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    Ukraine’s gas monopoly prepares for change [NGW Magazine]


Naftogaz tells NGW it is still hopeful that Nord Stream 2 will be blocked and is making bullish assumptions about gas transit when Gazprom’s present contract ends. (This article is featured in NGW Magazine Vol. 3, Issue 17)

by: William Powell

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NGW Interview, Featured Articles, Europe, Premium, NGW Magazine Articles, Volume 3, Issue 17, TSO, Nord Stream 2, Ukraine

Ukraine’s gas monopoly prepares for change [NGW Magazine]

NGW: Why has the unbundling of Ukrtransgaz been delayed so long? It was supposed to happen soon after the Stockholm arbitration.

Naftogaz: The position of the Russian gas export monopoly Gazprom on amending the transit contract with Naftogaz prevents the unbundling to proceed until the expiration of the contract [December 31, 2019]. An earlier transmission system operator (TSO) unbundling requires either Gazprom’s written consent for the new TSO to enter the contract or reaching a consensus with Gazprom on relevant amendments to the current contract. Both options have been so far unattainable.

At the Berlin meeting with the European Commission (EC) Naftogaz once again offered to change the contract immediately to enable the unbundling, however, Gazprom declined again. The EC has acknowledged this means that the TSO unbundling is not possible until 2020, when the current transit contract with Gazprom expires (See box).

Prior to these talks, Naftogaz tried to open the way to the unbundling via the Stockholm arbitration but the tribunal decided this matter was out of its scope.

Nevertheless, Naftogaz is actively preparing for the TSO unbundling in 2020. The company has engaged PwC to support the transformation of Ukrtransgaz and prepare it for the TSO unbundling. Currently the consultants are focused on three key work streams:

1) Identification of natural gas transmission assets not involved in transit activities and organization of transfer of such assets to Magistralnye Gazoprovody Ukrainy [Gas Trunklines of Ukraine]. This should happen in accordance with the following criteria:

(a) the transfer of these assets does not jeopardize transit activities or any obligations of Naftogaz of Ukraine or Ukrtransgaz under the transit contract with Gazprom;

(b) the transfer is compliant with both primary and secondary legislation of Ukraine; and

(c) separation will not pose risks to the further financial sustainability of both operators. 

2) Development of a roadmap for Branch TSO extension and separation into a legal entity within Naftogaz of Ukraine. 

3) Assessment of functions to be transferred to the Branch TSO and implementation of a pilot project for the optimisation of selected functions and their transfer to the Branch TSO.

Based on the results of the above focuses, Naftogaz of Ukraine will plan and initiate longer-term preparations for the unbundling of the TSO in the post-2019 period.

NGW: Regarding future gas transit, what steps if any has Naftogaz taken to mothball or decommission old pipelines carrying Russian gas and what steps has it taken to modernise the system? 

Naftogaz: At this stage, we are neither mothballing nor decommission our pipelines, as we cannot forecast post 2019 transit volumes. It is possible that Nord Stream 2 is blocked or delayed due to possible US sanctions or amendments to the EU’s gas directive or some other factors. The EC and the German government have expressed the need to preserve “meaningful volumes” of transit via Ukraine to protect EU energy security. However, if Nord Stream 2 and Eugal [the onshore line south through Germany] are constructed and used, they will make much of Ukraine’s system a stranded asset. Gazprom is so far unwilling to let its buyers decide where they would like to receive the gas they bought which is further proof that the Russian company is abusing its dominant position. These issues are discussed during in the trilateral format originated by the EC.

Naftogaz is committed to maintain 110bn m³/yr until the end of 2019 under the contract with Gazprom – and the Stockholm tribunal has ruled that Gazprom has to pay for this capacity. The system is servicing Gazprom’s orders flawlessly, and Naftogaz ensures all necessary maintenance works are done and financed on time. Beyond that, Naftogaz and Ukrtransgaz (the current TSO) are implementing a wide-scale modernisation program, which includes the reconstruction of five key compressor stations. Regardless of the future transit volumes, these assets are necessary to serve the internal market of Ukraine. 

NGW: Can you please update our readers on the decision of the Stockholm arbitration court and the resulting payments due Naftogaz?

Naftogaz: The Stockholm Tribunal awarded damages of $4.63bn in the transit case. The award means that Gazprom has to make payments to Naftogaz in the order of $2.56bn after residual payments for gas delivered in 2014 and 2015 have been settled.

The Stockholm awards are final and binding, though Gazprom tried to challenge them in the Svea Court of Appeal. It cited the procedural aspect and a dubious linguistic expertise allegedly proving that the awards had been written by third parties instead of the arbitrators. The attempt was vain, as the Court of Appeal rejected this “linguistic” argument.

Nevertheless, the Russian gas monopolist continues to ignore the awards of the Stockholm Tribunal. Naftogaz has received nothing of the remaining $2.56bn from Gazprom yet and it is seeking to enforce the awards through freezing Gazprom’s assets in some European jurisdictions, including the Netherlands, Switzerland, and the UK.

Based on financial media reports, these legal efforts have forced Gazprom to cancel a planned Eurobond issue in Luxemburg, owing to the risk of having the proceeds frozen. Other reports suggest that UK banks have suspended capital raising projects with Gazprom for the same reason. Further proceedings in European jurisdictions are underway.

NGW: Have you informed Gazprom what it will cost to transport its gas from 2020 and the methodology used? 

Naftogaz: In May 2015, Ukraine adopted the new law on Gas market, which transposes relevant EU regulations into Ukrainian legislation. Since then, Gazprom has known that the tariff methodology will change and there will be no more dollars/’000 m³/’00 km. The new tariff system was introduced on January 1 2016. Since then, the tariffs have been set by the regulator and no longer by contract between two companies. However, Gazprom is ignoring this legislative change.

On July 13, 2018, Naftogaz submitted a proposal to change the methodology for calculating gas transmission tariffs to the National Commission for State Regulation on Energy and Utilities of Ukraine (NCSREU). These are aimed at bringing the methodology into line with the requirements of EC Regulation (EU) 2017/460, adopted in March 2017 and harmonising transmission tariff structures for gas. Implementing the new methodology could result in a reduction of gas transit costs by a factor of 2.3, compared with the current regulated tariffs provided certain conditions are met.

Naftogaz’ proposal also takes into account the intention of the Energy Community Secretariat to make Regulation 2017/460 mandatory for all members of the Energy Community.

Changes to the methodology were developed by Ukrtransgaz and a team of international experts with extensive experience in advising national energy market regulators in Europe. Naftogaz proposed to the NCSREU its amendments to the tariff-setting methodology for the new five-year regulatory period starting from 2019.

Among other proposed changes, the submission provided for:

(a) bringing the methodology of allocation of allowed revenues between tariffs for entry/exit points in conformity with requirements of Regulation 2017/460;

(b) adding reconciliation for under-recovery and over-recovery of allowed revenues in the current regulatory period during next two regulatory periods;

(c)  clustering of some entry and exit points – including entry points for gas production in Ukraine, entry interconnection points on the eastern border, entry interconnection points on the western border, exit points to distribution system operators and direct consumers.

In addition to the tariff methodology changes, Naftogaz has submitted to the NCSREU an indicative calculation of tariffs for entry and exit points in accordance with such proposed changes, and based on long-term regulated parameters approved for the current regulatory period. These parameters include regulated rate of return on assets and efficiency coefficients for operating costs.

Naftogaz assumed that the pipeline system will be fully used at exit points to the EU, or 141bn m³/yr, which is equal to factual transit volumes in 1998.

This could be possible if Nord Stream 2 is not built and if gas produced by private Russian companies and companies from Central Asia is allowed by Russia.

Based on this scenario, the average cost of gas transit through the territory of Ukraine in the next regulatory period, converted from capacity-based tariffs into volume- and distance-based tariff, would be about $2.17/’000m³/’00 km (including VAT and fuel gas).

This is a fifth less than the existing transit contract between Naftogaz and Gazprom, and 2.3x less than the average cost of gas transit according to the regulated entry/exit tariffs established by the NCSREU in December 2015. It is also lower than the expected average cost of gas transmission on a distance basis through Nord Stream-2. This comparison reinforces the attractiveness of the Ukrainian gas transit route and raises further doubt regarding the economic rationale for Nord Stream 2.

Under the same parameters, the tariffs for domestic entry points for the Ukrainian gas producers are estimated at hryvnia 127/’000 m³ including VAT; and at hrynia 136/’000 m³ including VAT for domestic exit points to distribution systems and direct consumers.

Under other parameters (inter alia, with respect to the expected volumes of booked capacities), the estimated tariffs should change accordingly. In particular, the adjustment procedure provided for by the methodology envisages a review of tariffs in case of changes in the forecasted volumes of booked capacities.

In addition to the submitted proposed changes to the tariff methodology, Naftogaz group plans to develop a proposal for the consideration by the NCSREU with respect to multiples applied to reference tariff (which take into account the duration of capacity booking), and a proposal about conditions of using discounts for capacities with restrictions. The proposed methodology is now being considered by the regulator. 

NGW: What has happened to residential gas prices and what proportion of that sector is actually metered? 

Naftogaz: The industrial segment of the Ukrainian gas market is fully liberalised and competitive, with more than 500 traders operating in it. Naftogaz has recently published its price offer for industrial users in September, which is hryvnia 10 208 – 11 115 ($363 - 395)/’000 m³ net of VAT. Naftogaz’s share of the industrial segment is less than a tenth. Naftogaz is one of many gas suppliers in this segment. Other suppliers set their prices and conditions freely based on their assessment of the demand. 

The residential segment remains regulated by the government through public service obligations (PSO) imposed on Naftogaz. Between April 2014 and April 2016, the gas price for households has been raised by the government by approximately eight times in local currency terms. It reached import parity during the last revision in April 2016.

However, since then gas prices in the European gas market have more than doubled, and the hryvnia has lost about a tenth of its value. Naftogaz sells gas for hryvnia 4,942 ($176)/’000 m³ under PSO to designated intermediaries and heat producers. The government is likely to revise the current price following the discussions with the International Monetary Fund in the coming weeks.

Based on the information available to Naftogaz, about 92% of the gas consumed by households is metered. There are still quite a lot of consumers who are billed by norms; but they are mostly small volume consumers. We share the opinion that 100% of consumed gas should be metered.

NGW: Thank you very much.


Unbundling set for 2020

Naftogaz and the independent transmission system operator-to-be, Magistralni Gazoprovody Ukrainy (MGU), have set a timetable for the unbundling of the latter: January 1, 2o2o. Naftogaz supervisory board is chaired by former British gas regulator Ofgem, Clare Spottiswoode; her counterpart at MGU is the former head of Austrian regulator E-control, Walter Boltz.

MGU was set up by the Ukrainian government and, like Naftogaz, has a supervisory board with a majority of independent members, said Naftogaz September 12. Its major contract is with Russian exporter Gazprom, which has objected to the assignment of the contract to a separate company.

Spottiswoode said that the boards of Naftogaz and MGU were demonstrating commitment to work collaboratively to make the unbundling happen while ensuring operational efficiency of gas transmission. Boltz for his part said that this understanding "is a solid step on the way to unbundle the TSO by 1 January 2020. We set as our first priority the need to guarantee security of supply for Ukrainian gas consumers and assure uninterrupted gas transit to Europe.”

Commenting on the unbundling plans to NGW, one industry observer in Kiev said that giving the contract to PwC Poland might not be the best choice in terms of competition. “Poland is not a model of market openness,” he said, “and yet Naftogaz has talked about the Polish approach.” A number of traders have given up on the Polish market. He also said that the government was not monolithic and there was “a government within” working to a different agenda, slowing down the rate of reform.

And commenting on the contractual risk, he was surprised by Naftogaz remarks. “According to its 2017 annual report, it received $2.77bn from transiting 93.3bn m³ that year (or $29.6/’000 m³). But it claims it made hryvnia 14.5bn ($542m) in accounting profits from transit, applying depreciation expenses.

“UkrTransGaz (UTG), according to its 2017 annual report, had revenues of hryvnia 51.2bn from all its activities and yet ended up with a net loss of hryvnia 24.8bn. 

“Hence, the question arises: how would a company like UTG with revenues of $2.77bn from already mature and depreciated assets manage to make a loss? This raises a wider question: in whose interest is Naftogaz managing the GTS?”