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Hans van Zon

Conference “Geopolitical and geoeconomical problems of Russian-Ukrainian relations

(estimations, prognoses, scripts)” - January, 2001

THE REFORM OF UKRAINE'S ENERGY COMPLEX

AS A PRECONDITION OF ELIMINATING

UKRAINE'S ENERGY DEPENDENCE

Only 16 per cent of Ukraine's gas and 13 per cent of its oil is produced domestically and more than half of Ukraine's imports consist of energy.ⁱ Most of energy imports originate in Russia. This energy dependence upon Russia and problems to pay for energy deliveries is perceived as a big threat to Ukraine's sovereignty. Unauthorised siphoning of gas destined for Western Europe urged Russian Gazprom to start negotiations about a gas pipeline bypassing Ukraine. This would bereave Ukraine of a major source of income, i.e. between one quarter and one third of its domestic gas consumption.

Ukraine's energy dependence upon Russia and security threats involved are investigated in this contribution.

It is argued that with a reform of the energy economy, energy dependence would be very limited. The level of energy dependence is, among others, dependent upon the levels of domestic energy consumption and production. Energy consumption is very high due to lack of incentives to economize on energy consumption. Domestic energy production could be more efficient and much more cheaper if proper incentives would be in place. The payments crisis and the parasitic role of energy traders constitute the root of the current energy crisis. The obstacles that prevent a reform of the energy economy are the same that prevent Ukraine reducing its energy dependence.

First problems of energy consumption, trade in energy and the energy payments crisis are analysed. Subsequently domestic energy production is looked at. Then the results of the reform of the energy sector of the Yushchenko government are dealt with. Finally, energy imports and energy dependence upon Russia are analysed.

1. Wastage of energy

In Soviet times, enterprises and households did not have any incentive to economise on energy consumption. All houses had central heating and costs of heating were included in the very low fixed rent. Enterprises consumed huge amounts of energy that was delivered for a very low price because the Soviet Union had enormous amounts of energy reserves. Moreover, all enterprises were faced with soft budget constraints: the state would automatically cover losses. It made the Soviet Union one of the most energy intensive economies in the world.

After the independence of Ukraine the situation changed. Ukraine imported more than half of the energy it consumed and soon Ukraine had to pay the world market price for the oil and gas that was mainly delivered by Russia. In three years time the price went up from approximately 15 per cent of the world market price to the world market level. Although not all delivered energy was paid for (Russia continued to subsidise Ukraine although regularly cutting of supplies) and Ukraine started to indebt itself, the change-over had an enormous impact upon the economic situation in Ukraine. It contributed to the economic collapse (a 65 per cent production decline from 1991-1996) and partly explains why Ukraine was performing so much worse compared to Russia.

Although Ukraine had to pay much more for the energy it consumed, the wasteful attitude of households and enterprises towards energy use hardly changed. Households still generally do not have thermo-regulators and do not have individual gas meters.

Although households had to pay more for the energy they consumed they were not given the means to diminish energy consumption.ⁱⁱ The local energy providers reacted upon lack of energy resources by switching on the heating later in winter and switch it off earlier in springtime. As far as cut-offs occurred, they were usually arbitrary and often not directly related to non-payment.

Enterprises had to pay more for energy but the budget constraints of big state owned enterprises and many privatised enterprises remained rather soft and non-payment of the energy bill often did not result in cutting off of energy. In 2000, 13 000 debtor companies continued to receive energy. On the other hand, new private enterprises had incentives to take energy saving measures.

The industrial structure of Ukraine changed. The share of energy intensive industries like heavy metallurgy and chemical industry increased. Heavy metallurgy as a share of total industrial production increased from 14.4 per cent in 1990 to 26 per cent in 1999, mainly as a result of increased exports. Thirteen per cent of total gas consumption is by heavy metallurgy and 11.3 per cent by chemical industry.ⁱⁱⁱ The energy intensity of heavy metallurgy is such that if costs of energy would be reflected in the export product, it would not be competitive. Most steel enterprises produce steel in open-hearth furnaces (Martin ovens) that are already several decades ago abandoned in the Western world. Therefore Ukrainian steel enterprises use up to 60 per cent more energy as their foreign competitors. However, steel enterprises do not pay for all the energy they use. This is the reason that Ukrainian steel exported abroad is often faced with anti-dumping procedures.

Although Ukrainian steel enterprises often managed to make some profit, revenues are hardly used for new investments, among others in energy saving measures.

During the 1990s Ukraine became the most energy inefficient country in the world.^iv International comparison of GNP per kg oil equivalent (US dollars) shows that Ukraine produced in 1996 only 0.5 dollars per kg/oil equivalent, while it was 3.0 dollars for South Korea, 5.4 for the Netherlands and 7.0 for Germany.^v

Little has been done hitherto to reduce the energy intensity of production. President Kuchma complained that there is no governmental activity in the sphere of energy conservation.^vi With a more efficient use of electricity, 20-25 per cent could be saved on the electricity bill, according to the Energy Center of the European Union, 40 per cent according to the Energy Research Institute of the Ukrainian Academy of Sciences.^vii Yet, energy intensity of industrial production has increased during the 1990s, because generally, decline of power consumption has been less than the general decline of industrial production. In 1994, electric power use per unit GDP was 4-4.5 times higher in Ukraine than in Western Europe. This ratio was 2.5-3 times in the 1980s.

Nowadays, Ukraine surpasses virtually all Western European countries in per capita electric power consumption.^viii Ukraine, with 49 million inhabitants, burns the same amount of gas as affluent Germany with 80 million inhabitants.

According to O. Khraban, of the Danish energy-technology firm Danfoss, ‘the potential market for energy saving technology is huge, but the real market is much smaller, mostly because there is little awareness of the problem.’^ix There is also the misconception that energy saving technology is expensive.

Some energy conservation projects clearly show the problem. With the help of a USA agency a school in Lviv insulated windows and accomplished herewith 43 per cent energy savings. Also a new heating control system was installed. Before the upgrade has been made, the school paid 900 000 hryvnas monthly for energy, while two years after the work has been completed the school pays 544 000 hryvnas monthly. The costs of the works were 29 000 dollars. Two years after completion Lviv got 10 000 dollars back and is saving 5000 dollars a year.^x

Unfortunately, very few institutions followed this example. For example, hospitals still spend on average 20 to 30 per cent of their budget for heating, while economizing on energy could free money for salaries and equipment.^xi

2. Energy payments crisis

Energy trade is one of the most profitable business in Ukraine, despite the fact that there is a payments crisis in the energy sector. Official statistics about the financial situation in the energy sector are not reliable because most actors involved are opposed to transparency. In many ways tax-authorities are cheated. The fact that large part of energy is traded in barter deals makes energy trade very opaque. Barter gives ample opportunities to siphon of profits and hide revenues for tax authorities. This situation is further complicated by the fact that energy traders often get the exclusive right to provide energy to designated enterprises. This gives them the opportunity to squeeze these enterprises, usually with the collaboration of these manufacturing enterprises.

For example, a steel enterprise buys gas from a trader that is imposed upon the enterprise by political authorities. The trader delivers the gas for a high price and receives in exchange, apart from a small amount of cash, the larger part in the form of undervalued steel. On paper, the steel enterprise pays only for part of the delivered energy. The energy trader sells the undervalued steel for a low price to an off shore steel trader, owned by the energy trader. Subsequently the offshore company makes big profits selling the undervalued steel for the world market price abroad.

On paper, both the steel enterprise and the energy trader are making losses with this deal. On paper, the energy trader receives only payments for part of the delivered gas. The steel enterprise becomes indebted with the energy trader.

In many cases, steel enterprises are loss making (on paper) and receive direct or indirect subsidies from the state. Energy traders are often on paper also loss making and do not pay for all energy delivered by energy producers. Often, the state jumps in and subsidises the energy traders and energy producers. Energy traders often bought from energy producers energy on loans, guaranteed by the state. When the energy trader failed to pay, the state paid back the loan.

Independent energy traders can buy cheap gas, for example by paying immediately in cash and bypassing Gazprom. According to Yulia Timoshenko, in such a case gas could be bought for 25-30 dollars per 1000 m3, while Ukraine buys gas from Gazprom for 80 dollars in barter deals. Itera, the Russian/Ukrainian joint venture can, according to her, sell gas at 60 dollars per 1000 m3. The advantage of paying by cash gives the small private traders enormous profits. ^xii

The whole set up favours the energy traders, not the energy producers. As President Kuchma said in early 2000: 'By getting hold of and monopolising the (energy) market, countless intermediaries are making super-profits, looting energy facilities and enterprises.'^xiii Unfortunately, the president himself helped to create such a situation.^xiv The energy producers are all state owned, therefore the state pays here the bill. Despite the fact that energy traders are the winners in the equation, they do not invest in the energy transportation infrastructure, because non-reported profits are channelled abroad. The deteriorating state of the electricity grid generates each year more power outages. Gas leakage increases each year due to bad maintenance of the pipeline system.

Government placed a lot of enterprises and institutions on a list of entities that can not be disconnected from the energy grid under any circumstances. Among these are the most chronic non-payers of energy. This further aggravates the payments crisis.

3. Energy production

Almost half of the energy Ukraine consumes is produced domestically. Almost all consumed coal is produced in Ukraine. An important asset is the nuclear power stations that produce almost half of the electricity consumed in Ukraine.

Of all Ukrainian energy needs, 26 per cent are accounted for by oil, 35 per cent by gas, 34 per cent by coal and 4 per cent by nuclear power and hydroelectric power. ^xv

The output of coal, the major part mined in South-Eastern Ukraine, declined from 216 million tons in 1975, to 189 million tons in 1985, 165 million tons in 1990, 84 million tons in 1995 and 81 million tons in 1999. Since the independence of Ukraine, 1991, coal production declined by more than half while employment dropped by more than one third. While the coal industry employed 650 000 employees in 1995, the beginning of restructuring, it counted 410 200 employees in January 2000.^xvi

Table 1 Energy production in Ukraine

1990 1995 1999

coal (million tons) 165 83.8 81.7

electric energy (kWh) 298 194 172

gas (m3) 28.1 18.2 18.1

oil (million tonnes) 5.3 4.1 3.8

Source: Ukraine v Tsifrax 1999, p. 65

The loss making coal mining sector is still for the larger part not privatized and receives large direct and indirect subsidies.^xvii Coal mines are being kept afloat that produce coal twice the world market price while conditions for coal mining are deteriorating, given the prospect of even more expensive coal in the future.

The easily available coal had been extracted so that what remained lay in thin and sloping seems, often more than 1200 meters deep with each passing year average depth of the coal faces increased by 10-15 meters. Quality of coal was declining. Mining technology is very primitive: 75 per cent of all jobs in the mines are done manually (from the mid-seventies onwards investments in coal mining were channeled to other regions than South Eastern Ukraine). One third of the mines is more than 50 years old, and some date of the 19th century. Many key pieces of equipment, including one third of the ropes hauling the mine elevators, are well beyond their service time.^xviii

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