Ukraine’s historic gas sector reforms are under threat

Since 2014’s Euromaidan Revolution, Ukraine has introduced comprehensive gas sector reforms that have attracted attention not only in Western capitals but also across Eastern Europe. This international interest is understandable. Within the space of just five years, Ukraine’s gas sector ceased to be a source of widespread corruption and became a model for neighboring countries seeking to reform their own energy industries.   

Moldova and Georgia were among the numerous countries to note this progress. Both nations share Ukraine’s own experience of Russian dominance and both were emboldened by Ukraine’s ability to transform what has traditionally been a notoriously difficult sector of the economy to reform.

The Ukrainian experience also resonated beyond the boundaries of the post-Soviet space. For Eastern European and Turkish energy companies that had seen the reform process falter in their own countries, post-2014 Ukraine appeared to offer an alternative vision. Here was an energy sector that was able to establish transparency and the rule of law, while at the same time creating the conditions for private initiative.  

Inside Ukraine itself, the reform of the energy sector was widely recognized as one of the few unambiguous indications of progress following the political upheavals of 2014. Once synonymous with corruption, the gas sector emerged as a rare success story in the reform of Ukraine’s state-owned enterprises. Instead of acting as a huge drain on government finances, state-owned energy giant Naftogaz became the single biggest contributor to the national budget.

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Ukraine’s gas sector progress is now at risk of falling victim to political interference.

In recent days, the Ukrainian government has introduced a raft of proposals that could reverse years of hard work and undo numerous landmark reforms.

The government has approved a price cap for natural gas sold to households, less than six months after this segment of the market was deregulated. This means a return to subsidies.

The removal of subsidies to all types of consumers has long been a key condition imposed by the International Monetary Fund (IMF) for the disbursement of financial credits to Ukraine. Subsidies were previously a major source of corruption that allowed supplying companies to receive gas at cheaper rates before diverting it to consumers who were paying higher market prices. It is worth noting that similar decisions taken in neighboring countries have had disastrous consequences on markets as well as on the household consumers they meant to protect.

Although Ukraine’s new price cap is expected to be in place for two months starting from February, this populist measure has also raised concerns among foreign partners who expect predictability and stability of rules.

The Ukrainian government is also looking to transfer the country’s gas and electricity transmission system operators, GTSO and Ukrenergo, from the jurisdiction of the ministry of finance to that of the ministry of energy. This has raised major concerns over potential conflicts of interest. Such a move would call into question the political independence of the two operators.

Ukraine’s gas transmission system operator GTSO was unbundled from mother company Naftogaz in 2019 and placed under the control of the ministry of finance, which was chosen specifically because it was not involved in energy policymaking.

If approved, the transfer would call into question the ability of GTSO to abide by OECD corporate governance rules. It may even prompt Russia’s Gazprom to call into question the validity of its long-term contract for the transmission of gas via Ukraine.

Russia signed a five-year deal in December 2019 for the shipment of gas to EU markets via Ukraine on condition of the certification of GTSO as an independent entity. If that independence now comes into question, the situation could be exploited to strengthen Moscow’s arguments regarding the importance of completing its two controversial pipeline projects bypassing Ukraine, Nord Stream 2 and TurkStream/Balkan Stream.

It is hard to pinpoint the exact origin of these latest moves to reverse reforms and extend political influence over the Ukrainian gas sector.

Some individual politicians may be seeking to gain power and believe such populist ideas will boost their chances of advancement. The government may be acting to counter falling approval ratings. There have been reports of alarm over a recent wave of protests following hikes in household energy bills triggered by high winter demand. With this in mind, the government might be inclined to abandon challenging structural reforms in favor of short-term political gains.  

As is so often the case with Ukraine, it is also impossible to rule out a Russian role. Moscow would hardly wish to miss an opportunity to divert Ukraine away from its path towards Westernization, and has traditionally used the gas sector to influence Ukrainian politics.

Whatever the cause, Ukrainian politicians and policymakers should understand that their actions could have negative consequences that will be felt both domestically and in the wider region. Ukraine’s energy sector reforms of the past seven years have won plaudits throughout Eastern Europe and helped demonstrate that change is possible. The demise of Ukraine’s much-trumpeted gas reforms would therefore be a big blow to the country’s broader post-2014 transformation. It would also send a negative message to reformers in neighboring countries who had regarded Ukraine’s progress as a potential model to emulate.

Dr. Aura Sabadus is a senior energy journalist who writes about Eastern Europe, Turkey, and Ukraine for Independent Commodity Intelligence Services (ICIS), a London-based global energy and petrochemicals news and market data provider. You can follow her on Twitter @ASabadus.

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The views expressed in UkraineAlert are solely those of the authors and do not necessarily reflect the views of the Atlantic Council, its staff, or its supporters.

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Image: Ukraine's proposed price cap on private company natural gas sales is symptomatic of what is wrong with the country’s broader approach to the market economy and must be avoided at all costs, writes Willem Buiter. (Gareth Fuller via REUTERS)