Ukraine gas business reforms have been a huge success. By unbundling the production and transport segments the country has attracted hundreds of traders that compete on a vibrant market that has largely eliminated the old corrupt scams and brought prices down for the consumer.
The reform has been based on the deceptively simple principle of separating the trading and production of gas from its transportation and making the pipeline network accessible to anyone that has gas to transport at the same price.
The old system was based on the principles of “who you know” and “how much you are willing to pay” that led to chronic corruption and a distorted market as the oligarchs knew everyone and were willing to pay a lot.
The Ukrainian gas market reform came to fruition in 2015 with an unbundling that brought Ukraine’s gas market into line with the EU’s third energy package. The main feature was an unbundling of the system and a separation of the production housed in Naftogaz as well as the creation of the pipeline operator. At the end of 2019 Gas Transmission System Operator of Ukraine (GTSOU), a fully independent state-owned company under the Ministry of Finance, was created to manage access to the pipelines. At its birth the GTSO, by dint of its existence, becomes the basis of a vibrant and competitive market for gas.
“The new gas law brings Ukraine into line with the EU’s third energy packet. It is an unbundling that mirrors the reforms in the EU,” Sergiy Makogon, CEO of GTSO, told bne IntelliNews in an exclusive interview. “The GTSO is an independent company and must supply equal access to the pipeline network to everyone on the market.”
And it is massive. The Druzba pipeline system that crosses the country was built in Soviet times and even at the height of the Cold War, the Soviet Union continued to be the main supplier of natural gas to Western Europe, supplying up to 80% of its gas as late as 1970.
Since then, Europe has diversified its energy supplies, as following the collapse of the Soviet Union demand has risen, but there have been rising concerns about Europe’s dependence on Russian gas following several “gas wars” in the noughties where the EU found its gas supplies briefly cut in depths of winter.
Today the GTSO manages thousands of kilometres of pipelines that transit Russian gas on its way to European clients. There are four main pipelines that can carry 146bn cubic metres of gas a year, the equivalent of between two thirds and three quarters of all of Europe’s imports of Russian gas.
However, since relations with Russia soured following the 2014 annexation of Crimea the amount of Russian transit gas has fallen dramatically. Under the terms of a new transit deal signed at the last minute in December 2019 Russia contracted to send at least 65 bcm of gas via Ukraine in 2020, but actually sent 55 bcm. For the subsequent four years it is contracted to send 40 bcm on a take-or-pay basis.
The unbundling of the gas business has created an open and transparent market for gas that has at a stroke gone a long way to ending the corruption and distortions of the business that had long been a feeding trough for the oligarchs. The reforms are not finished, but the heavy lifting has already been done.
“We completely independent from Naftogaz, although of course we work closely with them. We are certified by all the relevant European authorities and 84% compliant with the EU gas network codes, so there is still some work to do. But we are already one of the biggest gas transit companies in Europe,” says Makogon.
Ukraine has been quietly restructuring its energy business to put it on a transparent market-based footing and a lot of progress has already been made. The power market has also been overhauled but there have been a lot more problems there, as the government has been struggling to pay $1bn it owes to the producers of renewable energy that have set up in the last few years. But the gas business transformation has gone a lot more smoothly.
The unbundling is complete but the one big piece still missing is a gas market exchange for trading contracts, says Makogon. “We have an exchange, but it is not up to EU standards. However, there is already settlement and clearing of deals but more needs to be done.”
The old system was tightly controlled by a few players. Dmytro Firtash is probably the best known of the oligarchs who were big players in the gas business and still controls companies that account for 80% of the delivery of gas to households.
He also set up a string of unnecessary intermediate trading companies to handle the transit of gas from Russia to Europe that skimmed billions of dollars off the top to enrich those in the top tier of the Ukrainian government as well as Russian officials and the leaders of Gazprom. Those scams have been closed down many years ago, but the sector still suffers from some of these problems. However, the entry of hundreds of independent gas traders has been the key to the success of the reform.
“There are more than 900 companies working on our market. All the big European gas traders are here and 100 companies are involved in importing gas to Ukraine,” says Makogon. “European traders already account for tens of billions of cubic metres of gas imports to Ukraine – it's a huge amount.”
The sheer number of players means that the old school corrupt deals are almost impossible to do any more. There are simply too many players offering better deals.
Most of this gas trading is aimed at industrial customers, as the retail gas business has not been completely freed but is the focus of the current round of reforms. Companies now have a wide choice to potential suppliers and are paying rates that are set by an open market.
In August last year a new law came into effect that opened the retail sector up to competition too. Consumers will be able to choose to buy their gas from any supplier they want and those that can’t afford to pay their utilities bill will get help from the government under the Public Services Obligation.
“The main goal of the reform is to lower prices for households. At the same time, for those that can’t afford gas there will be subsidies to help so that people can pay as much as they can and the state will help with the rest,’ says Makogon.
Paying for gas is a politically sensitive issue. The Soviets used to supply gas, power and heating to the entire population for free and many still regard utilities as something the state should provide and not something they should pay for. The International Monetary Fund (IMF) insisted that the heavily subsidised domestic energy tariffs be increased to market rates, a demand the Ukrainian government vigorously resisted for several years. However, the reform was eventually pushed through and remains highly unpopular; so unpopular that Zelenskiy’s government recently reduced the prices again “temporarily” due to the coronacrisis and unusually cold winter. Zelenskiy’s ratings in the polls has been flagging recently but the president has earned some brownie points from voters with this and other populist moves.
The introduction of competition in the retail market will also help finally kill off another scam that was used by oligarchs; heavily subsidised gas earmarked for residential customers was re-routed and sold to the oligarch-owned industrial assets, thereby reducing their costs and boosting their profits.
“Now retail and industrial prices are more of less the same,” says Makogon. “It is no longer possible to manipulate the market, as the difference is so small.”
Firtash is still in a dominant position on the retail market and what competition has been introduced into the retail business has helped, but GTSO says that the price of gas for the consumer is still high, as the suppliers are not reducing their prices. It is hoped that throwing the market open to even more competition this year will make a bigger impact.
Naftogaz will help drive this process, as the national gas company is also expanding its retail operations, adding a retail sales arm to its operations. The company has already seen its share of the residential gas supply market increase from 4% a few years ago to 12% now and its share continues to grow fast.
Ukraine’s power companies are also getting into the residential gas supply business.
“It will be easier for them, as they are already set up to do this business,” says Makogon. “They already have a business relation with the consumers, the local offices and all the payment and back office set-up they need to operate.”
Imported gas and Nord Stream 2
Russia is still sending a significant amount of gas through Ukraine to Europe, but Ukraine itself has cut imports of Russian gas for its own use to zero. Ukraine has not imported gas from Russia for more than five years and has turned to partners in Western Europe for the approximately 10 bcm of gas imports a year it needs.
The problem is that this gas is more expensive than the gas Ukraine could import from Russia, but in fact Ukraine would end up spending the same amount if it bought the gas directly from Russia.
“The problem is, there is only one Russian company to deal with,” says Makogon. “Why would Gazprom charge less when there is no one else to deal with on the Russian side? If they let the other Russian companies export gas there might be a chance to do a deal, but Gazprom has a monopoly on exports.”
Gazprom only accounts for about half of gas supplies on the domestic Russian market and has to compete with several other big players such as the state-owned Rosneft and the privately owned Lukoil at home so Russians also benefit from a competitive internal market. But the state-owned gas behemoth is the only company allowed to export gas.
This set-up is one of the foreign policy tools the Kremlin uses to manage relations with its neighbours in the Commonwealth of Independent States (CIS). Good relations come with cheap gas prices; in the noughties Belarus used to pay a quarter of the price Ukraine was charged and still enjoys preferential rates today.
Despite Ukraine’s massive overcapacity, Russia has decided to build Nord Stream 2 with a capacity of 55 bcm that will, if completed, allow Gazprom to cut Ukraine out of the transit loop completely; 55 bcm is exactly the amount that Ukraine transited to Europe last year.
While Ukraine has cut its own imports of Russian gas to zero it has been lobbying hard to keep the transit business, which is worth some $1-2bn a year in transit fees. There are two arguments in play: the political and the economic.
The political argument is straightforward: the two countries are effectively at war, Ukraine has repeatedly sued Gazprom in court and claimed (successfully) that it was underpaid. Russia says the gas is its own and can do what it likes with it.
The economic argument is a little more complicated.
“We spend UAH200bn a year on maintenance and will invest about $1.5bn over the next 10 years. Nord Stream 2 costs $12bn to build, so the two projects are incomparable,” says Makogon.
Moreover, Nord Stream 2 is a single pipeline, whereas Ukraine has massive redundancy with its multiple pipelines over its territory. Makogon points out that in 40 years of operation it has never had to halt gas deliveries due to accidents or maintenance, whereas Nord Stream 1, the already functional pipeline, had to turn off supplies last summer for a week while it carried out repair works.
“And there are no compressor stations along Nord Stream 2; only one at the start of the pipeline. If something goes wrong then that will shut down the deliveries. The Ukraine system has none of these problems. We provide a lot more flexible alternative,” says Makogon.
If Ukraine is cut out of the delivery loop Makogon says it won’t maintain its system as some kind of back-up in case the Russian system breaks.
“We can’t just wait. We have to spend continuously on maintenance. We employ 11,000 people. We will downsize and take care of our own needs as a country,” says Makogon. “It means Europe will lose the flexibility that Ukraine offers. It will become fully dependent on Russia.
Ukraine has been frustrated by Germany’s refusal to block the pipeline’s construction, which it insists is a purely economic project. Nord Stream 2 maybe less flexible and carries a higher exposure to outages caused by accidents, but it is probably cheaper to use and it runs directly between Russia and Germany, eliminating the political risks from a transit.
German Chancellor Angela Merkel has suggested a compromise where Russia sends most of its gas via Nord Stream 2 but agrees to also send part of its gas deliveries via Ukraine’s Druzhba pipelines, which ironically means “friendship” in Russian.
Makogon is convinced that if Nord Stream 2 is completed then the transit business will simply come to an end.
“The main goal for Russia is to cut Ukraine out of the transit completely. Since Turk Stream II came online [that passes to Ukraine’s south] Ukraine has lost 20 bcm in transit business, as gas that used to go to Romania, Greece via Ukraine now all go via Turk Stream I and II,” says Makogon. “Gazprom will probably find a way to cancel the contract. It definitely won’t prolong it.”
Another solution that has been suggested is that Ukraine make use of its massive storage capacity as a business. In the run-up to the new transit deal in 2019 the consensus was no deal would be done so all of Ukraine, Russia and EU members stored as much gas as they could to ensure uninterrupted energy supplies over the winter of 2019-2020.
The Soviets built huge storage capacity in Ukraine as part of its business of selling gas to Europe. Today these tanks are filled in the summer to ensure delivery to Europe in the winter – something else that Nord Stream 2 cannot offer. But Makogon says that storage has limited appeal.
“The problem is storage is cheap. The cost is in transport. It is not economically viable to send gas from Germany via Slovakia to store in Ukraine, only to send it back again when it gets cold,” says Makogon.
In the long term one of the key questions is what will happen to European demand for the relatively clean source of fuel that gas is. Will it go up or down?
Demand for energy in Europe is clearly on the rise, but then so are the alternative sources of energy. In the 1970s Ukraine supplied 80% of Europe’s energy needs, but since then energy supplies have diversified and the share of Russian gas in the mix has fallen to about 35% today.
The advent of renewable energy and the new EU green deal that aims to make Europe carbon neutral by 2050 is moving the goal posts. At the same time, US LNG production has expanded rapidly and it is already the biggest supplier of LNG to Europe. Even Russia has big plans for LNG.
Makogon believes that over the long term demand for gas will fall, thus eating further into the transit business.
“Demand for gas will go down over the medium to long term. In some markets like Poland it will continue to rise as they need to replace their coal-fired power stations with something cleaner but in the long term demand will fall and so there is no need for Nord Stream 2,” says Makogon. “If Europe expects to use less gas then why commit to Nord Stream 2 for the next 40 years?”