Ukraine’s slow path to reform [NGW Magazine]

Ukraine has chalked up several key successes in its drive to reform its gas market. But each step forward has been met with resistance, and there are still outstanding challenges.

At the centre of reform effort is national gas supplier Naftogaz. But US businessman and former diplomat Amos Hochstein resigned in early October from the company’s supervisory board, citing frustration over opposition to change as well as political interference.

A success story

Ukrainian energy reforms began in 2015, the year after its Maidan revolution, when parliament enacted a long-awaited law aimed at breaking up Naftogaz’s monopoly over the sector, expanding competition and aligning laws and practices with the EU’s Third Energy Package. The road has been slow, but there have been notable achievements. Ukraine has to a large degree transposed and implemented EU energy legislation, going further in some cases than EU members such as Slovakia.

“So this makes it a success story, but of course there are still some things that do not function perfectly,” Janez Kopac, director of the Energy Community (EC) Secretariat, told NGW.

Ukraine joined the EC, a body that aims to assist non-EU countries liberalise their energy markets in line with bloc norms, in 2011. Its secretariat publishes a progress report on its members each year, and Ukraine has scored comparatively well. The next report is due to be released in mid-November. Other members include Moldova and the western Balkan republics of former Yugoslavia.

Transposing EU law paved the way for Ukraine to spin off and certify national gas transmission system operator GTSOU, formerly part of Naftogaz, in December last year. But even that was not straightforward: Gazprom signed the EU-compliant transport contract with Naftogaz instead, as it wanted to avoid – as Naftogaz put it in an email to NGW – “potential risks of regulatory changes.” So most of Gazprom’s monthly prepayments goes to GTSOU, and Naftogaz says it keeps less than 5%.

But there have been efforts to roll back the progress made in market reforms. “There were attempts to diminish the independence of the transmission system operator by constant changes to its statute,” Kopac said. “Here we have some clout at the ECS as the TSO’s certification is conditional on our positive opinion and we can always threaten to revoke that opinion.” This highlights just how reform in Ukraine has been a “constant battle,” the director said.

In May this year Walter Boltz, the chair of the supervisory board of state company MGU that manages GTSOU, was dismissed because of “improper organisation” of the board’s work. Boltz, a senior EU energy advisor and former chair of the pan-EU regulatory panel Acer, has defended his performance. Two other independent board members at MGU threatened to resign but retain their posts for now.

Also in May, a group of Ukrainian lawmakers led by former prime minister Yulia Timoshenko made an unsuccessful attempt to get GTSOU’s unbundling declared illegal. One of those MPs Viktor Medvedchuk went on to file a draft law on October 8 proposing the removal of independent directors at joint-stock companies like Naftogaz. They would be replaced by five voting directors who are Ukrainian citizens and two advisory directors.

The motion is very unlikely to pass, given that the ruling Sluga Naroda (Servant of the People, which is also the name of a television political satire starring the current president, Volodymyr Zelensky) party with a sizeable majority in parliament opposes it. But it demonstrates the resistance to corporate governance reform in some political circles.

Efforts at sabotage

Hochstein quit the position he had held at Naftogaz for three years on October 12. In a statement, Naftogaz said the former Obama administration diplomat had “urged the Ukrainian government to further ensure the independence of supervisory boards at state-owned enterprises in Ukraine as a safeguard against corruption.”

Hochstein was much more forthcoming in an article he wrote for the Kyiv Post on October 12. While praising Naftogaz’s achievements, he said the board’s work had been “resisted at every step of the way.

"The company has been forced to spend endless amounts of time combating political pressure and efforts by oligarchs to enrich themselves through questionable transactions,” he said. "These efforts at sabotage increased over the years as the international community experienced Ukraine-fatigue and the Trump administration no longer pursued an anti-corruption agenda.”

He drew attention to a memorandum that the Ukrainian government signed in May with an until-then unknown US company called Louisiana Natural Gas Exports on US LNG supplies to Ukraine. One of Louisiana Natural Gas' executives Robert Bensh was then offered a seat on Naftogaz's supervisory board.

"Every part of this sordid affair represents the ills and dangers facing Ukraine as it slides back towards its past," Hochstein continued. "Signing an agreement with an unworthy and questionable US company while appointing its executive, a man who worked for the very same corrupt Yanukovych and [ex-energy minister] Yuriy Boyko schemes that the EuroMaidan Revolution sought to oust and end."

Hochstein took on the role at Naftogaz after all its independent directors resigned in 2017 over the government’s lack of commitment to corporate governance reform. The current board, chaired by Clare Spottiswoode, a former UK gas market regulator, includes Bruno Lescoeur of France and Ludo Van der Heyden of Belgium, along with state representatives Nataliya Boyko and Yuliya Kovaliv. No other board members have suggested they will resign as yet.

Zelensky, who replaced Petro Poroshenko in May 2019 after winning a landslide in elections, has vowed to ensure the independence of state institutions. But in another sign of continued interference, Ukraine's central bank governor Yakiv Smolii resigned in July because of what he said was "sustained political pressure," prompting concern from the IMF over the institution's independence.

In an encouraging move, however, Ukraine’s cabinet on October 21 approved a new ownership policy at Naftogaz in line with OECD guidelines. Among other things, the policy emphasises the independence of the supervisory board and sets reform as one of the company’s central goals.

There have been unwelcome developments as well, though. Ukrainian media in early October reported allegations of mismanagement at Naftogaz, citing anonymous documents. They noted that a treason case over the theft of gas supplies had been opened against CEO Andriy Kobolev. Kobolev responded to these allegations saying that management had “nothing to hide,” and that he had lost count of the number of criminal cases that have been brought against the company over the years.

"The old tactic of using prosecutors and auditors for intimidation and retaliation is back," Hochstein wrote in his article. "I can no longer stand by and be used to endorse this negative trend, and it's why I must voluntarily leave the board."

The EC’s Kopac noted that some questionable decisions by Ukrainian courts seemed to be to the detriment of state companies and the benefit of private interests.

Work left to be done

The “unfounded accusations,” as Hochstein described them, were levelled after the government finally ended public service obligations (PSOs) in the household gas market over the summer. PSOs require Naftogaz to supply gas from its production arm for sale to residential consumers at regulated tariffs. The end of these "corrupt" schemes has given Ukrainian households a choice of supplier for the first time, Hochstein said.

In place of PSOs, Ukraine selected Naftogaz in a tender in July as a supplier of last resort, which provides gas to consumers that are unable to get supplies from elsewhere, typically after defaulting on their bills.

Suppliers of last resort are used commonly in the EU. However, in Ukraine the system does not work exactly how it should, Kopac said, as Naftogaz offers lower than market prices, allowing it to use the role to maintain its dominant position. More than 400,000 retail consumers switched to Naftogaz in the last month, the director estimated.

The main lingering problem in Ukraine’s gas market is that PSOs remain in force for district heating companies, which account for 15% of consumption. These companies are heavily in debt to Naftogaz, but the company is legally prevented from cutting them off during the heating season. Naftogaz has accused them of overcharging their customers for gas capacity, to keep them in debt and so unable to switch supplier.

PSOs for district heating are due to be ended by May 1, 2021, although Kopac said he was “almost certain” this deadline would not be met, owing to “unsolved structural problems” in heat distribution.

“The companies are constantly loss-making and are heavily under-capitalised, and they have huge gas leakage problems,” Kopac said. “The majority of them are simply incapable of paying.”

Ukraine’s district heating network is oversized, owing to demographic changes and reduced consumption owing to weaker economic conditions and increased efficiency. “But still the operators must somehow maintain this huge network, even with an insufficient collection rate,” Kopac said. “It’s a huge problem.”

Gas distribution tariffs are not cost-reflective and need to be increased, the director said. About 70% of the regional distribution companies are owned by Dmytro Firtash, a Ukrainian businessman who was highly influential during the pre-revolution Yanukovych administration. These intermediaries were created as cash cows, and have long been cited as a major source of corruption. Naftogaz accuses them of using “legal loopholes to shift their risks and losses to the TSO.”

Kopac also pointed to other unresolved issues with gas market balancing and interconnection agreements with Ukraine’s neighbours.

By and large though, Kopac sees Ukraine’s gas market as moving in the right direction, noting – as if this were compensation – that there are much greater challenges in its electricity sector.