Towards a Green Modernisation Programme for Ukraine

In the city of Pokrovsk, in the part of Donetsk oblast under Ukrainian government control, coal miners have been protesting and setting up roadblocks for more than a year over persistently delayed payments. Despite heavy government subsidies, many Ukrainian coal mines operate on the edge of commercial viability. Pokrovsk is home to one of the largest coal mines of Ukraine. It supplies coking coal to some of Ukraine’s metallurgy industry concentrated in the east and southeast of the country. In some way, Pokrovsk, and the Donetsk and Luhansk oblasts at large, encapsulate the delicate situation of the Ukrainian economy. 

The once prosperous coal and metallurgy industries from Soviet times have been hit hard, first by the collapse of the Soviet Union and its aftermath, including mismanagement, corruption, chronic underinvestment, and more recently by the disastrous Donbas war. While most parts of the Ukrainian economy have more or less successfully diversified, some regions such as the Donetsk and Luhansk oblasts are still heavily reliant on the coal sector, not unlike the German Ruhr region in the second half of the 20th century. Considering the decreasing profitability of Ukrainian coal mines, unsustainable subsidies, and Ukraine’s climate ambitions, a coal phase-out is an inevitable step for Ukraine on its path to decarbonisation. 

Ukraine recently committed to carbon neutrality by 2060 and signalled support for the European Green Deal that aims for net zero emissions by 2050. Until 2030, the upcoming update of its Nationally Determined Contributions (NDC2) aims at a reduction of economy-wide greenhouse gas (GHG) emissions of at least 65% below the 1990 level. While overall emissions reduction targets are thus broadly in line with the Paris agreement, current policies remain uncoordinated across sectors and insufficient in scale and scope. Not least due to the lack of policy coordination, the country struggles to mobilise sufficient capital for financing low-carbon investment. Access to capital for private companies remains difficult, capital costs are high and external financing options are limited.

It seems like, for the moment, Ukraine is stuck in the middle between its carbon-intensive past and a low-carbon future. That grey area is a dangerous policy space to occupy as it creates uncertainty for investors, businesses, and policymakers alike. If sectoral policies remain uncoordinated, half-baked reforms could lead to high costs without much emission abatement. No action is no alternative either, especially in the light of the country’s decaying infrastructure and risks such as an EU carbon border adjustment mechanism (CBAM) and the Large Combustion Plant and Industrial Emissions Directives (LCPD & IED) looming on the horizon. Thus – metaphorically speaking – attack is the best form of defence: ambitious climate action today is better than reacting to imminent infrastructure needs and mounting outside pressures tomorrow. Furthermore, decision-makers should be aware that “being stuck in the middle” might actually be more expensive than moving forward: Ukraine’s energy transition will likely not only be more effective, but also cheaper if reforms are ambitious and front-loaded.

While unintuitive at first, there are important reasons that make bold action preferable over hesitation. A credible commitment to an ambitious and clear decarbonisation path including comprehensive and coordinated policies that ensure achieving it sends a strong signal to investors: Low-carbon investment will be secure and profitable. This avoids wasteful investment in stranded assets such as additional thermal power plants, reduces policy insecurity and thus risk premia for capital costs, and mobilises external financing from bilateral and multilateral institutions as well as foreign investors. Furthermore, regulation in line with European standards avoids costs due to an EU CBAM and penalties for exceeding LCPD & IED emission limits. Regulatory reform could moreover eliminate payment obligations for wasteful subsidies in the electricity market, coal production subsidies and other indirect subsidies to fossil fuels such as for freight transportation of coking coal. Last but not least, increasing penetration of renewable electricity (combined with adequate storage, dispatchable peak generation capacity and/or demand side management) and a comprehensive reform of the electricity market could reduce market power of dominant thermal power producers, thus reducing the price of electricity for consumers.

Broadly speaking, Ukraine needs to focus on a triad of policy measures: improving regulation, increasing the carbon price, and lowering capital cost for sustainability investments through a well-governed green modernisation fund. Importantly, these policies can only achieve their goals if deployed in tandem. Increasing the carbon price to European levels would cripple carbon-intensive industries if not accompanied with a green modernisation fund that recycles part of the carbon tax revenues for supporting low-carbon investment in the affected industries. A green modernisation fund, on the other hand, would incentivise only marginal decarbonisation if not accompanied with a higher carbon tax and improvements in the regulatory environment, such as cost-recovering tariffs in the electricity market, that make low-carbon investments profitable for the individual investor. While regulatory reforms would improve functioning of the current markets, they would not bring fundamental change without a higher carbon tax and a green modernisation fund that incentivises deep decarbonisation. 

An ambitious climate policy as outlined above could serve as a kick-start for green modernisation of Ukraine. Large parts of the country’s energy and industrial capital stock are fully depreciated, often technologically obsolete and worn out. They need to be refurbished or replaced soon.  Places such as Pokrovsk and other coal-producing areas need investments for a transition to a post-coal economy. The southeast of Ukraine, and the country as a whole, has great potential for renewable electricity generation from solar and wind energy. Accompanied with the right regulatory environment, low-carbon investments could become an important puzzle piece for building a post-coal economy, even in regions once dominated by coal mining and heavy industry. About 120 kilometres south of Pokrovsk, in the Nikolskiy and Mangush districts of Donetsk oblast, a Chinese-Ukrainian consortium has recently announced plans to build the largest onshore wind farm of Europe with 800 MW of installed capacity without government subsidies.

While the renewable sector has seen a boom throughout the last years due to generous feed-in tariffs, this has created other problems such as increasingly unsustainable debt in the Public Service Obligation (PSO) responsible for financing those green tariffs. The planned move to auctions goes in the right direction to address those issues and should be combined with a move from rigid feed-in tariffs to flexible feed-in premiums (ideally in the form of Contracts for Difference), complemented with reforms to the PSO system and the wholesale electricity market (such as removing price caps to encourage deployment of flexible peak generation capacity and storage*). 

Investors are increasingly perceiving the potential of Ukraine’s renewable sector, but regulatory hurdles, an insignificant carbon price and a lack of streamlined support for low-carbon investment inhibit a truly economy-wide mobilisation of resources. Particularly in other sectors such as industry, buildings, and transport, low-carbon investments are still lagging behind levels needed for reaching Ukraine’s energy and climate targets. Importantly, these sectors are also more labour-intensive than the renewable sector. Well-designed regulatory and fiscal incentives could thus have an important employment effect. If paired with early retirement schemes for older workers and retraining opportunities for younger workers, this could enable a socially sustainable coal phase-out where former miners are trained in energy-efficient retrofitting of buildings, electrification of railroads, etc.

The next steps for Ukrainian decision-makers would be to develop more detailed policy proposals for improving regulation, increasing the carbon tax and streamlining investment in the different sectors. In the course of its support for the Ministry of Energy of Ukraine in setting up a National Energy and Climate Plan for Ukraine, Low Carbon Ukraine has developed a series of ten policy proposals for the most crucial topics. The policy papers provide a comprehensive analysis and propose concrete policy measures based on international experience. We propose a linearly increasing carbon tax reaching EUR 39/tCO2 in 2030, ideally levied upstream and covering all sectors of the economy (details of the proposal can be found here). While certainly ambitious for Ukrainian circumstances, we believe such a setup would help avoid paying carbon border adjustment charges on exports to the EU, making sure that these funds are instead channelled to beneficial investment in Ukraine alleviating the effect of the additional tax burden. For that purpose, the raised tax revenues could be partially used to finance decarbonisation measures in the most affected industries through a green modernisation fund and compensate low-income consumers through higher support from the Housing & Utility Scheme (HUS). 

Together with increasing renewable capacity auction quotas, introducing auctions for storage capacity, and regulatory reform to the PSO and electricity market, these measures would assure renewable deployment compliant with Ukraine’s decarbonisation targets, while maintaining security of supply. A timely synchronisation with the European grid could help achieve these goals while simultaneously increasing energy independence from Russia and decreasing long-term electricity costs. The green modernisation fund could also play a key role in decarbonising Ukraine’s steel sector in the medium- to long-term, as outlined in our assessment of this key sector of Ukraine’s economy.

For the construction sector, we propose an ambitious energy efficiency retrofit programme for 50% of public buildings until 2030. We show how this could be financed through issuing green bonds, leading to savings in energy expenditures in excess of capital costs for the retrofits. Such a programme for public buildings could notably serve as a training ground for construction companies, preparing the ground for similar measures in the residential sector. 

Finally, we also propose an integrated transport strategy, connecting rail, road and aviation. We argue that the low rate of motorisation should be seen as an asset rather than a deficiency, allowing Ukraine to avoid mistakes and leap-frogging the car-centred mobility system in favour of a transit-oriented system. To achieve that, emissions-based vehicle taxation and urban congestion charges could co-finance investments in railway infrastructure and public transport, for example.

We hope that these proposals will contribute to a fruitful and constructive discussion and help Ukraine to develop ambitious, yet realistic energy and climate policies. Ukraine has a historic opportunity to embark on a path of green modernisation if enacting comprehensive regulatory reform now. It is a pivotal time for decision-makers to seize this opportunity.