"Early Stalinist Measures" in the Ukrainian Energy Sector

Among numerous experts at the 6th Annual Ukrainian Energy Forum (Kiev, Ukraine), the presentation by Professor Alan Riley of City University of London  received significant attention. Natural Gas Europe had the opportunity to interview Prof. Riley who discussed the challenges of the Ukrainian energy sector from the legal angle.

NGE: In your speech at the Ukrainian Energy Forum you compared Ukrainian tax system in energy sector with the early Stalinism. Please elaborate.

AR: Well, we should understand what we are talking about. The Stalin regime in the Soviet Union has four stages: early Stalinism, high Stalinism, war Stalinism, late Stalinism. During the early Stalinist period, Josef Stalin was trying to take over the country and create structures which undermine the semi-capitalist system which was operating, known as the New Economic Plan. So he would resort to such measures as oppressive tax levels and denying access to the consumer market to strangle capitalist businesses. There is therefore a similarity with the current government’s recent energy measures that is why I referred to ‘early Stalinism measures’.

There are two main problems with what the Ukrainian government is doing: 1) incredibly high taxes which means that no one is going to invest and 2) effectively cutting off the gas producers from the consumer market. That is why the six major producers are massively reducing the level of their production. Whilst that decision makes commercial sense it leaves Ukraine in a difficult political predicament. Ukraine has a huge supply dependency on Russia and it is trying to reduce this dependency, but the measures in fact have the opposite effect. The government says: “Well, we are doing this in order to make money, we need revenues to fight the war”. In reality they are not making any money on this because they are generating lower tax revenues as a result of falling gas production. So Ukraine gets the worst of all worlds: no gas, no taxes and they are increasing supply dependency.  It actually would probably cost them money in the end because they will have to pay more money to Gazprom for more gas. This is craziness. So I think there is a real question about adopting panic measures which do not really work and then finding yourself in a political position which is very difficult.

Besides, there is other issue as well: this may well constitute indirect expropriation. If a company cannot produce any gas because the tax regime makes it unprofitable and a company has no access to consumers, then a license is worthless. So, this is potentially expropriation and companies can raise that in the Energy Charter Treaty which Ukraine signed and ratified. It is quite dangerous for Ukrainian officials to keep these taxes rates because they can end up with potentially huge liability as well.

You may have noticed is that all the discussion at the conference ended up being about royalty tax. At the panel on shale gas we could not really talk about developing Ukraine's shale gas resources because the tax regime means that it will make no sense whatsoever to invest.  It just pollutes every discussion about the Ukrainian energy sector.

NGE: Do you believe in a possibility of Ukraine using its own reserves to provide itself with gas in 10 years?

AR: I am absolutely sure. The point about it that people do not understand is that originally Ukraine was the home of the Soviet gas industry. Moreover, all the resources were never used up. The Soviet Union moved the production to Western Siberia largely because of security reasons. There are still huge amounts of oil and gas to be produced in Ukraine. Currently Ukraine is producing about 20 bcm of gas. With some energy efficiency measures the country needs 35 bcm. I think it is entirely achievable in a decade. They could do that but with latest measures in the energy sector nothing will happen.

NGE: Ukrainian government suggested the EU using its storage system. How reliable is it for Europe?

AR: First of all, the storage facilities are depleted gas fields which were originally produced in the 1950s and they are all in Western Ukraine. So it is safe. Secondly, it is close to all the Central European consumers, so it convenient from a point of view of Hungary, Poland, Slovakia -  it is a fantastic place to put a lot of gas. If Western Ukraine starts to produce shale gas then it might make a lot of sense to use Ukraine’s storage facilities  - just pump all the gas in there. So that would be a potentially good option to take.

NGE: Country is currently trying to diversify its sources of supply to get rid of Russian dominance. How much progress have been achieved?

AR: Well, Ukraine has done that to some degree by reverse flow. They got about 5 bcm of gas reverse last year, and we are expecting them to get at least 10 bcm this year. That is a lot of gas. Most of this gas is Russian but it is gas that was sold to Germany and then Germans reversed flow back to Ukraine via Poland or Slovakia. It also could be virtually reversed. Actually, this gas is cheaper because the price Ukraine pays is higher than the price Germany pays.  The German border price is about $350 and Ukraine price is  between $360 and $450. Last year they saved $500 million by buying Russian gas from Germany instead of buying Russian gas direct. That also puts huge leverage on Russia as well.

The other big point about the pipeline between Slovakia and Ukraine is that could help Ukraine significantly. It has a huge capacity -  100 bcm. Part of that capacity can be reverse flowed to Ukraine. Gazprom does not use that capacity so it remains unused. The antitrust rules in the EU revolve around the concept that is called “capacity holding”. If you hold unused capacity without legitimate commercial justification and you are a dominant supplier - that is potentially illegal. The EU could also apply its liberalization rules, in particular the – use it or lose it rules: either use the capacity or lose it.

NGE: One term repeated heard at this conference was "transparency". What is in your opinion should be done to ensure transparency of energy companies operation in Ukraine? 

AR: To be fair, traditionally there was no transparency at all. You know Churchill’s joke comparing Soviet politics to a dogfight under a carpet? In the Ukrainian energy sector there was  a very large carpet with very small dogs. So no one had any real idea about what was happening. However, now things are beginning to change. For instance, Naftogaz has put all the details of the state of their gas storage facilities online. Obviously there are a lot of things that should be done – you need full unbundling to take place, so that a market is opened up and there is more liberalization. Some steps have been made but they need to go a lot further.

NGE: We hear a lot about Ukraine trying to comply in with the EU regulation. Is this more of a talk or an action? 

AR: There have been a lot of announcements. It seems to me that there were practical measures. Janez Kopač,, the Director of Energy Community Secretariat spoke about Ukraine moving toward the compliance. Of course, we need to keep up pressure to make things happen. The Ukrainian energy sector will not be reformed over night. While there is room for optimism steps like the royalty tax and market restriction measures are worrying.

Marina Zvonareva

Marina Zvonareva is a Natural Gas Europe analyst focused on Russia’s international energy relations. Follow her on Twitter: @ZvonarevaMar1na