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12 Commercializing Ukraine’s Energy Sector

Patrick Lenain, and Peter Cornelius
Published Date:
February 1997
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Laszlo Lovei and Konstantin Skorik 

In the period 1991–95, state ownership of assets and direct control over their use were the main vehicles for the implementation of energy policy in Ukraine. Energy sector enterprises were not allowed to determine their own production, investment, pricing, and marketing strategies. A system of administratively controlled energy prices was intended to guarantee social justice. Differences between energy prices and supply costs were covered by: (1) the budget, in the form of price subsidies and investment grants; (2) external fuel suppliers, in the form of uncollected receivables and long-term credit; (3) the domestic banking sector in the form of subsidized credit for working capital and investments; and (4) the energy suppliers themselves, in the form of postponed maintenance and rehabilitation expenditures. In addition to the wasteful consumption of fuel and energy resources, the respective consequences were (1) growth of the budget deficit (at the beginning of the period) and the need to impose additional taxes on the economy (toward the end of the period); (2) rapid accumulation of internal and external debt and payment obligations; (3) below-market interest payments by the banking sector to depositors and the crowding out of credit to other sectors of the economy; and (4) deterioration of the quality and reliability of fuel and energy supply.

Over the next two to three years, the liberalization and proper regulation of fuel and energy prices should result in the complete elimination of price subsidies and investment grants in the energy sector. The objective of social justice would best be served by providing targeted subsidies to low-income consumers for the payment of their housing and utility bills, and funding the cost of measures to mitigate the social impact of downsizing the coal industry. Public support in the area of investments should be restricted to the establishment of a stable regulatory framework and a system of guarantees that provide assurances to private investors and commercial lenders (temporary support from the budget in the form of investment credit may be needed in the coal industry—see below). In the medium term, the bulk of productive assets should be privatized, and regulation should be the main vehicle for the implementation of state energy policy.

Coal Industry

The coal industry has received substantial subsidies under a number of classifications (e.g., compensation for low prices, support of centralized investments, geology survey) and through several channels (e.g., budgetary grant, credit from the budget, credit from the National Bank and commercial banks guaranteed by the budget) since Ukraine’s independence. These subsidies have contributed significantly to the overall budget deficit. The support for the coal industry was equivalent to 8.3 percent of total budgetary expenditures, or about 4 percent of GDP, in 1993, and 5.6 percent of budget expenditures or 3 percent of GDP in 1994. In 1995, Krb 36 trillion of production/investment subsidies was spent on the coal industry, equivalent to only 0.8 percent of GDP (or about 1.6 percent of total budget expenditures).

The declining trend of subsidies (in real terms) clearly indicated a change in the direction of fiscal policy, despite considerable political pressure to reverse the trend. However, the sustainability of this rate of decline is highly questionable given that direct subsidies were replaced to a considerable extent by cross-subsidies and arrears accumulation, in the absence of a fundamental restructuring of the coal industry. Indeed, during the course of 1995 the gradual breakdown of the cross-subsidy system and increased import competition led to substantial arrears accumulation, the imposition of a coal import tax (of about 10 percent) in July, and a resurgence of direct subsidies in the second half of the year. (The Krb 36 trillion spent on the sector represented a budget overrun of almost 30 percent.)

Accumulated payables of the coal industry rose to US$2.2 billion equivalent by June 1, 1996 (from US$1.0 billion in August 1995), while receivables reached US$1.1 billion (compared with US$750 million in August 1996). The negative net position of the coal sector thereby increased from US$250 million to US$1.1 billion during the winter of 1995/96. The 1996 budget recognized the overambitious nature of the decline in fiscal support originally planned for 1995, and includes Krb 151 trillion for the coal sector (equivalent to 2 percent of GDP, 4 percent of total government expenditures, or approximately US$800 million). Of the Krb 25.3 trillion disbursed in the first quarter of 1996, Krb 25 trillion went to pay wage arrears. Nevertheless, in June 1996, a substantial wage arrears problem remained—Krb 36.4 trillion (plus Krb 46.2 trillion of unpaid pension and other social protection contributions). The effective abolition of cross-subsidies during the first quarter of 1996 (see below) and the continued appreciation of the real exchange rate are likely to create further demands on the budget for payment of direct subsidies.

The system of wholesale and “accounting” prices set centrally by the Ministry of Coal Industry creates a number of distortions. The wholesale prices send the wrong signals to consumers by keeping steam coal prices 20–30 percent above the price of imported coal, and overcharging consumers for washed coal. “Accounting prices” that the mines are paid provide a cross-subsidy from low-cost mines to high-cost ones, thereby reducing incentives to increase efficiency and denying the opportunity to reinvest profits. In addition, the unpredictability of administratively established “accounting prices” impedes the ability of the low-cost mines to obtain credit from the banking sector.1

During the winter of 1995/96, most coal was still distributed under a centralized system rather than marketed under contracts that engaged suppliers and consumers. While officially only a small portion (less than 1 percent) of the coal was distributed as “state order” with explicit payments from the state, more than 90 percent of domestic coal production was distributed in a way (called “Uglesbyt”) very similar to the previous central allocation and distribution system and with the same distorting results on the development of a true market. A number of factors reduced the willingness of the mines to pursue direct contracts. First, high-cost mines received the cross-subsidized “accounting” price when they sold their coal through Uglesbyt. Second, low-cost mines had difficulties finding promptly paying customers since they lacked marketing skills. And third, there was a perception of state guarantees behind the payments for the fulfillment of “sector orders/plans.”.

The 263 coal mines are organized into 23 coal production associations, and 12 mines operate independently. A presidential decree was issued in February 1996 that ordered the government: (1) to make each mine a legal entity in early 1996; (2) to corporatize the viable mines and establish a number of holding companies by September 1996; and (3) to start the process of closing unviable mines if attempts to lease/privatize them are not successful. In addition to the mines, holding companies will also include coal-washing plants, marketing organizations, mine construction companies, and other essential units. Nonessential activities will be separated and turned over to the State Property Fund for privatization. Social assets will be turned over to the municipalities during 1996/97. Holding companies will decide about investments and other issues that the affiliates delegate to them. Prices will be set by the mines but subject to a limit set by the Ministry of Coal Industry after agreement with the Ministry of Economy. The mines will be free to decide about the marketing of all the coal they produce. The system of “accounting” prices will be replaced by a system of “rents” set by the cabinet based on the geological conditions of mines. Rent payments will be collected by the tax authorities and directed into an extrabudgetary “Energy Development Fund” to be used for specific investment projects. The “Energy Development Fund” was established in late 1995 from the proceeds of a levy on coal and petroleum product imports.

The presidential decree represents a major step forward. However, it includes provisions that may distort the coal market in Ukraine. The proposed system of “rents” would, in effect, be a continuation of the current cross-subsidy scheme, although under a more transparent and stable arrangement. Even more damaging would be the survival of the price list as an upper limit—it would make it impossible for coal prices to follow changes in supply and demand. A practical compromise might include the phase out of the price ceilings during 1996/97, and a limit on the “rent” of US$3 per metric ton equivalent (about 10 percent of the price). The decree did not set a schedule for the closing of unviable mines. It is likely that not more than about 20–30 mines can be closed each year, for sociopolitical reasons.

The closure of uneconomic mines and the need to reduce costs in all mines after the industry starts to operate competitively will significantly reduce the number of jobs in coal extraction. Altogether, about half of the people directly employed in coal extraction may have to leave over the next five years. Taking into account likely job reductions in other areas (for example, washing plants, construction, and the social sphere), 300,000–400,000 people may need to exit the coal industry in the medium term. The number of workers that the Ukrainian coal industry needs to shed is one of the highest ever attempted by a single industrial branch in Europe. This task is even more complicated by the high concentration of mining activities in a single region (the Donbass). Furthermore, the country and the mining industry have to start this process in a period of extreme scarcity of financial resources and little alternative employment because of the depression the economy is currently going through.

In view of the critical situation of the Ukrainian coal industry, most of the cost of restructuring has to be borne by the budget. However, it is important to channel budgetary support in a way that minimizes the risk of distorting decisions about future production activities and investment. The market rather than the government should make decisions on the allocation of resources for coal production. This can be achieved if budgetary support is primarily aimed at relieving the industry of unproductive expenditures such as the cost of mine closures and social protection while phasing out the use of public funds for investments. However, production subsidies will also be needed to cover the losses of unviable mines that cannot be closed immediately. In addition, viable mines may need credit from the budget for essential investments until they can access commercial credit and private capital.

A major challenge for the government is the development of a mechanism that determines and channels production subsidies and investments to the mines in a way that provides the right incentives to contain production costs, speed up the closure process, and focus investments on profitable activities. The first step is the division of mines into viable, potentially viable, and nonviable categories. Mines in the first two categories should be corporatized and placed under 10–15 holding companies. Mines in the third category should be placed under the direct supervision of the sectoral ministry and have their closure plan prepared as soon as possible. The first 20 of these mines should be immediately placed under UDKR, the Ukrainian company specializing in mine closures, and about 20–30 mines a year should be transferred to UDKR thereafter.

Mines in the first category should be eligible for investment credit assuming that their proposals meet certain technical, financial, and environmental criteria. Mines in the second and third categories would be eligible for production subsidies calculated on the basis of their predicted costs and revenues. The managers of these mines would be given performance contracts with incentives focused on the reduction of costs, with particular attention to labor costs. Mines in the second category would be given a year to demonstrate profitability and move to the first category. Mines that remained unprofitable after one year would be placed in the third category and removed from the holding companies. Mines in the first category would have full autonomy to make production decisions, set prices, and market their coal. In summary, the proposed mechanism would ensure that no mine would receive both a production subsidy and an investment credit; mines under the holding companies would not be subsidized (following a one-year transition period for some of them); viable mines would no longer need to cross-subsidize nonviable ones; and the number of mines receiving production subsidies would be progressively reduced as the closure process moved ahead.

Oil Industry

In 1994–95, Ukraine made significant progress in reducing the role of the state in the production, refining, transportation, and marketing of crude oil and oil products. The state order system was eliminated, prices were liberalized, the import and export of crude oil and oil products were commercialized, and several oil product marketing outlets were privatized. However, little progress was made in the privatization of crude oil exploration, production, and refining activities, making possible the maintenance of informal controls over price margins and product marketing. Although a Law on Underground Resources was adopted in mid-1994, and a licensing system (managed by the State Geology Committee) was established in late 1994, only a few oil/gas exploration licenses were issued in 1995–96. Owing to limited (but not insignificant) geological reserves and the lack of a modern petroleum law, Ukraine has not been able to attract any of the large international companies in the oil/gas exploration and production industry. Without significant investments in modern technology and know-how, the further decline of domestic oil (and gas) production is inevitable.

The process of corporatizing and partially privatizing the refineries and the companies that operate the major oil pipelines was started in 1995, but progress has been limited so far. More was achieved in the privatization of automotive fuel retail outlets; by now, privately owned or leased retail outlets play an important role in all major cities. However, the storage depots and the transportation fleet have not been privatized (although a few depots are leased to the private sector), and the plan is to keep all major oil product depots in state ownership. The existence of excess and mostly obsolete refinery capacity (about three times more than what is needed), the lack of a well-articulated strategy for the restructuring and privatization of the oil industry, and the parliament’s prohibition of the privatization of the oil pipelines have so far thwarted attempts to attract foreign capital, leading to further erosion in the competitiveness of the refineries and postponement of the modernization of the marketing of oil products. Frequent changes in the leadership of the State Oil and Gas Committee and the lack of clear regulatory responsibilities further compounded the problems.

As in other countries, the Ukrainian oil industry is a significant source of budgetary revenues. These revenues are collected from taxes on the import and consumption of oil products, and from a system of special taxes and royalties on oil production. A small part of the revenues (about Krb 10 trillion in 1995) is channeled back to the State Geology Committee and the State Oil and Gas Committee to fund the cost of geological research and exploration activities. A larger sum is earmarked for state support to the energy sector (particularly the coal industry) through the “Energy Development Fund” (see above).

The 1995 budget also included Krb 0.9 trillion (US$6 million equivalent) for the construction of the new Odessa (Yuzhniy) Oil Terminal. Apart from providing this initial seed money, future construction costs should be funded off-budget. Although the proposed terminal has a certain strategic importance in terms of the security of Ukraine’s future oil supply, it is doubtful that Ukraine will ever need the full design capacity of the terminal or that the most cost-effective option was chosen (a smaller terminal could be constructed by modernizing the existing port and using the facilities of the obsolete Odessa refinery). Reliance on commercial funding sources will provide an important market test for the economic viability of the planned terminal.

Gas Industry

The Ukrainian economy is one of the most gas-intensive economies in the world, both in absolute (per capita) and relative (per economic output) terms.2 Most of the gas consumed (more than 75 percent) is imported from Russia and Turkmenistan under contracts that were guaranteed by the state until the end of 1995. In the period 1992–95, gas imports created a heavy burden on the budget. Domestic gas prices were subsidized for all customer classes until 1995. Widespread domestic payment arrears, coupled with the underpricing of gas, led to the accumulation of about US$6 billion state debt/arrears to Russia and Turkmenistan by mid-1995. Signaling a policy reversal, most consumers were required to pay the full cost of importing in 1995, and households remained the only group whose gas consumption was still subsidized. The total household gas subsidy was Krb 80 trillion (US$530 million equivalent) in 1995, and a similar amount is planned for 1996 (despite the planned increase of the price households pay for gas, subsidies in nominal terms will not change since the cost of gas will also be higher).

At the end of 1995, the government decided that the practice of state-guaranteed gas imports should be stopped in order to establish proper commercial relationships between gas suppliers and customers. In addition, the gas transit fee was increased to a level that is in line with international practice. This, together with the gradual phaseout of household gas subsidies, provides an opportunity to reverse the previous situation by making the gas industry a net source of budgetary revenues. However, RAO Gazprom, the company that exports gas from Russia, insisted that the transit fee be used as a guarantee for payments for gas imported for domestic consumption. It appears that this maintained the perception that part of the imported gas is secure even when customers do not pay for it, endangering planned budgetary revenues from gas transit.

There is no need to maintain 100 percent state ownership of gas production, transmission, storage, and distribution assets. First, the current vertically integrated structure of Ukrgazprom3 (production, transmission, and storage within one company) should be broken up. These assets and the assets of the gas distribution companies could be separately marketed to private investors to attract foreign capital and know-how to the sector, and to create additional revenues for the budget. The role of the state should be reduced to the regulation and licensing of natural monopolies in the gas sector. Progress in this respect was very limited in 1995. Ukrgazprom and the gas distribution companies were corporatized, but pipelines and compressor stations were not included among the assets. In addition, parliament stopped the initial steps toward the partial privatization of transmission and storage facilities. Finally, regulatory responsibilities continued to be divided between the cabinet, the Ministry of Economy, and the State Committee for Oil and Gas Industry, and the State Geology Committee.

There were several changes in the ownership and marketing of gas during 1995. The government decided to transfer the responsibility for marketing gas from the local gas distribution companies to Ukrgazprom and UkrRezursy (the importer of gas from Turkmenistan). Ukrgazprom and UkrRezursy were asked to sign contracts directly with consumers, including local governments who were given responsibility to purchase gas for households and other very small customers in their geographic area. The administration of such a large number (about 3,000) of contracts proved to be very difficult, particularly for Ukrgazprom. In the second half of 1995, the idea of a wholesale gas market (similar to the one being established in the power industry; see below) was actively considered by the government, including a brief review of the experience of other countries by the Ministry of Economy and the State Committee for Oil and Gas Industry.

After recognizing that a large amount of preparatory work was required before the establishment of such a market, the government postponed indefinitely the start of the wholesale market. For 1996, a number of companies were licensed to import gas and market it to final consumers in distinct geographic areas. The licenses were issued by the cabinet based on recommendations by the State Committee for Oil and Gas Industry. The state maintained the responsibility for providing gas to households, communal services (for example, district heating), and budgetary organizations by allocating domestically produced gas for that purpose (domestic gas had to be augmented with gas imported by Ukrgaz, the association of the gas distribution companies). A limit for the gas price for final consumers was established by the Ministry of Economy. The price the licenced marketing companies pay for transmission and distribution services was also set by the Ministry of Economy.

These arrangements include the elements of an open access gas transmission/distribution system. There are three major weaknesses, however, in the scheme implemented in 1996. First, the licensing and price setting procedures are neither transparent nor predictable. Second, the geographic allocation of marketing/supply licenses restricts competition. Third, the withdrawal of the state from gas supply is only partial. The elimination of these weaknesses would require the following policy changes: (1) the separation of the natural monopoly elements (transport, storage, and distribution cost) from the potentially competitive elements (import and domestic production costs) of the gas price paid by the final consumers, and complete liberalization of the latter; (2) the permanent assignment of responsibility for regulation to one of the existing agencies or a newly created agency, and the establishment of a set of rules that would make price regulation and licensing transparent and predictable; (3) the promotion of competition among gas suppliers by allowing licensees to serve any customer with a demand above a preestablished minimum level; (4) restricting the state guarantee only to the level of the price subsidy that is temporarily provided to households with a parallel strengthening of the social protection system; and (5) ensuring that neither the central nor the local governments interfere in the decisions of gas suppliers to cut off delinquent customers.

Power Industry

The power industry succeeded in remaining largely “off-budget” in the 1992–95 period, since the cost of household electricity price subsidies was covered by surcharges on other electricity consumers (primarily on industrial enterprises). In the second half of 1995, the power industry became the first public utility in Ukraine to introduce a tariff that charges higher prices to (nonprivileged) households than industrial consumers (although further real price increases will be needed to achieve full cost recovery). The power industry was also a forerunner in the area of demonopolization and corporatization; separate generation, transmission, and distribution companies were established in 1995, and the preparations for the start of the competitive wholesale market were completed by the end of 1995. Equally important was the establishment of a transparent, license-based, nongovernmental regulatory system that is intended to provide a stable environment free of political interference for future investors.

As in the case of gas distribution, the extension of the electricity distribution system should be funded by customers and the distribution companies. The market price of electricity is expected to be sufficient to cover the full cost of electricity generation, including the rehabilitation/completion of power plants. However, funding from the state (and/or external sources) will be required for the decommissioning of the Chernobyl plant and dealing with the consequences of the 1986 accident.

With the start of the wholesale market in April 1996, the first phase of the restructuring of the power industry was completed. The preparations for the second phase—the privatization of generation and distribution companies—are expected to start in late 1996. In addition to developing a privatization strategy that balances the interest of political expediency, revenue generation, and attraction of technical and managerial knowhow, the task of establishing a solid track record for the operation of the wholesale market and the new regulatory system is equally important. The track record would include the cutoff of nonpayers leading to improved collections (see below), a new settlement system that discourages barters, and other measures to strengthen the power companies financially. Without such a track record, the interest of serious, strategic investors cannot be guaranteed.

As in the gas industry, nonpayment has become a major problem in the power industry. The payment collection ratio was particularly low (50–70 percent) in the winter of 1995/96. Industrial enterprises, farms, and budgetary organizations were the major culprits, although the number of delinquent residential consumers also started to grow rapidly. The required measures are (1) the introduction of strict procedures that electricity suppliers should follow when dealing with payment arrears; (2) the elimination of protected (nonhousehold) customer categories; (3) ensuring that neither the central nor the local governments interfere in the decisions of electricity suppliers to cut off delinquent customers as long as the above procedures are followed; and (4) the earmarking of part of the budgetary support to local governments and other centrally funded entities for the payment of electricity bills, thereby preventing the misallocation of funds.

District Heating

In line with the essentially local nature of this service, the responsibility for district heating has been delegated to local governments. However, the revenues of local governments would have been inadequate to cover the large price subsidy provided to households and had to be augmented by a budgetary transfer from the central government. In 1995, the state budget allocated Krb 69 trillion (US$460 million) for that purpose. The strategy of the government is to rapidly increase the cost recovery ratio to 100 percent while putting in place a system of targeted subsidies that covers part of the housing and utility expenses for individual households who qualify for state support. Accordingly, the 1996 budget allocates price subsidies of Krb 40 trillion for district heating, and a separate Krb 86 trillion for the funding of the housing and utility subsidy scheme.

The current owners of the district heating networks—local governments—will not be able to afford the expenses required for the rehabilitation and modernization of the networks. The right strategy is to corporatize the local district heating companies and sell part of the shares to private investors who are able to bring the necessary capital and knowhow. For privatization to be successful, the local governments should establish transparent and stable regulatory mechanisms and ensure the reduction of payment arrears. Finally, both the central and local governments should promote and facilitate energy efficiency investments in residential and public buildings.

1The system of “accounting prices” was discarded in the second quarter of 1996 when each mine was given the status of a legal entity.
2In 1990, Ukraine was the second largest gas consumer in Europe (after Russia). Although gas consumption decreased by 27 percent between 1990 and 1995, the relative importance of gas in terms of its share of the fuel market and the use of gas per unit of economic output both increased.
3The producer of domestic gas and the importer of Russian gas.

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