• WHY SWITCH TO TARGETED SUBSIDIES?

    The transition from implicit cross subsidies to direct targeted subsidies for Ukrainian household gas supplies is a long overdue step. Prior to this process, in 2014 the price of gas for households was 10 times lower than the price industry paid for gas. This created huge corruption incentives, with gas acquired for households but used for commercial purposes.

    In addition, the low price of household gas formed the basis for more complex inefficiencies, including economic waste and paternalism. With gas heavily subsidized for all consumers, investments in energy efficiency and modernization were commercially unattractive. The system of indiscriminate cross subsidies required that prices for locally produced gas remain at an extremely low level, leading to a decline of gas production by state-owned gas producers.

    This system has resulted in huge costs. Over the past four years, the state budget spent almost UAH 360 billion in direct and indirect subsidies to supply households with natural gas. This created a huge gap in public finances and had a major negative impact on the stability of the hryvnia.

    The population grew accustomed to inefficient gas usage because the consumers did not have sufficient motivation to save energy. Gas was consumed in huge quantities. Low prices made most of the measures to improve energy efficiency financially unattractive. It was easier and cheaper to buy gas rather than to replace an old boiler with a more efficient one, insulate a house, or simply change usage habits. This culture of inefficiency led to the degradation of the country's technical and utility infrastructure.

    Some of the gas used by Ukrainian households was of domestic production, while some came from Russia at relatively higher prices. To keep gas prices for households at average lows, the state set paltry purchase prices for gas from Ukrainian producers.

    In Ukraine, 2/3 of people do not use gas or use it in small quantities, often only for cooking. Because of the low prices for Ukrainian, these citizens have not received adequate compensation for the tens of billions of cubic meters of gas that have been produced over the years from the subsoil that belongs to every citizen of Ukraine under the Ukrainian Constitution.

    Under-pricing for Ukrainian state gas producers also meant underfunding of exploration works and lack of financing for the intensification of extraction. This led to site exhaustion and reduced production. The money for imported gas came from the national economy with no new jobs created, while the budget lost tax revenues. In effect, we were supporting the Russian gas extraction industry instead of supporting our own.

     

    Why was nothing done earlier to stop the waste of funds? Cheap gas is corruption

    The answer is simple and complex at the same time: this energy sector inefficiency was a vehicle to make multibillion-dollar fortunes that allowed the beneficiaries to buy literally everything — legislation, prosecutors, and even the support of voters.

    For ordinary Ukrainians, this so-called "cheap" gas was cheap on paper only. The price the nation paid for this scheme is evident in neglected and abandoned buildings, rusty and inefficient heating pipelines, underfunded medicine, education and science, and tiny state pensions. The worst problem of all is the omnipresent lack of public trust fuelled by politicians who previously made their fortunes by taking advantage of differences in domestic gas prices.

     

    WHAT ARE THE GOALS OF TRANSITION TO THE NEW SYSTEM?

    Transition to the new system, whereby citizens will pay the full price for gas with medium-income and poor families receiving targeted social assistance from the state, is a difficult but necessary and responsible step. This transition has several objectives.

    1. Elimination of a key platform for illicit enrichment and corruption

    Charging different gas prices for different groups of consumers created the possibility of shadow profits from the resale of "cheap" residential gas to industrial consumers of "expensive" gas. Excessive rates of gas consumption by households, a lack of full accountability, overstated technological standards for writing off gas, and unauthorized extraction — this is just a partial list of the many tools used to allow "cheap" gas conversion into "expensive" gas. The illegal incomes this created helped keep such schemes in place, financing the bribery of officials and politicians, as well as creating personal fortunes.
    With prices for different customers now set at the same level, this avenue of corruption is no longer available.

    2. Creating financial incentives for consumers to save gas

    Low consumer prices removed the motivation to save gas. There was no reason to use gas more efficiently or to take measures requiring investment such as home insulation, replacement of gas boilers with more efficient equipment, or the installation of heat pumps. The state spent billions of dollars to pay for Russian gas instead of running a modernization program for Ukrainian housing and getting rid of the need to buy gas abroad.
    Ukrainians are now motivated to save gas, insulate their homes, and upgrade heating systems. The state offers support to help finance these efforts.

    3. Creating the basis for competition in the household gas market

    Since gas price for households was 90% below the market, private companies had no reason to compete selling gas to this segment. Therefore, for many years, competition was not developing in the household segment. Instead, the focus was on access to "cheap" gas and government subsidies. Anyone with access to this resource could make money by taking advantage of price differences and providing substandard services as a monopolist.

    On 1 May 2016, gas prices for different categories of consumers reached parity. The household gas supply market suddenly became economically attractive to private companies. This has created the basis for genuine competition on the consumer market.

    4. Saving public finances

    The difference between artificially "cheap" gas and its real cost was previously offset by the state. This meant taking money from the defence, education, and healthcare budgets, as well as from a host of other spheres. Ukraine also had to buy gas abroad, spending huge amounts of foreign currency and supporting foreign economies instead of its own.

    Gas imports have now significantly decreased. For almost a year, Ukraine has not bought gas from Russia. For the first time in 10 years, Naftogaz will not receive support from the state budget. In contrast to previous years, in 2016 Naftogaz will pay UAH 60 billion in taxes, which represents about 10% of the state budget. Even after paying subsidies to vulnerable citizens unable to pay the new price for gas, the state will receive an additional UAH 25 billion that it can channel to other priorities including pensions, healthcare, and defence.

    5. Development of Ukrainian gas extraction

    For many years, state-owned Ukrgazvydobuvannya (UGV) had no funds for the development of domestic gas production. As a result, less new jobs were created, sizeable orders were not placed with Ukrainian producers, fewer taxes were paid, and more money left the Ukrainian economy to pay for gas imports.

    Starting from 2016, UGV is receiving funds to invest in production development. Ukrainian producers of equipment have begun receiving commercial offers from UGV. Production facilities abandoned for many years have started to recover. Procurement tenders take place via the ProZorro system. Any producer who can deliver a quality product or service at the most competitive price can now supply UGV.

    The "Gordian knot" of problems tied to "cheap" gas was so massive that cutting it completely and removing the root cause of corruption was the only way to create hope for future improvements.

    WHAT ARE THE RESULTS OF TRANSITION TO THE NEW SYSTEM?

    1. The volume of gas consumed by households has significantly decreased

    Compared to the average level of consumption in 2012-2013, private households consumed 5 bcm less gas in 2015. Once the decrease due to the occupation of regions in eastern Ukraine is taken into account, and also adjusting figures to account for the warmer winter weather, these savings still amount to more than 2 bcm of gas.

    These huge savings came uniformly across the country, reflecting the fact that consumers started to use gas more efficiently due to higher prices. Even consumers who continued to receive subsidies tended to use less gas. This decrease in consumption has continued in 2016.

    2. State budget subsidies to Naftogaz reduced to 0

    This has reduced state budget expenditures in 2015 by about UAH 30 billion. In 2016, Naftogaz will not receive any compensation from the state budget.

    3. Naftogaz payments to the state budget significantly increased

    Following the adjustment of prices in 2016, the Naftogaz group became a net contributor to the state budget. This is the proper and customary role for state-owned European energy companies. Low-income citizens remain protected by subsidies while wealthier consumers pay the full market price.

    4. UGV increases investments and engages new technologies

    Improvements in the financial capacity of the group allowed UGV to increase funding in 2016 for the exploration of new deposits. The negative trend of declining domestic production has been reversed.

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    The new system of targeted subsidies is fairer, providing greater protection to more vulnerable segments of Ukrainian society

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    5. Redistribution of budget expenses allowed for increased funding of defence

    The suspension of funding for cheap gas from the state budget helped strengthen the country's defence. Defence budgets during the past two years have increased 2.5 times. If the state budget continued to allocate tens of billions to pay for subsidized gas for all households without exception, this money would not have been available for defence purposes.

    The transition to the new system of targeted subsidies was not only a logical step that destroyed multibillion-dollar corruption schemes while promoting the economic development of Ukraine. It was a necessary measure in order to save Ukraine as an independent state.

    HOW THE NEW SYSTEM OF SUBSIDIES WORKS

    The simplification of rules for utility subsidies was a logical and reasonable step that allowed the state to mitigate the impact of levelling gas prices on disadvantaged sections of the population. This step has completely paid off. The new system of subsidies is generally effective.

    More than five million families requested help and currently receive subsidies for utility costs. This is significantly less than the 13 million families that previously received indirect state aid through indiscriminately subsidized gas.

    The system of subsidies is structured so that the average family spends no more than 15% of their family budget on utilities. Large, single-parent families or those with a disabled member usually spend a smaller fraction of their budget on utilities if they receive a state subsidy. The share of income that needs to be spent for utilities depends on the level of income per capita. The less money the family has, the smaller share of its budget it will spend to cover its utility costs. 

    This system helps facilitate a fairer distribution of state aid. Under the previous system, consumers who used more gas actually received more state aid in the form of subsidized gas. The current system of targeted social assistance provides more protection to less wealthy consumers.

    However, it has become clear that the simplified system of subsidies has certain shortcomings. Addressing these problems would help to allocate budget resources more effectively and increase the level of social justice in the allocation of subsidies. One of the most significant shortcomings is the lack of incentives for recipients of subsidies to adopt energy saving behaviour.

    Less consumption, less imports

    Measures that could enhance the system of subsidies include improving social standards, introducing mid-term subsidy reduction schedules, automatizing calculation processes, reconciling subsidies with actual consumption levels, and tracking changes in the economic status of recipients.

    In addition, in order to encourage energy saving behaviour among beneficiaries, a transition towards the gradual monetization of subsidies is advisable. Households that consume less than a certain established norm could then use these saved funds to finance other needs.

    NEXT STEPS

    In 2016, price liberalization reached the intermediate stage when the methodology for calculating the price of gas for households at 100% import parity was approved. Despite the expected increase in subsidies for households, tax payments from Naftogaz group will be more than sufficient to cover these costs from the state budget. In 2016, the volume of gas consumption by households continues to decline.

    UGV will receive additional revenue which will fund large-scale works on increasing gas production. The path towards price liberalization has laid the foundation for the transition to the final phase of reform — the creation of a full-scale competitive market of gas for household consumers.

    HOW GAS PRICE IS FORMED

    HOW GAS PRICE IS FORMED

     

    CORPORATE GOVERNANCE STRUCTURE

    CORPORATE GOVERNANCE STRUCTURE

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