Ukraine’s energy sector: Reform finally, with the help of Putin?

Last week, Russia’s President Vladimir Putin turned a three-month long, mainly domestic political crisis in Ukraine, which appeared headed to resolution, into a full-blown international crisis.

When I started working on the Ukrainian energy sector a dozen years ago, a wise old hand told me, “You can always count on Russia to overplay its hand when it comes to Ukraine.”

Western leaders also consistently misread Ukraine. The dismal failure of the Orange Revolution after 2005 did not compel Europe or the United States to assess clearly the actions of Viktor Yanukovych when he became president in 2010. Wishful thinking or wilful ignorance informed policies that assumed a government that was highly corrupt (even by Ukrainian standards) and brutal (by any measure) was ready for an association agreement with the European Union and to move toward European values and standards.

The courage of the protesters in EuroMaidan and, ironically, Putin’s historic overreach may have provided Ukraine with a unifying national idea, as well as with the opportunity to extract itself from energy corruption which infected its politics and governments ever since independence, free it from economic overdependence on Russia, and allow it to fulfil its economic potential.

Conventional wisdom suggests that Russia has leverage over Ukraine because of its energy dependence. However, more than half of Gazprom’s gas exports to Europe still pass through Ukraine and large gas-storage facilities in western Ukraine are critical for the smooth functioning of the old Soviet international gas-transit system. Ukraine has not used its negotiating leverage to normalise gas relations with Russia because of its venal political leaders since 1992, not because of its inherent vulnerability. Neither Russia nor Ukraine will interrupt gas flows to Europe unless the current crisis escalates and military hostility breaks out, in which case all bets are off.

It is imperative for the United States and EU to strengthen Ukraine’s economic condition, in addition to its security, before it worsens beyond rescue. Western financial assistance is needed immediately to restore market confidence and a functioning economy. Saying we will leave it to the International Monetary Fund (IMF) or World Bank and other international financial institutions (or for the United States to leave it to the EU) is no longer a sufficient policy response to this severe threat to global security and stability.

Rather than a point of vulnerability, the energy sector is actually a low-hanging fruit for economic reform in Ukraine. The current crisis and the removal of leaders steeped in energy graft may finally instil the political will to implement long-overdue reforms. This includes the de-control of domestic gas and electricity prices over time to reflect their market-clearing levels. Artificially low prices served to encourage wasteful consumption by those with privileged access to cheap supplies, while others suffered shortages. Low prices also discouraged investment in energy production by both domestic and foreign companies. Ukraine’s economy has an energy intensity that is higher than Russia’s. Gas production stagnated despite favourable geology, because domestic prices were controlled at a small fraction of imported prices.

Multi-tier pricing fosters a gray market in domestic energy, which favours well-positioned insiders, and corruption in energy trading with Russia, which belonged to the top circle in Ukrainian politics. Private interests hijacked various state assets in power generation, gas distribution, nuclear power, coal mining, oil and gas production, refining, pipelines, even renewable energy. Naftohaz, the state-owned oil and gas monopoly, is a veritable black hole requiring billions in government bail-outs every year while equally large sums are siphoned off through corrupt business practices.

Corruption reached an unsustainably voracious level under the last government. Even some eastern Ukrainian oligarchs, who were excluded from the most outrageous rent-seeking by Yanukovych administration insiders, have rallied in recent days to support the new government in Kiev in the face of Russian threat to national unity. This provides the opportunity to offer a one-time amnesty for economic crimes committed before Yanukovych became president in 2010, as long as billionaire oligarchs contribute to Ukraine’s difficult economic transition now, including helping the truly needy in society. Without the sharing of economic pain, it will be difficult for a long-suffering public to accept sacrifices for the sake of reform.

Market competition and transparent regulation have to be introduced for the first time in much of the energy sector. With protection of property rights, Ukrainian capital can be re-invested in modernising industrial plants and manufacturing processes to be more energy-efficient, conform to European standards, and integrate into global markets rather than depend on exports to Russia. The massive capital flight of recent years will reverse itself. Restoring business confidence will attract foreign direct investment, including in energy production. The stated aim of reform must be economic growth.

Responsibility for creating a modern society and economy belongs foremost to Ukrainians and their elected leaders. Even as the current crisis offers a historical opportunity for Ukraine to embark finally on the road to reform, however, the country has been robbed of financial resources and lacks the capacity for effective governance. The newer member states of the EU, such as the Czech Republic, Lithuania and Poland, can share important lessons learned from their own challenging but ultimately successful transition to democratic rule and market economy. They can help with capacity-building along with other European countries and the United States. The West must step up now with financial and other critical resources to support Ukraine before the moment is lost again for its integration into a modern Europe. 

Edward Chow is a senior fellow at the energy and national security program of the Center for Strategic and International Studies in Washington, DC and has advised various Ukrainian governments on energy policy and investment since 2001. This commentary originally appeared in European Voice.

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Edward C. Chow
Senior Associate (Non-resident), Energy Security and Climate Change Program