[NGW Magazine] Ukraine – Europe’s gas basket

This article is featured in NGW Magazine Volume 2, Issue 13.

Ukraine, a transit country struggling to shake off the legacy of the Soviet past, wants to increase co-operation with the EU as partner and supplier. 

The outflow of news from Ukraine over the last year leaves no doubt about the far-reaching improvements that could be in place soon. 

Once a handy place for eastern European businessmen to turn public gas into private funds, Ukraine is now making major progress in cleaning up its act.

Network codes and European Union (EU)-style gas balancing agreements with neighbouring grids; stable gas production by the state Ukrgazdobuvannya; the ability to offer foreign investors up to 14bn m³ of storage capacity without paying customs duties on the gas for over three years; separation of transport from supply and the findings of the Stockholm arbitration court in what would have been a ruinous take-or-pay case with Russia – these have all helped de-risk Ukraine.

In the opposite scales are the lumbering and hostile bureaucracy and murky corporate governance.

However the focus at a conference in Brussels June 22 was on the cheerful side of the balance-sheet. “Ukraine has done more in the past year than in the previous 20,” said the European Commission’s vice-president Maros Sefcovic. Observing that the EU is matching this commitment in its support for Ukraine, he pointed to the recent visa waiver agreement that entered into force at the beginning of the month, as well as the association agreement with the EU, which, at the risk of annoying Moscow, will set the framework for ever closer co-operation and which is set to be ratified during the Ukraine-EU Summit in Kiev July 12-13.

In the energy sector in particular, Sefcovic praised the ongoing unbundling of state-owned Naftogaz; the recent adoption of the electricity market law in April; and the progress on establishing a truly independent electricity market regulator. Together with previously adopted laws, such as the natural gas market law adopted in May 2015, the country hopes to reach EU legislation standards set out in the Third Energy Package (TEP).

Storage and supply potential

If all the planned legislation is implemented effectively, the role of Ukraine could swiftly move from a transit country to an important partner for the EU, potentially both becoming a supplier of natural gas and also providing it with storage capacity.

Significant efforts are needed in order to make such a change however. In 2014, Ukraine’s consumption amounted to 42.6bn m³/yr, and Ukraine’s own production of natural gas covered only about half of that, at 20.5bn m³ that year. NGW understands that there might still be money due Gazprom for gas Ukraine used but allegedly did not pay for that year. 

Ukraine has the objective of producing 27bn m³ by 2020 according to the government programme; independent producer JKX believes the country could produce 40bn m³/yr based on the large reserves and low production rate – if taxes were lowered and bureaucracy slashed. That would enable it to export gas. 

But as the head of the national investment council of Ukraine Yuliya Kovaliv said at a forum organized by domestic gas producers late June: “The complicated process of obtaining permits is one of the biggest obstacles to attracting investment funds.” She described the process as “unacceptably slow.” Representatives of the office went to Texas in order to see how they managed to compress into a few weeks maximum at the Railroad Commission a permitting process that took Kiev two or three years.

JKX might not be around in its present incarnation however, for much longer.

There is significant potential for increasing both production and energy efficiency in Ukraine. According to Sefcovic, “if only it reached Poland’s level of energy efficiency, Ukraine could save as much energy as Spain consumes per year.” 

The EU has formed a €100mn fund for financing energy efficiency in Ukraine in July 2016, a fund that was finally unlocked June 22 when Ukraine’s parliament adopted the final two pieces of legislation required, relating to heat/water metering and energy efficiency. Furthermore, Sefcovic added that he is reaching out to international financing organisations to extending that fund further.

Moreover, if the legislation adopted during the past few years is indeed implemented effectively, it would provide the legal security and incentives that European and US investors need to engage in modernising the country’s infrastructure. 

The gas market law adopted in 2015 is already contributing to a liberalised and competitive market. In this scenario, Ukraine’s large storage capacity – Europe’s largest, outside Russia – could be  used  to  supplement  existing  capacity  in  central  and  eastern  Europe, with the possibility of creating new business models for energy security in the EU, said Sefcovic. 

And, “investing in Ukraine could be a way of achieving the gas supply of Nord Stream 2,” suggested long-term NS2 opponent Jerzy Buzek. He chairs the energy committee at the European Parliament and was once a prime minister of Poland.

Unbundling Naftogaz

Unbundling and investment in the gas transmission system remain behind the plan, however. Naftogaz Ukrainy CEO Andriy Kobolev said June 23 that the company would “step in to make sure Ukraine’s gas transmission system (GTS) modernisation plan is developed… We agree that further delaying the development of the system’s modernisation plan is unacceptable.”

Naftogaz Ukrainy is in technical breach of the TEP as its pipeline business, UkrTransGaz, remains a wholly-owned subsidiary. But in late June it announced that the Polish branch of international consultancy Pricewaterhouse Coopers has won the $341,200-tender to draw up a plan for unbundling this year.

Ukraine’s energy and coal ministry was supposed to ensure that the corporate governance structure of the new transmission system operator – as defined by the EU TEP – was established in line with its corporate governance action plan by the beginning of October 2016. The new company would have its own supervisory board and management, the latter tasked with modernising the GTS. But “unfortunately, the government has not started carrying out the new TSO’s corporate governance plan,” Naftogaz said.

The shadow of Nord Stream 2 

Ukraine is in a difficult position: for all Kiev’s antipathy towards Moscow, its desperate need for cash means that it has to act as a transit country for Gazprom. Ukraine reported record transit in January-May, exceeding the average transit volume for January-May 2013-2016 by nearly 9bn m³. 

Using the original transit fee of $2.70/’000m³/100 km, that would mean $1.24bn of revenue in total, compared with the typical value of $2bn for a whole year. 

So Naftogaz is arguing against NS2. Kobolev said NS2 had two objectives: first to weaken Ukraine and second to divide Europe.

Transit of Russian gas using the Soviet-era system underneath Ukraine – what Naftogaz calls Direct Stream – was reduced by half between 2006 and 2014, from 128.5bn m³/y to 62bn m³ with NS1. NS2 would also have a capacity of 55bn m³/y, so it could drastically eliminate transit via Ukraine; and eliminate it altogether in conjunction with TurkStream 2, if Gazprom could bring gas up through the soon-to-be redundant transBalkan line that TurkStream is to replace. Gazprom has said it will only keep enough compression for no more than 20bn m³/yr post-2020, perhaps as an insurance policy rather than continuous use. 

Direct Stream however is itself very old, and while the low-carbon benefit of the very high pressure NS2 is not the chief justification for the line, it is nevertheless an advantage. Ukraine’s system by contrast needs investment of the order of $3bn, according to consultants KPMG.

Mandate for NS2

Energy ministers from the EU countries met in Brussels June 26, where they were briefed by the EC on its request for a mandate to open negotiations with Russia on the regulatory framework for the operation of NS2. 

The purpose of the mandate is to establish a legal framework that would apply specifically to NS2, and ensure that it is operated in line with international law and with EU energy legislation, in particular with the third energy package, the security of gas supply, as well as environmental and competition rules. 

“It’s clearly a collision of legal regimes, and EU legislation (TEP) lacks provisions for this case,” said Sefcovic, not fully agreeing that NS2 is completely legal and compliant with the relevant legislation. An official mandate would only be given if the notion has a qualified majority in the Council of Ministers. 

Future developments

Deputy foreign minister Olena Zerkal argued that her country is fully committed to European integration, even applying for full membership. She also praised Naftogaz’s reforms as an example of the transformation that can be achieved with EU support.

Buzek suggested that Ukraine could even become a key axis in an “Energy Union of 36”. Here he toyed with the idea of creating an energy market that included the Balkans, and Armenia, Georgia and Azerbaijan. While the question of whether Ukrainian gas would be cheaper than NS2 Russian gas was left unanswered, Buzek insisted on the political advantages on supporting Ukraine, arguing that “co-operation gives us power on both sides.” 

Sara Vargas, William Powell