How Europe Can Help Ukraine Clean Up Its Gas Sector
Though Ukraine’s politicians adopted a gas law in April, they have not been able to agree on a model for the unbundling of Naftogaz’s different business lines, or on which should be prepared for privatization
Reform of Ukraine’s gas sector is under threat.Though Ukraine’s politicians adopted a gas law in April, they have not been able to agree on a model for the unbundling of Naftogaz’s different business lines, or on which should be prepared for privatization. The risk is that if Naftogaz is not quickly and comprehensively reformed, the old habits of political corruption will resurface. Because of the importance of Naftogaz to Ukraine, this could undermine the country’s association process with the European Union. That is why the European Bank for Reconstruction and Development should step in.
Naftogaz, the giant publically-owned Ukrainian oil and gas company with 80,000 employees, used to be a synonym for wastage, corruption and opacity. But it looks like it might have turned a corner. Thanks to a new management team, a fourfold increase in gas prices and the beginning of legal reforms, its losses in 2015 will be down to 3.1 percent of Ukraine’s GDP, from 5.5 percent in 2014, according to the International Monetary Fund. The impact on the deficit should fall to 0.2 percent in 2016, according to IMF estimates, and Ukraine’s dependence on Russian gas has been markedly reduced.
But just as skies were clearing, new clouds appear. The reform of Naftogaz is stalling. Though they adopted a gas law in April, Ukraine’s politicians have not been able to agree on a model for the unbundling of Naftogaz’s different business lines, or on which should be prepared for privatization. The risk is that if Naftogaz is not quickly and comprehensively reformed, the bad old habits of redistribution and political corruption will resurface. Because of the importance of Naftogaz to Ukraine, this could undermine the country’s association process with the European Union. In addition, the income from gas transit, from which Naftogaz currently earns about $2bn per year, might drop to zero should Russia’s Gazprom finalize its attempts to circumvent Ukraine’s gas transit system via the Nord Stream II pipeline, which it plans to do by 2019.
The only sensible response to both challenges is to complete the reform of the regulatory framework and to fully unbundle Naftogaz in line with the Third Energy Package. The gas transmission arm should become a fully independent business that is regulated like its peers in the EU and shielded from political control, in order to convince European suppliers that any new alternative to Ukrainian gas transit would be a waste of money. This is urgent, because uncertainties over gas transit through Ukraine are a pretext for the Nord Stream II. And it is also crucial in the longer term, because the badly needed investment in Ukrainian gas production requires non-discriminatory access to the pipelines.
Unbundling the gas transmission business and freeing it from political control implies significant political cost for the oligarchs and politicians that will lose influence over the main Ukrainian rent-generating machine. Moreover, the benefits of reform will only accrue over time – but Ukraine places more value on income today than on future benefits. Furthermore, the obvious solution – privatising the gas-transit business, and regulating it according to the EU rules that Ukraine has signed up to (the famous ‘third package’), is problematic. It is not feasible because an immediate privatisation will look like a sell-out of the country. No sensible western investor without political leverage in Ukraine would invest money and time in Naftogaz’s gas transmission business, only for their investment to be implicitly expropriated when the revenues start flowing . And the plan is not credible for transit customers, because there are strong incentives for future governments to use the regulatory tools at their disposal to extract economic or political rents from gas transit.
But there could be a solution. Ukraine could sell a share  in its gas transmission business to a benevolent investor that has an interest in a prosperous Ukraine and stable gas transit. One candidate could be the European Bank for Reconstruction and Development (EBRD) which has built up expertise in Ukraine’s gas sector over two decades and has experience of pre-privatisation deals. From the perspective of the mainly European taxpayers that fund the EBRD, such a transaction is justified by self-interest. The EU would stabilise gas transit through Ukraine, enable gas sector reforms that are crucial for Ukraine’s political stability and might even extend its internal gas market to a country with significant gas storage and production potential.
To enable the deal, the Ukrainian government would have to commit to a regulatory framework enabling the EBRD to make profits if the gas transmission business is well managed. Based on this commitment, the EBRD could bring in western expertise and money to restructure the business. The aim of the operation would be full privatisation of the state and the EBRD shares some years down the road. The expected revenues when this final privatization step takes place would be a major incentive for the Ukrainian government to stick to its commitments to the EBRD.
Selling the gas transport system to a ‘foreign’ investor at a price that might appear low compared to private transactions of similar assets in the west could be unpopular in Ukraine, especially as household energy costs are set to rise. To address this concern, a fixed share of the profit that the EBRD makes when privatisation takes place would be returned to the Ukrainian budget. This would also increase the incentives for the Ukrainian government to develop a regulatory framework that increases the privatisation value of the gas transmission business.
For the EU, the outlined pre-privatisation deal would be a much more beneficial way to reduce gas transit risk, compared to building a redundant gas pipeline through the Baltic Sea. Most importantly for the EU, restructuring Naftogaz would not just be about the efficiency of the Ukrainian gas sector or fiscal sustainability. It would have positive repercussions on the political culture of Ukraine and the entire association process.
 There is a time-inconsistency problem: you promise to an investor to come and invest; but after he has done his irreversible investments and wants a fair return for the high risk; policy-makers often find it hard to justify the high returns flowing to a private/foreign investor. So policy-makers have strong incentives to change the rules (taxation/regulation) to keep some money to the state.
 This does not necessarily have to be a majority share. It should only be enough to send in some board members.
The author doesn`t work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations