- Increase in gas production
The Groysman government planned to fully supply Ukraine with gas by 2020. To solve this problem, in 2016, the state-owned company Ukrgasvydobuvannia (UGV) presented the 20/20 program – a project to increase gas production by 2020 from 14.5 billion cubic meters to 20 billion cubic meters. However, it can be stated that the 20/20 program failed: in 2018, Ukrgasvydobuvannia produced only 15.5 billion cubic meters of gas. Naftogaz explains this by the absence of new licenses for the development of subsoil and lack of financing.
The failure of the program, among other things, led to the dismissal of UGV chief Oleg Prokhorenko. However, the new UVG management also plans to increase gas production. Prime Minister Goncharuk also sees a solution to the problem of high tariffs for the population in increasing of own production. However, talk about “cheap” Ukrainian gas under the current import parity pricing model is populism. Currently, the price of gas for the population is formed by the average cost of gas on a German hub. This applies not only to imported gas, but also to gas produced in Ukraine. That is why the increase in own production without changing the pricing model will not be effective. But it can significantly reduce the outflow of currency from the country.
- Utility tariffs
During the presidential campaign, the Zelensky team often touched on the painful topic of high tariffs for the population. Zelensky himself never openly promised to lower tariffs, but said they were too high for Ukrainians. After winning the election and taking office, the majority of respondents in various polls said that the most expected of Zelensky was the tariff reduction. Therefore, the issue of tariffs remains a significant challenge for Zelensky and his team.
Since April, gas prices for the population have actually decreased. In five months, blue fuel lost 25% of its value, but market conditions contributed to this. There is a risk that the gas will rise again in winter. Already in November, the price of gas for domestic consumers increased by 14.6% compared with October – up to 4889 UAH per thousand cubic meters excluding VAT and transportation costs.
Nevertheless, according to the ministry’s forecasts, gas prices for the population will fall to historic lows if Ukraine signs a new transit contract with Gazprom. Also, from January 1, 2020, the government will no longer regulate gas prices for the population. The Cabinet of Ministers plans to introduce an “insurance” gas price for Ukrainians, which will be 7% lower than in the first quarter of 2019.
- Subsidy monetization
In Ukraine, about 4 million families out of 14 million receive subsidies for housing and communal services. Over the last five years alone, over UAH 250 billion has been spent on budget subsidies.
In 2014, UAH 6.9 billion was spent, in 2015 this amount increased to UAH 19.1 billion, in 2016 – to UAH 46.4 billion. In 2017 and 2018, UAH 72.4 billion and UAH 72.7 billion respectively were allocated from the budget for subsidies. The total amount allocated for payment of subsidies for 2019 was 55 billion UAH.
However, the ten-year subsidy system was ineffective in terms of promoting resource efficiency. However, experience shows that the monetized form of subsidies stimulates the subsidy to save gas. Prior to the move to monetization, subsidies consumed 1.6 times more gas for individual heating than non-subsidies.
Thus, another important direction for the new government was the full transition to the monetized form of subsidies. The 2020 budget provides for only monetized form of subsidy, which is a positive one. However, it is important that in the coming years, there will be no return to the previous subsidy system.