Increase Natural Gas Prices, But Carefully

“Restructuring of the Ukrainian natural gas market will result in significant increases in prices. Current price controls create the situation when demand is encouraged and supply is discouraged” – writes Russell Pittman, a U.S. government economist in his column for VoxUkraine. Removal of controls will remove an artificial “shortage” created by price controls. However, the movement of most consumers of natural gas away from price subsidies should be done carefully, households and enterprises should, at the first place, get technical capability to control their demand, and those without the means to take actions to protect themselves deserve special consideration.

There are many sound reasons to favour a restructuring of the Ukrainian natural gas market that results in significant increases in prices. Some of these reasons are quite familiar from your university Economics course, while others are not.

Among those that you did NOT study in Economics class, but that are perfectly valid, are the following:

• Excessive gas usage in Ukraine increases the country’s dependence on Russia, its marginal supplier (exactly as excessive petroleum usage in the US increases its dependence on the Middle East)
• Favourable pricing for certain users provides strong incentives for other users to use corrupt means in order to obtain access to those channels (exactly as, soon after Russia allowed charities to import cigarettes tax-free, suddenly Russian charities became the largest importers of cigarettes);
• Price controls are a very inefficient way to help the poor, since wealthier citizens can afford larger apartments and houses and use more gas than poor citizens (which is one political reason why subsidies, once granted, tend to persist); and
• Ukraine’s poorest citizens are not connected to natural gas supplies anyway, but rather burn firewood and sunflower husks to heat their small village homes (and thus lose out when available government funds are devoted to costly natural gas subsidies rather than to, say, rural roads or schools).

In a better world, you may learn about such factors in your Economics class, but that is a debate for another day.
From your economics class, however, you should have learned that price controls, while protecting some customers from higher prices, have two harmful long-term effects:

• On the supply side, they fail to provide as much encouragement as they should to companies that might consider exploring, producing, and selling their own domestic supplies of natural gas; and
• On the demand side, they encourage excessive usage by both households and industrial and commercial users, all of whom would be inclined to use less if they faced prices that fully reflected costs.

Thus, almost any economist would argue, price controls create an artificial “shortage”, as demand is encouraged and supply is discouraged, and the removal of controls — again, while unfortunately likely to make some poor people pay higher prices — should remove both those effects and therefore act to eliminate the shortage.

So far, so good. But what if some users are in a position whereby they cannot change their usage? What if these users are completely unable to affect their own demand levels? In that case, increasing prices from subsidized to unsubsidized levels serves only to transfer money from those users to others (the seller, the government) without reducing demand, and in particular without allowing the users the ability to “control their own destiny” by cutting back on their usage in response to the higher prices.

Unfortunately this is exactly the position in which a large number of natural gas users in Ukraine find themselves. Estimates differ, but apparently fully 40 to 50 percent of Ukrainian households rely for their home heating on “district heating” companies: public urban enterprises that send heat from giant boilers through underground piping to apartment buildings throughout a metropolitan area. In addition, public sector enterprises often rely on the same heating suppliers, so that as much as 60 percent of Ukraine’s heating (as well as urban hot water) supplies are provided by district heating companies.

In some settings, district heating can be an efficient and cost-effective way of providing municipal heating supplies. (Copenhagen is one example.) Unfortunately this is not the case in Ukraine (or other post-Soviet countries, other than the Baltic states); municipal district heating companies tend to have badly deteriorated assets, with little insulation, ancient, inefficient boilers, and badly leaking piping systems that lose over half their energy while delivering heat throughout the city.

Of course these depreciated assets in part reflect the long-standing price controls that have starved their district heating enterprises of resources for maintenance and improvements.

The more important point for our purposes, however, is that Ukrainians living in a traditional block of flats served by a district heating company in Kyiv or Odessa or Dnipropetrovsk have no control over the amount of heat that they receive, and so over the amount of natural gas that they consume. Traditionally even the apartment building itself lacks control of these decisions, which are made at the center for central district heating substations (CTP) that encompass many streets and blocks of apartment buildings. Under those circumstances, natural gas price increases to individual households simply take money from them without providing them with the opportunity to change their consumption behavior in response.

Fortunately this problem is being addressed. International lenders have begun supporting the investments necessary to move the control of apartment building heating levels from the central substations to individual substations (ITP), at the level of the individual building. The experience in other countries suggests that when a group of tenants in a building can control its consumption — with billing typically divided according to the square footage of each apartment — natural gas usage goes down by at least 15 percent. Metering and control at the level of the individual apartment — of course even more expensive to install and operate — results in a further reduction of similar magnitude.

At this point in time, there is no realistic alternative to the decontrol of natural gas prices in Ukraine; the government budget cannot afford the huge expense of continued subsidies, and international lenders insist on the removal of subsidies as a condition for further assistance. But it will be important for both political and fairness reasons that decontrol be accomplished in a targeted and gradual manner.

In particular, the largest category of users, representing about 40 percent of consumption, is heavy industry, and there is no realistic alternative to heavy industry moving to unsubsidized prices for natural gas, with those enterprises able to become more efficient and competitive surviving for the long term and the others dropping by the wayside.

On the other hand, the importance of these enterprises for the Ukrainian economy and employment emphasizes the crucial role of the availability of loans and grants for retrofitting equipment and improving energy efficiency in order for the enterprises to survive in the new world of unsubsidized prices for gas.

Likewise, many apartment buildings, individual apartments, and individual homes have direct control of their gas consumption and pay bills according to their individually metered use. The international experience suggests that such blocks of flats and households can respond to gradual price increases through both investments in energy efficiency and changes in behavior that can greatly cushion — even almost compensate for — the price increases. Again, the availability of loans for energy efficiency improvements, as well as a price increase regime that is gradual enough to allow behavioral responses, will ease the pain for the population.

It is the third set of users, those living in blocks of flats without direct control over their own heating use and gas consumption, that would seem to require the most careful treatment, for reasons of both political acceptance and basic fairness. A “big bang” policy of the abrupt and complete termination of subsidies is not likely to be well accepted by a population that has no way to reduce its consumption. Rather, to the degree possible, it seems advisable to “couple” the introduction of individual building or apartment metering and heat control with price increases. Only in that way can the population take its fate into its own hands and change its behavior in such a way as to cushion the blow.

Finally, all of this is not necessarily to suggest that in Ukraine, or in any other country, the entire population must pay full-cost-recovering prices for all essential services. Democratic governments around the world have utilized various types of “universal service” mechanisms to ensure that all the population is able to enjoy a minimum level of supply of necessary services. Different mechanisms — neighborhood targeting, household targeting, low prices for basic levels of consumption, subsidies for connection but not for usage — have different costs and benefits, advantages and disadvantages, and it seems likely that Ukraine will choose some means to insure that the poorest of the poor are not left without heat (and water and electricity) because of their inability to pay full price.

It is to suggest, though, that the movement of most consumers of natural gas away from price subsidies, while inevitable, should be done carefully, and that those without the means to take actions to protect themselves deserve special consideration.

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