Privatesector P U B L I C P O L I C Y F O R T H E Note No. 169 December 1998 Laszlo Lovei Gas Reform in Ukraine Monopolies, markets, and corruption Many countries are Reform of the natural gas industry in Ukraine started a year later than reform of the power struggling to liberalize their energy markets industry. Because gas reform had no blueprint, its direction has remained ambiguous. That and to replace rigid state controls with ambiguity is the result of a conflict between those who advocate vertically integrated, opaque, private initiative and ownership. Ukraine monopolistic structures and those who want a transparent, competitive gas market governed by illustrates the extreme difficulties stable rules. This conflict will likely continue for several years, making the ultimate outcome of this transformation when a country’s difficult to predict. More by accident than by design, the reform produced a number of innovative macroeconomy is severely imbalanced, features that might be of interest for other countries planning to restructure and privatize their enterprise governance is poor, and political gas industries. leadership is ineffective —shortcomings that also exist in several In 1990 Ukraine consumed 115 billion cubic holds, budgetary entities, and district heating other countries of the former Soviet Union. meters of natural gas (figure 1), representing companies used 43 percent less, and power This Note is the second about 40 percent of primary energy con- plants used 62 percent less. Despite the de- of three on Ukraine’s sumption. Over the next seven years gas con- crease, gas accounted for more than half of reforms; the other two are on the electricity sumption dropped to about 80 billion cubic primary energy consumption in 1997, making and coal industries. meters a year. In 1997 industrial enterprises Ukraine one of the world’s most gas-intensive used 40 percent less gas than in 1990, house- economies. FIGURE 1 NATURAL GAS DEMAND, 1990–97 FIGURE 2 NATURAL GAS SUPPLY, 1990–97 Billions of cubic meters Billions of cubic meters 120 120 100 100 80 80 60 60 40 40 20 20 0 0 1990 1991 1992 1993 1994 1995 1996 1997 1990 1991 1992 1993 1994 1995 1996 1997 Industry Power Households and Losses Net imports Ukrgazprom Other producers district heating Source: Ukraine State Oil and Gas Committee. Source: Ukraine State Oil and Gas Committee. The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 Gas Reform in Ukraine Ukraine has significant proven and probable Gas Committee, the main government agency gas deposits, both onshore and offshore. Today responsible for implementing the government’s domestic gas fields produce about 18 billion gas strategy and the de facto representative of cubic meters of gas a year (figure 2). The rest the state as the owner of gas industry compa- of domestic gas demand is covered by imports nies. Gas exploration was supervised by the State from Russia and Turkmenistan (though Russia Geology Committee. The Ministry of Economy is expected to become the sole external sup- regulated gas prices and transportation tariffs. plier in 1998). Ukraine is on the main export route for Russian gas to the rest of Europe. As Main challenges and initial reforms payment in kind for the transit service, Ukraine In early 1995 the Ukrainian government faced three major challenges in the gas sector: revers- Ukraine became one of the first countries ing the decline in gas production, ensuring that only those that paid for imported gas received in the world where gas transmission and it, and preserving Ukraine’s strategic position on the east-west gas transport corridor in Eu- distribution were unbundled from gas rope. In 1994 RAO Gazprom announced that a major new line through Belarus and Poland import and supply. would be constructed to carry gas from the Yamal peninsula to Germany. Early construc- tion of this line would enable RAO Gazprom to receives up to 30 billion cubic meters a year of divert some of the gas flows that currently go gas from RAO Gazprom. (RAO Gazprom, through Ukraine. Russia’s largest company, produces about one- quarter of the world’s natural gas.) Ukraine has The first reform step addressed the problem of extensive gas storage facilities (capable of stor- declining domestic gas production. Gas produc- ing an active volume of 32 billion cubic meters), tion had the potential to increase to 30 billion a well-developed transmission system (10,000 cubic meters a year following large investments kilometers of high-pressure lines), and an ex- in exploration and production over a period tensive distribution system (60,000 kilometers of about five years. But these investments of small-diameter pipes). In early 1998 the gas would have to come from abroad because industry employed about 110,000 people. Ukraine lacked sufficient financial resources, technology, and know-how. Recognizing this, A 1994 parliamentary decision banned the priva- the State Geology Committee started awarding tization of transmission and distribution pipe- exploration (and later, production) licenses to lines and the related infrastructure, so these private (mostly foreign) companies in 1995. formally belong to the State Property Fund and are not included among the assets of the gas The second reform step addressed the prob- companies. Until recently Ukrgazprom, a fully lem of inadequate payments for gas imports. state-owned company, was the main domestic Until 1996 Ukrgazprom was the sole importer gas producer and operated gas transmission and of gas in Ukraine. This monopoly fit well with storage facilities. About fifty oblast- and city- the State Oil and Gas Committee’s centrally based distribution companies were responsible planned approach to balancing gas supply and for the operation and maintenance of the distri- demand. It also suited RAO Gazprom because bution networks. Ukrgaz, a former association import volumes, prices, and payments were ne- of gas distribution companies, managed state- gotiated with and guaranteed by the Ukrainian owned shares in the gas distribution companies. government. But highly subsidized domestic Gas production, transmission, and distribution gas prices led to the rapid accumulation of activities were supervised by the State Oil and payment arrears in 1992–94. Even after indus- The World Bank Group 3 trial gas prices were raised to the import parity Although the system was left largely intact in level in early 1995, the state continued to build 1997—the only notable changes were the re- up external arrears at an unsustainable rate distribution of supply franchises in favor of po- because payment discipline was poor and state- litically influential traders and the permission owned distribution companies were reluctant given to Ukrgazprom to import a limited to cut off delinquent customers. In 1996, un- amount of gas—the need for additional reforms der pressure from the International Monetary was widely acknowledged. Even Ukrgazprom, Fund, the government took a radical step: sov- a company that had opposed any change in ereign guarantees for gas imports were elimi- the status quo, argued that it could not ensure nated, and private gas traders were given the reliability of the transmission system unless exclusive rights to import and sell gas to all consumers in specific oblasts assigned to them by the Cabinet of Ministers. With this measure The frequent redistribution of supply Ukraine became one of the first countries in the world where gas transmission and distri- franchises among traders led to bution were unbundled from gas import and supply. occasional violence and to accusations Continuing problems of corruption, and payment discipline Awarding exploration and production licenses remained low. to foreign companies and transferring respon- sibility for gas imports to private traders had mixed results. On the positive side, foreign it stopped giving gas to privileged consumers direct investment started to flow to the upstream at low prices and mostly without payment. In gas industry, traders managed to improve pay- fact, Ukrgazprom should have been the most ment discipline among industrial customers, profitable company in Ukraine in 1997. It pro- and the government stopped accumulating duced 14 billion cubic meters of gas at a cost additional debt to Russia and Turkmenistan. of about US$400 million, about 30 percent be- On the negative side, none of the main multi- low market value. It also received from RAO national oil and gas companies found the legal Gazprom 30 billion cubic meters of gas with a and regulatory framework attractive enough to market value of US$1.2 billion to US$1.4 bil- make large-scale investments in gas explora- lion as payment for the transit service, while tion and production, the frequent redistribu- the cost of providing this service was about tion of supply franchises among traders led to US$700 million. occasional violence and to accusations of cor- ruption, and payment discipline remained low Several shippers—RAO Gazprom, a number of among households, district heating companies, gas traders, and a private gas producer—pointed and power plants. Even on external debt, suc- to deficiencies in the tracking and control of cess was only partial. RAO Gazprom claimed gas flows in the transmission and distribution that the Ukrainian government was responsible network, deficiencies that made it extremely dif- for the arrears accumulated by private traders ficult to enforce commercial contracts between because the traders were pressured by central gas sellers and buyers. Potential foreign inves- and local governments to maintain supplies to tors in the upstream gas industry noted the lack politically important customers, and were afraid of assurances about their access to the trans- of losing their franchises if they ignored “na- mission and distribution network and their abil- tional interests.” In the summer of 1998 the ity to market gas to third parties. A commission government accepted responsibility for US$1.37 created by Parliament to investigate “irregu- billion of debt incurred in 1997–98. larities” in the energy sector demanded that 4 Gas Reform in Ukraine territorial supply monopolies be abolished and mits. After some relaxation of these require- a properly functioning gas market be established. ments, more than twenty traders were autho- rized to import and sell gas to industrial Competing reform concepts consumers at freely negotiated prices in 1998. Two very different reform concepts emerged in Meanwhile, the State Property Fund sold the the debate. The first, put forward by Ukrgazprom majority of the shares of several gas distribution and the State Oil and Gas Committee, favored companies to company managers, employees, increased state control over the gas industry and local financial investors at very low prices. through the vertical integration of gas producers, The low share prices resulted from a number of transporters, and distributors. This setup, it was factors that deterred strategic investors: argued, would improve the flow of revenue from ▪ The assets of the companies did not include consumers to producers and facilitate the the pipelines (since pipelines could not be reallocation of profits to priority investments. privatized). The second reform concept, developed by the ▪ The rights of the companies to operate and Ministry of Economy, National Agency for Devel- manage the pipelines in the long term were opment and European Integration, and World unclear. Bank, advocated reduced state intervention ▪ The price of gas marketed by the distribu- through the separation and privatization of tion companies was set at US$66 per thou- Ukrgazprom’s production, transmission, and sand cubic meters, including a distribution marketing activities, elimination of exclusive gas fee of US$5.34 per thousand cubic meters— supply franchises, privatization of gas distribu- barely enough to cover recurrent costs. tion companies, liberalization of gas prices, and ▪ Local governments and influential politicians establishment of an independent regulatory body remained strongly opposed to the curtailment to ensure open access to the transmission and of gas supplies to delinquent consumers. distribution network. Various presidential de- crees and Cabinet resolutions issued in 1997 at- Developments in 1998 tempted to combine these two concepts into a coherent reform plan, with limited practical Payment collections from households and results. district heating companies remained low in the first six months of 1998. The newly privatized A change of government in mid-1997 opened a gas distribution companies kept enough rev- window of opportunity for those who wanted enue to cover their wages and other recurrent to eliminate the regional gas import and supply costs and sent what was left to Ukrgazprom. monopolies awarded to selected gas traders. The Still, Ukrgazprom’s financial situation contin- newly formed Cabinet announced that the gas ued to deteriorate. The supply to industrial con- market would be divided into two segments in sumers was at risk because few traders were the coming year. The first segment, for the im- sufficiently creditworthy to purchase gas from port and supply of gas to industrial consumers, RAO Gazprom. Nevertheless, price liberaliza- would be assigned to private gas traders with- tion led to a significant drop in the prices paid out any restrictions on service areas or prices by large consumers, particularly when part of (figure 3). The second segment, for the supply the payment was in cash. of gas to households and district heating com- panies, would be assigned to gas distribution In early 1998 supporters of a vertically inte- companies selling Ukrgazprom’s domestically grated industry structure focused their efforts produced and transit-fee gas at prices fixed by on establishing Naftogaz, a company whose the Ministry of Economy. Subsequently, the State assets would include everything that the state Oil and Gas Committee issued requirements that owned in the oil and gas industry. It was ar- gas traders had to meet to receive import per- gued that Naftogaz could solve the problem of The World Bank Group 5 FIGURE 3 PLANNED GAS SUPPLY AND DEMAND, 1998 Imports from In-kind transit compensation Domestic production Supply Russia and Turkmenistan 30 bcm 18 bcm (82 bcm) 34 bcm Ukrnafta Ukrgazprom Chernomornaftogaz 14 bcm 4 bcm Ukrgazprom Trading Itera Intergaz Others Wholesalers 44 bcm 8 bcm 6 bcm 20 bcm Transporter Ukrgazprom Transportation Distributors Ukrgaz/Kievgaz Losses 8 bcm Households, district heating, Industry and power Consumer sectors and budgetary organizations 40 bcm 34 bcm Note: The abbreviation “bcm” means billion cubic meters. Source: Ukraine State Oil and Gas Committee. low payment collection because it could take gas-producing subsidiaries into joint ventures away the right to manage and operate distri- (until then, only the State Property Fund was bution assets from gas distribution companies authorized to privatize these and other gas that performed poorly. Its supporters also industry assets). Finally, supporters claimed that claimed that Naftogaz could increase foreign Naftogaz could provide funding for priority direct investment in oil and gas production be- investments because it could reallocate profits cause it could enter the assets of its oil- and among its subsidiaries. 6 Gas Reform in Ukraine These arguments were apparently accepted by customers will be transferred to other enti- all the relevant government agencies, and in ties (domestic or foreign) with a proven track February 1998 a presidential decree ordered record. the government to establish Naftogaz. Naftogaz ▪ Starting in mid-1998, organization of quarterly can also be seen as an attempt by the govern- gas auctions where gas traders and large con- ment to regain control over the privatization sumers can purchase gas from Ukrgazprom process in the oil and gas sector in response to for cash. the increasing influence of the Parliament over ▪ Improvements in 1998–99 in the metering, the State Property Fund. As a gesture to those tracking, and balancing of gas flows, includ- who argued for separation rather than integra- ing the introduction of contractual arrange- tion, the presidential decree also ordered the ments for the settlement of differences on a implementation of organizational steps to un- daily and monthly basis. bundle gas production, transmission, and sup- ▪ Separation and privatization of the gas pro- ply functions, although this unbundling was duction activities of Ukrgazprom and the gas expected to take place within the framework exploration activities of the State Geology of Naftogaz. A government resolution issued Committee. in June approved the charter of Naftogaz and appointed its chairman and supervisory board. If implemented, the action plan will go a long way toward restoring the financial health of In a May 1998 meeting to discuss the recommen- the gas industry, increasing budget revenues, dations of a World Bank–government working addressing the complaints of investors in gas group on gas reform, advocates of the second exploration and production, and ensuring the reform concept argued that the nonpayment reliable transit of gas from Russia to Central, problem could not be solved unless the man- southern, and Western Europe. Several well- agement of transmission and distribution assets connected parties will be negatively affected, were transferred to strategic investors, that con- however. Private traders, for example, may lose trolling corruption would require introducing a their best customers when financially liquid transparent, cash-based gas marketing mecha- industrial companies can purchase their gas at nism, and that full-scale privatization (rather than auctions. Central and local governments will joint ventures) was needed to revitalize domes- be much less able to ensure the supply of gas tic gas production. At the end of the meeting to cash-strapped budgetary entities and public agreement was reached on an action plan that utilities. Managers who cannot adapt to a mar- included, among others, the following steps to ket environment and workers who are redun- be taken during 1998–2001: dant will lose their jobs. Government officials ▪ Setting up in 1998 of a state-owned joint stock who benefit from nontransparent gas trading company to operate the transmission net- arrangements will also be worse off. work, and appointment in 1999 of a consor- tium of domestic and foreign companies to To date, government performance in implement- manage the shares of this company for at ing the action plan has been mixed. The first least fifteen years. State ownership in the con- gas auction, in the summer of 1998, failed be- sortium will be limited to 25 percent plus cause of a high preset minimum price and lim- one share. The allocation of transmission ca- ited advertisement. Half a billion cubic meters pacity will be market-based, ensuring equal of gas were sold at a subsequent auction shortly treatment of all domestic shippers. afterward at a slightly lower minimum price. At ▪ Introduction in 1999 of incentives and crite- the third auction, in late October, just 9 million ria to improve the collection performance of cubic meters of gas were sold for US$37 per gas distribution companies. Where perfor- thousand cubic meters (equal to the minimum mance is poor, rights to operate the distribu- price), reflecting the weakening demand for gas tion system and supply gas to nonindustrial due to the recent depreciation of the hryvnia The World Bank Group 7 and a downturn in the economy. It remains to ticians and gas traders. (Russia, at least in the be seen whether the government (or its agent, short term, has no alternative route to European Naftogaz) will be willing to lower the minimum gas markets.) Thus the conflict between those price in order to sell more gas through auctions. supporting reform and those opposing it will likely continue for several years. Eventually, In September 1998 Ukrgazprom and Ukrgaz however, Russia will likely have one or two al- were reorganized into three companies: a gas ternatives to the unreliable Ukrainian transit transportation company that owns transmission system, creating strong incentives for players in and distribution assets, a gas trading house, the Ukrainian gas industry to clean up their act. and a gas production company. All three com- panies, however, remain under Naftogaz. A number of lessons emerged during the first Preparations have not started for the privatiza- three and a half years of gas reform. These tion of the gas production company and the may be of use for reformers in the former So- award of a long-term management contract for viet Union and other countries: the gas transmission system. ▪ The apparent contradiction between an ex- ternally imposed goal—that state guarantees A presidential decree ordered the transfer of re- for gas imports should be eliminated—and sponsibility for regulation of the gas industry the conviction of domestic decisionmakers— from the Ministry of Economy and the State Oil that the government’s operational control and Gas Committee to the National Electricity over the gas industry should be preserved— Regulatory Commission (although the Ministry was resolved by introducing private regional of Economy will continue to set household gas supply monopolies. Although the new ar- prices for a limited period). Given the time re- rangements reduced the state’s exposure to quired to recruit gas specialists and implement the risk of nonpayment, this benefit came at necessary organizational changes, the regulatory a high cost. A few politically connected trad- commission is not expected to be ready to dis- ers captured a large part of the gas market, charge its new functions until mid-1999. The corruption skyrocketed, and the moral au- State Oil and Gas Committee, having been thority of the government eroded. stripped of its ownership and regulatory func- ▪ Ukrgazprom’s ability to absorb the cost of tions, has refused to go out of business without nonpayment for domestically produced and a fight, and is lobbying for the preservation of transit-fee gas without catastrophic conse- its technical (that is, noneconomic) regulatory quences (at least in the medium term) re- functions. duced decisionmakers’ sense of urgency to initiate reform, demonstrating that gains do Lessons not motivate governments as strongly as do actual losses. Reform of the gas industry in Ukraine started a ▪ The regulatory, taxation, and market access year later than reform of the power industry. difficulties experienced by the first investor Because gas reform had no blueprint, its direc- in gas exploration and production strongly tion has remained ambiguous. That ambiguity deterred other potential investors despite fa- is the result of a conflict between those who vorable drilling and production conditions. advocate vertically integrated, opaque, monopo- ▪ The sale of the majority of the shares of the listic structures and those who want a transpar- gas distribution companies to workers and ent, competitive gas market governed by stable managers did not solve the payment collec- rules. The probability is low of a strong jolt— tion problem. In the absence of strategic in- such as a significant and lasting curtailment of vestors, the companies continued to lack the Russian gas deliveries to Ukraine to stop the commercial focus, experience, and indepen- accumulation of payment arrears—signaling the dence needed to stand up to political pres- need to end the “unholy” alliance between poli- sure and aggressively pursue delinquent 8 Gas Reform in Ukraine households, public utilities, and budgetary entities. ▪ The liberalization of gas supply provided certain immediate benefits to industrial con- sumers, but the development of a vibrant competitive gas market requires clear net- work access rules, better metering, tracking, and balancing of gas flows, and new con- tractual arrangements. Even the first step toward a spot market—setting up a system of occasional gas auctions—requires strong political commitment to overcome op- position from suppliers and traders that stand to lose customers. Laszlo Lovei (llovei@worldbank.org), Lead Specialist, Energy Markets and Reform Thematic Group Viewpoint is an open forum intended to encourage dissemina- tion of and debate on ideas, innovations, and best practices for ex- panding the private sector. The views pub- lished are those of the authors and should not be attributed to the World Bank or any of its affiliated organiza- tions. Nor do any of the conclusions represent official policy of the World Bank or of its Executive Directors or the countries they represent. To order additional copies please call 202-458-1111 or contact Suzanne Smith, editor, Room F11K-208, The World Bank, 1818 H Street, NW, Washington, D.C. 20433, or Internet address ssmith7@worldbank.org. The series is also available on-line (www.worldbank.org/ html/fpd/notes/). Printed on recycled paper.