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    Energy Reform for Ukraine: If Not Now, When?



Prof. Alan Riley offers his expert insights on energy reform in Ukraine, calling the increase of taxes on gas production a "royalty tax disaster."

by: Drew S. Leifheit

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Top Stories, Pipelines, Security of Supply, News By Country, Russia, Ukraine, Expert Views

Energy Reform for Ukraine: If Not Now, When?

In an event entitled “Ukrainian Energy Reforms and European Gas Supply” at the Center for Strategic and International Studies (CSIS), moderator Edward Chow, Senior Fellow with the CSIS Energy and National Security Program, set the scene in Ukraine, which he said is facing its greatest crises and challenges since independence almost 25 years ago now, foremost in security given the annexation of Crimea by Russia and the ongoing hostility in Donbass, not to mention the real prospect of economic and financial collapse and societal challenges, such as wide-spread corruption and poverty, extreme income disparity and other social ills.

He continued, “Some have called energy corruption the 'original sin' of modern Ukrainian statehood,” he remarked. “Billions of dollars have been siphoned off every year from the Ukrainian energy sector. A country that used to export gas to Russia as recently as the 1970s is dependent on gas imports. The country's abundant energy resources have been hijacked for private gain, and Ukraine is left with the most energy inefficient economy in Europe and a population which is underserved when it comes to energy services.”

He pointed out that Ukraine and its energy security also impacts Europe, since its pipelines still transit 40-50% of Russia's gas exports to Europe, depending on whether it's a high or low demand year, partly dependent on weather, and that

“There are no ready substitutes for Ukrainian transit in say the next 5 years, in spite of Russian declarations to the contrary,” Mr. Chow added.

He raised the question: “When it comes to energy reform for Ukraine, if not now, when?”

The event's featured speaker, Alan Riley, Professor of Law at the City Law School with City University in London, said there had been some good news in Ukraine.

“One is, it's spring, we got through the winter. There were no cut-offs. We survived – so that's a good start,” he remarked.

Via EU cooperation, he also cited the reverse flow movement of natural gas. “This is actually buying – usually Russian gas - on the EU market, and reverse flowing it into Ukraine.”

Ukraine had received about 5 bcm of such gas in 2014, according to Prof. Riley, who said this had implications for other EU states and the Balkans. The main interconnector between Slovakia and Ukraine, he said, has about 80 bcm of capacity.

“Most of that is not being used by Gazprom.”

Under EU liberalization rules, he said, there is a “use it or lose it” stipulation. “Because Gazprom is a dominant supplier, if you're sitting on capacity that you're not using and a competitor wants it and is refused, prima facie you're in breach of abuse of dominance territory,” he explained.

Up to now, nothing has happened regarding this, he reported, but it should. “You could potentially reverse flow a large amount of gas – 30 bcm – on that pipeline. But the other point is, because of the density of the transit network of Ukraine, you could also take some of that reverse flow gas and 'reverse reverse flow' gas: take it into Ukraine and through the Ukrainian transit system into the Balkans – Romania and into Bulgaria, to provide alternative supply of gas.”

Turkey could also be supplied with gas this way, said Prof. Riley, who opined that EU regulators should act on, which they have not done up to now. “It's an area where DG Competition need to act.”

Other good news, he said, includes the moves towards uniform pricing for gas in Ukraine, despite it being bad for poor Ukrainians. He offered, “The point one has to understand is that the pricing is not for poor Ukrainians, it's for rich Ukrainian oligarchs, because essentially there is a substantial siphoning off of the gas which is supposed to be for households to various parts of the business elite.”

Creating uniform pricing, said Prof. Riley, cuts out that potential form of corruption, and if there's a subsidy regime for those who need it, there's a more socially just outcome.

And, the formal introduction of liberalization into Ukrainian law, following EU liberalization law, he said, is also a “good thing,” but the devil is in both the details and in the execution, according to him. An anti-trust regulator is also a must, he said.

Another problem, he said, is the “royalty tax disaster” - Ukraine increasing the taxes on gas production from 28% to 55%; additionally, the open market has also been closed to independent gas producers' customers.

Prof. Riley reported that Ukraine's independent gas producers had responded by reducing their gas production, because they were losing money by producing.

“So on the one side, you've got the Ukrainian government going around Europe trying to get more reverse flow – and they've been successful at that; on the other hand, they've introduced a tax regime which suppresses gas production in the country,” he explained.

British explorer JXK, he said, had pursued an emergency expropriation of the Energy Charter Treaty, which had ruled the Ukrainian royalty tax increase unlawful.

It is a question, he said, of what underlies such actions by the Ukrainian government. “Is this the old game being played again? Is the idea to stop the independents from producing gas so they're all in breach of their licenses, and then they can be reallocated to someone who is a friend of someone in the government? Is that what's going on?” he queried.

The danger of such actions, he explained, is that it kills investment in Ukraine.

Meanwhile, the West, he said, is trying to save the country, putting in USD 17 billion and offering a huge amount of support and good will.

“My concern with the oligarchs is that they don't understand that the Maidan has happened, that people have lost their lives, that there's a war on, and that change is possible; equally, the West, ultimately, will not put up with this unwillingness to reform.”

This means strong support for reformist elements in Ukraine is necessary.

Prof. Riley suggested “Europeanizing” the Energy Community to which Ukraine is a party, because the organization only provides the text of the EU rules without offering institutional and constitutional support. Ukraine, he said, could sign a special protocol with the Energy Community, and create an energy court in Kiev with both international and Ukrainian judges.

“We would use that to enforce the full application of the EU's energy acquis across the area of Ukraine in order to actually assure that the energy market is fully opened up and international investors could rely upon that. And we could see change and reform actually happening.”

Richard Morningstar, former Ambassador to the European Union and former Special Envoy for Eurasian Energy, offered his remarks to Prof. Riley's views.

He asked, “Why isn't Russia just saying to Ukraine 'Screw you, we're not going to provide any gas and we'll deal somehow with the Europeans?'”

There are a couple of reasons for this, he explained. “I think Russia does recognize that the EU is more likely to stand by its laws and regulations now. Russia does need Ukraine for transit, at least through 2019 and, I would guess, for a long time after that.”

According to him, Russia can't afford to risk its gas supply to Europe, so having some accommodation with Ukraine is necessary to guarantee that.

“Russia needs every euro it can get right now, given its economic difficulties.”

Mr. Morningstar said that Turk Stream, while interesting, faces obstacles, like counting on completely cutting Ukraine out of the equation because of Turk Stream, as the first pipeline would only replace existing gas entering Turkey, and more than the capacity of the second pipeline (15 bcm) is going through Ukraine.

“Any pipeline coming from the European border after picking up Russian gas would have to comply with 3rd party access; with no destination clauses. Gazprom would face the same competition rules that they're facing now. There are existing contracts going through Ukraine that would have to be amended.”

If, he said, Russia saw the handwriting on the wall and was willing to comply with all EU law and regulations, acting transparently, “Gazprom would have as much right to sell gas as anyone else.”

Regarding Ukraine, Mr. Morningstar asked whether it would continue to be “Groundhog Day” there – referring to the premise of a film with Bill Murray. “Every day you wake up and it's the same day – just like the movie. There are some positive signs, but can those positive signs be sustained?”

Addressing questions of energy efficiency and uniform pricing is crucial, he said, and the opportunities of domestic production exist if an atmosphere for investment is created in Ukraine.

-Drew Leifheit