• The work on risk management is carried out at all management levels of the company. Although in 2015 the company did not have a separate department for risk management, the work on internal audit and risk management was integrated into other processes of the company within the existing organizational structure. Work on risk management is structured in order to conduct continuous monitoring and control, ensure early risk detection, and conduct consistent risk management related to the activities of the group, while providing an unobstructed channel of information and communication on existing or potential risks identified. Elements of risk management include job descriptions, regulations, corporate culture rules, methods and procedures of the company.

    A significant element of the internal control system in 2015 was the function of internal audit. In 2015, the Internal Audit Department conducted 17 inspections of production and financial-economic activity and of the individual transactions in 14 companies of the group.

    In December 2015, the Resolution of the Cabinet of Ministers of Ukraine No. 1002 approved a new statute of the National Joint Stock Company "Naftogaz of Ukraine", according to which the group implements an effective system of internal control functions through the creation of risk management, compliance and internal audit functions. The group aims to ensure that corporate governance and decision-making include a comprehensive assessment of risks and build its business processes on the basis of a system of internal control processes based on best practices and applying the experience of leading world companies. To this end, in May 2016 a risk management service was established in Naftogaz with the position of the risk management director that reports directly to the supervisory board of the company.

    The main tasks of the risk management service are:

    • Introduction of risk management standards and best practices;

    • Identification of risks that threaten the stability of operations, financial stability, health and safety of personnel, the environment, and achievement of the strategic objectives of the company and its enterprises;

    • Analysis of the risks identified with the purpose of the most correct evaluation of their impact and probability of their occurrence;

    • Development of response strategies, effective measures to minimize the negative effects of the risks identified, and to prevent any repeats in the future activities of the group;

    • Risk management in accordance with the measures developed;

    • Monitoring and control of implementation of the developed measures.

    The main risks that could cause a serious adverse effect to production performance, cash flows, and the group's financial position are described below.

     

    INDUSTRY RISKS

    Risks associated with reliance on a single supplier of imported natural gas

    Before 1 October 2015 Naftogaz has been a certified supplier of gas for industrial consumers with an annual natural gas consumption of more than 3 mcm, and enterprises engaged in the production of thermal energy. In the period from 1 October 2015 to 31 March 2017, the company has been assigned with responsibilities for selling natural gas to natural gas suppliers for household consumers and religious organizations and supplying natural gas to producers of thermal energy for the heat energy production. In addition, according to the Resolution of the Cabinet of Ministers of Ukraine as of 10 December 2015, No. 1307-p, Naftogaz was defined as the "last resort" supplier for three years. Also, for industrial and technological needs, Ukrtransgaz uses imported natural gas. To fulfil Naftogaz obligations and ensure the smooth operation of the Ukrainian GTS, the company has to buy natural gas abroad as the amount of gas produced in Ukraine is not sufficient. From 2009 to 2014, Naftogaz was purchasing the bulk of imported natural gas from Gazprom under a long-term contract at prices that did not correspond to the market level. Dependence on one supplier for such long-term contracts may adversely affect not only the ability of Naftogaz to provide natural gas to customers in Ukraine, but also the continuity and reliability of the gas transmission system, increase political risks, and deteriorate the financial condition of the company.

    RISK MANAGEMENT
    Diversification of sources of gas imports

    The group is taking active measures to diversify sources of natural gas imported from the EU. The share of imports from the EU grew from 25% in 2014 to 60% in 2015.

    The technical capacity to receive gas towards Ukraine from Europe is 61.1 mcm per day, including from Poland — 4.3 mcm, with Hungary — 16.8 mcm, from Russia — 40 mcm. On 29 May 2015, Naftogaz and Hungarian operator GTS (FGSZ LTD) signed an agreement on cooperation between the operators of gas transportation systems (interconnection agreement). The group will continue to facilitate negotiations on signing direct agreements on cooperation (Interconnection Agreement) with neighbouring European countries (Slovakia, Romania) to establish and expand "virtual" reverse flows to Ukraine. In order to increase the volume of natural gas supplies from Europe, Ukrtransgaz is conducting a feasibility study for the construction of a new gas pipeline "Ukraine-Poland". To increase the number and geographical diversification of supply sources, the company continues negotiations with Turkey as to the passage for LNG tankers through the Bosporus to Ukraine.

    Diversification of European suppliers

    Within the focus on contract diversification of imported gas suppliers, in 2015 the company increased the number of counterparties. Naftogaz procures gas only from leading and reliable foreign companies, maintaining a diversified portfolio of suppliers. Out of 11 companies that supplied us with natural gas in 2015, 6 listed companies had investment grade ratings.

    Increased reverse gas supplies

    Introduction of "direct interaction" between GTS operators of Ukraine and Slovakia at the point of connection "veľké kapušany" (Slovakia) towards the GMS "Uzhgorod". Signing the agreement on cooperation (Interconnection Agreement) at this point between adjacent GTS operators — Ukrtransgaz and Eustream a.s. would increase reverse power supply of natural gas to Ukraine up to 120 mcm per day from the current 40 mcm per day. The company will continue taking an active part in negotiations with the General Directorates for energy and competition and Slovak GTS operator for the introduction of "direct interaction" in this point.

    Maximization of gas production in Ukraine

    The priority investments of the group focus on the natural gas segment with the aim of maximizing the volume of domestic gas production which will reduce dependence on imported sources of gas.

    Risks associated with dependence on one customer for transit service

    The most profitable segment of the group's activity is transmission of natural gas. Transmission of natural gas for Gazprom is carried out by the group according to the contract signed in 2009 for 10 years. The contract establishes the rate for transmission services. The group's management believes that the actual volume of gas transmission for the 2010-2014 period was lower than the base amount specified in the contract. The level of payments for natural gas transmission has never been revised in line with the European principles of pricing on gas transmission services, leading to additional losses for the group. However, other consumers of these services are available. Gazprom pursues a policy of natural gas supplies bypassing Ukraine (at the request of Gazprom, the transit volume from 2020 will become minimal) which could adversely affect the group's activity.

    RISK MANAGEMENT
    Ensuring compensation for damages caused in the past and application of European principles on transit fees under the contract with Gazprom

    In October 2014, the group appealed to the Stockholm Arbitration Tribunal with a request to revise the fees for transmission of natural gas through Ukraine in accordance with the contract between the company and Gazprom. The group expects that upon results of the tribunal, the European principles on tariff setting will be applied and the tariff for transmission of gas under the contract with Gazprom will be revised. In addition, according to the tribunal, there will be a decision taken as to the validity of the requirements of the group as to the base volume of gas transmission guaranteed by Gazprom. As of 1 January 2016, the NEURC has set tariffs for transportation of natural gas with trunk pipelines to entry and exit points located on the state border of Ukraine, using RAB methodology. Naftogaz asked Gazprom to apply these tariffs for Gazprom's gas transit to Europe under the current contract. As the issue remains unresolved, the company has included the requirements for the new transit tariffs from 1 January 2016 within the claim over the contract for the transit of natural gas. Before the contractual relations are brought in line with the NEURC regulations, provision of gas transit services for Gazprom will be carried out under the conditions in force in 2015.

    Diversification of gas transmission services

    The company facilitates the creation of a single gas infrastructure and commercial space including Ukraine, Poland, Slovakia and Hungary and the creation of a single East European Gas Hub which will allow for the diversification of customers for transmission and storage of natural gas.

    Risks associated with the prices of oil, natural gas and petroleum products

    Prices for oil, natural gas and petroleum products significantly affect the financial performance of the group. In this case, since the import component in total natural gas consumption is a significant element, any fall in prices for natural gas on European gas markets positively affects the performance of the group (excluding the activities in natural gas transmission in Egypt and gas transfer for ammonia production by Ukrnafta). On the other hand, lower prices for oil and petroleum products lead to a deterioration of financial performance.

    RISK MANAGEMENT
    Cost optimization

    The group is taking steps to reduce operating and capital costs to ensure adequate profitability and liquidity while reducing the prices for oil and petroleum products. Also, depending on the current and long-term forecasts for the price of hydrocarbons, the group is making adjustments in the program on implementation of investment projects both abroad and in Ukraine.

    In the decision-making regarding the imported gas procurements for injection into the UGS, price fluctuations of the market are also taken into account.

    Risk associated with a decrease in oil transit

    Political instability in relations between Ukraine and the Russian Federation, as well as a significant drop in world oil prices, create rising risks of further reduction in the volume of oil transit through Ukraine to Central Europe.

    RISK MANAGEMENT
    Search for alternative routes for oil transmission

    The group is actively searching for new customers for transport services, primarily from the Caspian region, who have sufficient oil resources and are interested in entering new markets, and therefore, seeking routes for oil supplies to these markets. On the other hand, the group is working with oil consumers, primarily European refineries to inform them about possible ways to diversify oil supplies.

    LEGAL RISKS

    Risks associated with government regulation of the oil and gas industry

    The Cabinet of Ministers entrusted the state-owned companies Naftogaz, Ukrgazvydobuvannya and private gas suppliers with special responsibilities (Resolution of the Cabinet of Ministers of Ukraine of 1 October 2015, No. №758). For these categories of consumers, before 1 April 2017, in order to ensure social security, the government will set regulated prices for gas and limit the cost of delivery.

    In October 2015 the government adopted a number of regulations which, despite the declared goal, did not correspond to fundamental principles of existing European law and the criteria defined and, accordingly, did not bring the expected results.

    The rules adopted have not led to effective operation of the natural gas market. On the one hand, they are opaque and burdensome for bona fide market participants and companies that may be interested in operating therein, and on the other hand, they create a wide field for fraud and unfair conduct.

    RISK MANAGEMENT
    Ensuring the effective operation of the natural gas market

    In April 2015, with the active support of the group, the Law of Ukraine "On Natural Gas Market" was adopted that aims at enshrine the Directive 2009/73/ЄС and Regulation 715/2009 into the law of Ukraine. After the law entered into force on 1 October 2015, the competence of NEURC and other authorities in regulation of the natural gas market will be established according to European practices that in the future will create an efficient, open and liquid market for natural gas in Ukraine. As part of this process to improve the efficiency of the market, the company initiated discussions on changes in the secondary legislation which must reduce the risks of imbalance for suppliers and GTS operator, simplify the work for network users, and ensure the impartiality of the GTS operator, while carrying out our balancing actions and reducing the financial burden on suppliers.

    Risks associated with government control over the activities of the group 

    The government of Ukraine continues to exercise control over the operating activities of the group through its ownership of the company. Such influence can lead to social and economic initiatives that may cause a negative impact on the operations of the group.

    RISK MANAGEMENT
    Changes in legislation

    In December 2015, the Cabinet of Ministers of Ukraine adopted the Resolution "On some issues of improving corporate governance of the JSC "National Joint Stock Company Naftogaz of Ukraine". This Resolution regulated the following issues on the legislative level:

    • Approved the new version of the statute including provisions on the supervisory board and provisions on the executive board of the company, including the version of these documents which will enter into force from 1 April 2017;

    • Separated the functions of ownership and conflicting functions of government regulation and industry policy-maker by transferring control over 100 percent of the shares from the Ministry of Energy and Coal Mining of Ukraine to the Ministry of Economic Development and Trade of Ukraine (instead of the Cabinet of Ministers of Ukraine).

    The adoption of the following draft laws of Ukraine remains a priority:

    • "On Amendments to Certain Legislative Acts of Ukraine on Improving Corporate Governance of JSC "National Joint Stock Company "Naftogaz of Ukraine", the operator of the gas transportation system and entities, of which they are shareholders (founder, member)";

    • "On Prevention of Political Interference in Economic Activity of Oil and Gas Companies".

    For more information on corporate governance reform, see section Corporate Governance.

    Risks associated with the transfer of share ownership in subsidiaries and of property not subject to privatization by the state

    In 1998, after the establishment of the company, the government of Ukraine made a contribution to the share capital of the company in the form of shares of several public companies. These joint stock companies included JSC Main Pipelines Druzhba and JSC Prydniprovskiy Main Pipelines that were reorganized in 2001 into JSC Uktransnafta, JSC Ukrspectransgaz, JSC Chornomornaftogaz, and JSC Ukrnafta, as well as fifty four regional gas distribution companies. The government of Ukraine may transfer ownership of or control over the whole or part of its share of the company in these companies and/or other state-owned enterprises for the storage and transportation of oil and gas to other companies or government agencies, and these actions could cause a material adverse effect on the operations of the company.

    In 1998, the company signed an agreement "On the use of state property not subject to privatization" (hereinafter — the "agreement") with the State Property Fund of Ukraine and received operational control over the oil and gas transport system. The agreement was signed for one year, and the period of validity is extended automatically annually for one year if it is not terminated by notice from either party, and it is binding on the successors of each party. Historically, the agreement has been prolonged automatically because neither party has initiated its dissolution. As state property that is not subject to privatization forms the bulk of the business of the group, future operations and the financial performance of the group depend on the extension of the agreement.

    RISK MANAGEMENT
    Transfer of property to independent operators

    Under the terms of the Third Energy Package and the Resolution of the Cabinet of Ministers of Ukraine as of 1 July 2016 (No. 496) gas transmission systems operators will be soon separated from vertically integrated companies engaged in extraction and supply. The functions of gas storage operators will also be separated. State property will be respectively used by individual independent operators of gas transmission systems. Therefore, the company's management believes that the group will continue its activities with respect to state property in the near future.

    Risks associated with tax regulations

    The tax environment in Ukraine is characterized by the complexity of the tax administration, conflicting interpretations of tax laws, and regulations by the tax authorities which, among other things, can increase the financial pressure on taxpayers. In the normal course of business, the group enters into transactions, the interpretation of which by the group and the tax authorities may differ.

    Inconsistencies in application, interpretation and implementation of tax laws could lead to litigation, which ultimately may result in assessment of additional taxes, penalties and interest, and these amounts may be significant.

    RISK MANAGEMENT
    Compliance with legislation

    The group meets tax law requirements and continuously monitors changes and amendments made to laws and regulations, while assessing the possible impact of such changes on its activities. The group is focused on cooperation with state agencies to ensure compliance with the legislation on currency and tax laws. For operations of an ambiguous nature inquiries to the relevant authorities are submitted.

    Risks associated with safety and the preservation of assets

    The group's activity is related to operational risks of a technological, technical and climatic nature. The actions of personnel and third parties may also result in negative consequences, including as a result of human error, theft, terrorism, sabotage, etc.

    RISK MANAGEMENT
    Ensuring the protection of the group's industrial facilities

    The group pursues a policy of introducing Ukraine's GTS to modern methods of diagnostics, reconstruction and modernization.

    The group is studying existing technical systems for the security of the facilities, including the use of drones and capabilities of the State Space Agency of Ukraine for remote earth sounding.

    The group maintains constant interaction with the Ministry of Interior of Ukraine and its departments, including in the regions, with the Ministry of Energy and Coal Mining of Ukraine, and the Security Service of Ukraine in matters related to the security of the group's facilities.

    Risks related to legal regulation of subsoil use

    The state controls the activities of exploration and production of oil and gas in Ukraine by issuing the relevant licenses. Under the current law separate licenses for exploration, development and production of each oil and gas field are issued. Licences are issued for a period of two to twenty years, and they can be extended for the same period.

    The group bears the risk of failure to extend the right to use licenses or suspend the right to use licenses (e.g., failure to timely perform obligations to the budget or program of works provided for in license agreements).

    RISK MANAGEMENT
    Fulfilment of the conditions of license agreements

    The group takes steps to extend special permits for subsoil use by submitting the relevant applications to the central government and local authorities.

    The group also takes measures for timely and full implementation of the programs of works that are defined in the license agreements. In case of failure to perform tasks, the group prepares the relevant justification and proposals for adjustments to these programs and presents them before the Public Service on Geology and Mineral Resources of Ukraine.

    Risks related to litigation

    The group is involved in many lawsuits that may significantly affect its financial and economic activity. The most important of these are the current court litigation with Gazprom and the dispute with non-controlling Ukrnafta shareholders on the implementation of shareholder agreements.

    RISK MANAGEMENT

    The group takes all possible measures to reach pre-trial settlement of disputes.

    For trials initiated, especially those where rulings will have a significant impact on future financial performance, the group engages qualified teams of legal advisers. It also carries out ongoing monitoring of the decisions taken by higher courts, and evaluates the results of trials at courts of arbitration to subsequently use them in defending the interests of the group.

     

    FINANCIAL RISKS

    Currency risks

    The group carries out its operations in Ukraine and its dependence on the foreign exchange risk is determined mainly by the need to purchase natural gas from foreign suppliers, which is generally denominated in euros and US dollars. The group also exercises payment of interest and repayment of loans in foreign currencies.

    RISK MANAGEMENT
    Monthly review of gas prices for consumers taking the exchange rate into consideration (except for households and DHCs that sell thermal energy to households and religious organizations)

    From 1 October 2015, with the introduction of the Law of Ukraine "On Natural Gas Market", the company independently determines monthly prices for all consumers of natural gas, in addition to households and DHCs that sell thermal energy to households, taking into account the purchase price of gas denominated in the national currency. By April 2017, it is planned to transfer all categories of consumers to market prices, which will take into account currency fluctuations.

    Short-term currency risk management

    The group analyses the situation on the currency market of Ukraine and, depending on this environment, selects the currency in which the remaining balance of funds should be stored (in line with NBU legislation on this issue).

    Liquidity risks

    The Group's activity is seasonal: volumes of natural gas and transmission services sold during the heating season make about 70% of the annual volume. During this peak period, the cash flow for sold goods and services significantly increases. On the other hand, during the summer period, with a decrease in the group's cash flow, there is a need for additional financial resources to finance the injection of natural gas into underground storage facilities. In addition, poor payment discipline of gas consumers, and transition to pre-payment for imported natural gas, have led to a need for more investments to finance working capital.

    RISK MANAGEMENT
    Implementation of measures to reduce receivables

    In 2015, pursuant to the memorandum signed with the IMF, PricewaterhouseCoopers conducted a diagnostic analysis of accounts receivable. The analysis will allow the company's management to improve the process of collecting old receivables and avoiding problems with debt collection in the future, and to promote the transparency and proper management of debts.

    In order to eliminate legal barriers and enhance debt collection work as part of cooperation between Ukraine and the IMF, Ukraine fulfilled its obligations concerning the removal of two long-term moratoria that protected energy and other companies from application of enforcement procedures: a moratorium on enforcement proceedings and enforcement of court decisions on debt collection for companies included into the fuel and energy complex register, and a moratorium on the use of forced sale of property of state-owned enterprises and economic entities with a state share of no less than 25 percent.

    Also in 2015, the management of the group acted on collection of receivables of producers of nitrogen fertilizers. As a result, debts were paid for a total of nearly UAH 2.96 billion.

    The transition to gas payments upon delivery

    The group is undertaking measures for the gradual transition towards payment for imported gas upon delivery and to attract credit resources to finance the injection of natural gas into underground storage facilities in foreign financial markets at relatively lower interest rates compared to the Ukrainian market.

    Risk of changes in interest rates

    The group is a large borrower in the Ukrainian credit market. NBU discount rate changes can have a significant impact on interest rates, which in turn could adversely affect the financial performance of the group.

    RISK MANAGEMENT
    Diversification and optimization of the loan portfolio by interest rates

    In order to finance the purchase of imported gas, in 2015 the group signed a loan agreement with the EBRD on a renewable basis for the amount of USD 300 million, through which it will be procuring imported natural gas at the western border of Ukraine during 2016-2017. Additionally, to finance the purchase of imported gas in 4Q 2016, it is planned to sign an agreement with the World Bank for funding in the form of a letter of credit/credit lines for commercial banks against IBRD guarantees amounting to USD 500 million. In addition, it is planned to attract credit resources from the International Finance Corporation (IFC) amounting to USD 200 million. Credit funds from international financial institutions involve much lower interest rates than in the domestic market.

    Furthermore, the group is working with local banks to reduce interest rates in case of a decrease in NBU refinancing rates.

     

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