Restructuring Ukraine’s Electricity Sector: What Are We Trying to Accomplish?

The Ukrainian electricity sector will require a great deal of investment if it is to support robust national economic growth going forward. Many of the generation plants and a great deal of the long-distance transmission infrastructure are badly depreciated and quite inefficient; this is one reason that the Ukrainian economy is one of the most energy-intensive (per volume of output) in the world.

Low tariffs for households encourage wasteful use, while the high tariffs for industry that cross-subsidize the household rates threaten the international competitiveness of Ukrainian products.

To some this may be surprising. Ukraine was the first country of the former Soviet Union to undergo extensive electricity sector reforms back in the mid-1990’s; a day-ahead wholesale bidding market with the “single buyer” Energorynok was created that anticipated by years similar restructurings in many more advanced market economies. More recently, the Electricity Market Law enacted by the Ukrainian Parliament (Verkhovna Rada) in October of 2013 was designed to further liberalize markets, creating the conditions for bilateral contracts and wholesale exchanges that would allow all customers to choose their suppliers. On the surface it all looks like a page from the traditional World Bank advisors’ neoliberal playbook, and a devotee of that playbook might ask why the current state of affairs is no better than it is.

Unfortunately, as always, the devil was and is in the details. Around the world, liberalized electricity markets have proven to be effective only if real, workable competition is created, and this has not really been attempted in Ukraine. First of all, electricity tariffs have been highly regulated, with industrial tariffs cross-subsidizing household tariffs that are far below costs, and the overall tariff regime starving the system of funds for maintenance and improvements. Early problems with non-payment and non-cash payment seem to have been mostly resolved, but goals and promises to remove the heavy subsidies enjoyed by household users have been repeatedly made and then ignored.

Furthermore, the five large thermal generation companies created by the original reforms all remain either state owned or controlled by a single private firm, and the two companies using nuclear and hydroelectric technologies, respectively Energoatom and Ukrhydroenergo, are also state owned; these “big seven” companies can hardly be expected to compete very strenuously against each other.[1] The poor state of long-distance transmission lines – along with the semi-detachment of “Burshtyn Island” generation — means that surplus power generated in the west cannot flow eastward to compete with power generated by firms in the power-hungry, heavy manufacturing east.

It may be useful, though, to take a step backward and ask whether even a well functioning Ukrainian electricity sector restructured along these standard neoliberal lines was likely to achieve the goals of reformers. After all, the worldwide experience with attempts to replace closely regulated, vertically integrated monopoly electricity providers with privatized, competitive, vertically separated markets has been decidedly mixed, especially in the absence of large and inexpensive supplies of natural gas or hydro power.[2] In this respect Ukraine starts with the disadvantage of its reliance mostly and nuclear and coal-fired generation; neither of these is generally flexible enough for generators to adjust output quickly in response to wholesale price signals (though in Ukraine coal-fired generation has been able to fill that role to a degree).

And this in turn raises the question of what Ukraine is (and has been) trying to accomplish by restructuring its electricity sector. Is it, like the US, UK, and other wealthy countries, trying to make a fully functioning electricity sector work more dynamically and efficiently going forward? Or is it, like the typical middle and lower income country, trying to find ways to attract capital in order to refurbish an aging system that threatens to act as a constraint on manufacturing and services growth going forward? The question answers itself: both the deteriorating state of Ukraine’s electricity generation and transmission infrastructure and the dire state of Ukraine’s public finances dictate that unless future reforms succeed in attracting significant flows of private investment, an inadequate and unreliable electricity sector will act as a constraint on future economic growth.

This suggests that, moving forward, focusing on the details of implementing the move to bilateral electricity contracting and broadly functioning wholesale markets – not to mention the complex mechanisms in the new law for transferring inframarginal payments among nuclear, thermal, and “green” generation plants – may not be the best use of the limited resources and human capital of Ukrainian reformers. Ukraine is a large country, generally the size of multiple geographic markets for wholesale electricity in the US or Western Europe; even were generation plant ownership more dispersed, it is going to be a very long time before the coal plant at Burshtynska offers much competition to the nuclear plant at Rivne or the combined heat and power plants in Kyiv. Perhaps many years in the future this market creation project will be worth the effort, but today other needs cry out for attention.

In particular, economists working on the regulation of infrastructure sectors such as electricity have lately come to focus on the distinction between “low powered” and “high powered” regulatory regimes, a distinction associated with the work of the French Nobel laureate Jean Tirole and his late collaborator Jean-Jacques Laffont.[3] Low powered regimes are those, like traditional rate-of-return regulation, that provide investors with some assurance of returns, but do not create strong incentives for dynamic and efficient operations – in other words, little downside risk but little upside opportunity. High powered regimes, like price caps regulation, are the opposite: they create the possibilities of either real losses or significant gains.

Regulatory regimes at both ends of this spectrum – as well as hybrid regimes somewhere in between – all have their own advantages and disadvantages along different dimensions. It is perfectly sensible for an investment-poor country like Ukraine to adopt low powered regulatory regimes while investment-rich countries like the US and the UK adopt high powered regulatory regimes; the former has shown itself to be better at attracting investment, while the latter is better at encouraging efficiency.

Similarly, it may be perfectly sensible for Ukraine to adopt high powered regulatory regimes in ten or twenty years when its public utilities sectors have reached some threshold levels of capital adequacy and operational efficiency, while to focus on such regimes under current conditions is to, as the Brits and Americans say, “put the cart before the horse”.

In short, it is important for Ukrainian reformers to keep their eyes on the big picture. Of all the good things that the Ukrainian electricity sector lacks and requires in the immediate future, fully functioning day-ahead hourly auctions, or other aspects of the standard neoliberal public utilities reform package, should not be high on the list of priorities. Much higher on the list would seem to be the following:

• Attract private investment into the long-distance transmission grid. This may involve public-private partnerships, privatization, and guarantees of minimum returns – low powered incentives designed to attract capital.
• Attract private investment into thermal generation plants. This likewise may involve public-private partnerships, privatization, and guarantees of minimum returns. It may also involve privately owned (or franchised) firms vertically integrated among generation, transmission, and distribution – a trip “back to the future” of the electric utility sector that might look pretty good compared to the current situation.
• Encourage the use of real-time pricing, especially for industrial and commercial customers, in order to shave peak demand levels and thus to reduce both the need for new investment in generation and the system’s reliance on politically problematic natural gas.
• Provide businesses and households with low-interest loans to insulate and otherwise improve their energy efficiency.
• Terminate the cross-subsidization of household electricity customers by industrial users. To the degree that it is desired to save poor households from paying fully cost-reflective tariffs for electricity, take the same path that should be taken with household heating and hot water bills: fund those programs from the government budget, and choose among “universal service” mechanisms that have been found effective and economical around the world, including individual household targeting, neighborhood targeting, low prices for the lowest levels of service only, and subsidies for connection but not usage.

It is simply not time yet to try to create complex wholesale and retail electricity markets in Ukraine, and efforts to continue along this path are likely to lead to continued disappointment. If I may switch to a French saying, sometimes “le mieux est l’ennemi du bien”.

Notes