• The successful implementation of the gas market reforms launched in 2014 is one of the key priorities for Ukraine. This reform is essential for the protection of Ukrainian statehood, the country's sustainable economic development and the welfare of citizens.

    By implementing gas sector reform, Ukraine will become an equal and active partner of the united European gas market. The Ukrainian market with cease to be a place for abuse of monopolies and political interference, and will be able to attract investments. It will create new jobs, boost demand for Ukrainian companies, and support the work of Ukrainian scientists. Ukraine will increase the volume of domestic gas production, boost efficiency and completely free itself from reliance on gas imports. An effective gas market will help fund the state budget, paving the way for the sustainable improvement of living standards in the country.


    The reform of the gas market along European lines will lead to a separation of some of Naftogaz assets from the group. However, implementation of this reform is a prerequisite for the transformation of Naftogaz into an efficient commercial enterprise that complies with its new mission. Naftogaz aims to be capable of working in the interests of Ukrainian citizens as its ultimate owners, providing customers with high quality and reliable services at market prices and competing on equal terms with other market participants. In order to achieve these goals, Naftogaz is working together with the Ukrainian authorities and the country's international partners to guarantee the successful implementation of gas market reform.


    The introduction of the new law "On Natural Gas Market" in 2015 brought the legal framework of Ukraine closer with existing EU energy legislation. An important step in towards reform implementation was bringing regulated gas prices for households to import parity levels during 2015-2016.


    At the beginning of 2016, Ukraine adopted most of the needed secondary regulations and moved closer to the next stage of Naftogaz restructuring. However, there are still certain institutional limitations present in the domestic market.


    To complete the reform process, it is necessary to create conditions for an independent regulator, achieve full harmonization of Ukrainian legislation with European standards, and complete the separation of gas transmission and supply functions. An important prerequisite for successful reform implementation is bringing the gas transit contract between Naftogaz and Gazprom into line with current legislation. This is why the timeline for the gas market reform depends on the conclusion of arbitration proceedings in Stockholm.


    KEY CHANGES

    New gas market regulation


    During 2015, Ukraine has introduced a number of important changes to gas market regulation. One of the main achievements of this process was the adoption of the Law "On Natural Gas Market", which was developed with the active participation of Naftogaz. The document laid the foundation for the harmonization of gas market in Ukraine with the EU Third Energy Package.


    The law that entered into force on 1 October 2015 stipulates that the domestic natural gas market is based on the principles of free competition, adequate consumer protection and the security of the natural gas supply. It also enables the integration of the Ukrainian gas market with the markets of parties to the Energy Community, including through the creation of regional natural gas markets.


    The new Law strengthened the economically justified approaches established in the EU regarding the organization of the gas market. It also envisaged the unbundling of the gas transmission system operator (TSO) from gas production and supply functions, clearly outlined the role of the state and the independence of the regulator, and established the principle of tariff regulation of natural monopolies and free market prices in competitive segments of the gas market (with a transitional period until 1 April 2017).


    The Law created a framework for the development of a liberalized and competitive gas market, where each user can freely choose suppliers and purchase gas at market prices. The Law created private sector access to gas transmission and distribution networks, allowing private companies to sell gas to any consumer, including the households.

    Transition to RAB-based tariff policy for gas transmission


    Following the transposition of the EU energy regulations, Ukraine switched to regulated tariffs for gas transmission on an entry/exit basis. All signatory countries of the Energy Community are obliged to apply this principle. For example, Slovakia switched to this system in 2005. Previously, tariffs for gas transit in Ukraine were established by agreements between commercial companies. As of 1 January 2016, all gas transmission rates are set by the regulator.


    Given that natural monopolies by definition operate in the absence of competition, their income is limited by the regulator. In this case, the regulator must find a balanced solution that would minimize the consumer's spending while ensuring the stable operation of infrastructure covering the full economic costs of the operator.


    Calculating tariffs based on the RAB (regulatory asset base) is a generally accepted methodology that is used to establish justified tariffs for services of natural monopolies in the countries of the Energy Community. This methodology was adopted in Ukraine in September 2015 and implemented in January 2016.


    Using this methodology, the operator estimates and the regulator sanctions the rates for booking of the capacity at the entry/exit points in a way that guarantees an adequate return on the capital involved and covers all reasonable operating costs of gas transmission system operation as well as depreciation. Depreciation of the operator's fixed assets is determined based on the expected period of economically viable utilization of the assets. This methodology facilitates the timely modernization and development of networks.


    Gazprom reserved the capacities of the Ukrainian gas transmission system at 110 bcm per year until the end of 2019. Ukraine is thus currently obliged to ensure the availability of such capacities and spend money on their support. Therefore, these costs were included into the cost of entry from the relevant interconnection points.


    In the same time, Gazprom and the Russian government officials have repeatedly publicly stated that they did not intend to continue to use the Ukrainian gas transmission system upon completion of the current contract. Gazprom is actively pursuing alternative pipeline projects that will enable Russia to bypass the Ukrainian route. Therefore a significant reduction in economic benefits from the use of the Ukrainian gas transmission system is reasonably expected starting from 2020. In these conditions, the expected useful life of Ukraine's gas transmission assets had to be reduced accordingly. Following the RAB methodology, the Ukrainian regulator had to factor the accelerated depreciation of transit assets into the tariff.


    If the conditions are changed in a way that enables the Ukrainian regulator not to factor in the accelerated depreciation, the cost of transmission of the Russian gas to the EU via Ukraine will be comparable with the cost of similar services in Slovakia at a similar load level.
    If the situation does not change until the conclusion of the contract with Gazprom, accelerated depreciation will be included into the tariff by the end of 2019. As a result, starting from 2020, the cost of Russian gas delivery to the EU via the Direct Stream that runs through Ukraine's territory will be several times lower than alternative delivery channels. Ukraine is ready to compete with alternative transport routes and offer suppliers in both Russia and Europe attractive terms for gas transmission both from East to West and from West to South.


    At the time of the release date of this report, Gazprom was refusing to fulfil the requirements of Ukrainian legislation and did not pay for transmission services based on the new tariffs. The requirement to rectify this situation is included in the Naftogaz claim which is being considered by the Arbitration Institute of the Stockholm Chamber of Commerce.

    Cost of transit

    Bringing domestic gas prices to import parity levels


    On 1 October 2015, Ukraine completely abolished price regulation for industrial consumers. Since then the market price of gas has been determined by the balance of supply and demand, and correlates with the price of imported gas. In addition, in 2014-2016, the Ukrainian government has taken a number of unprecedented steps to bring domestic gas prices for households to import parity levels. Because of the price regulation, in 2014 more than half of the gas volume consumed in Ukraine was sold at prices that were 10 times lower than prices for other consumers. In 2016, the sales price for all consumers was almost equal: the price of gas for households was set at estimated import parity.


    This was a difficult but a vital decision for Ukraine. It is anticipated that the positive fiscal effect on the state budget from this transition, subject to adjustment for lower prices for imported gas, will be USD 4.7 billion in 2016 (the total amount of implicit and targeted gas subsidies in 2013 amounted to USD 4.9 billion in prices of 2016 and expected at USD 2.4 billion in 2016).


    Instead of covering the deficit from loss-making Naftogaz activities, the government now provides targeted support to those citizens who find it difficult to pay for gas at the market rate. The reduction of import parity prices in Ukraine due to the fall of gas prices in the European market and the actions of Naftogaz to diversify gas supplies have supported this transformation.


    In future, the price of gas for all consumers will be determined by the market principles of supply and demand. Currently, this transition is expected to be complete in 2Q 2017. This timeframe is enshrined in the IMF requirements and in the Law "On Natural Gas Market".

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    WHAT IS THE PURPOSE OF THE THIRD ENERGY PACKAGE?

    • The Third EU Energy Package aims to create open, competitive and transparent energy markets that promote trade between signatory countries while also creating access to diversified sources of energy. One of the tools to achieve this goal is eliminating conflicts of interest between production and supply on the one hand, and the transmission and distribution of energy on the other.

    • Gas distribution and gas transmission companies are considered natural monopolies, i.e. those where competition between several operators is not economically justified. This situation creates the possibility for network operators to act in favour of their own production and supply of energy.

    • The Third EU Energy Package sets out requirements designed to deprive the operating companies that are natural monopolies of such opportunities to abuse their dominant position.

    • The basic requirement of the Third EU Energy Package is the principle of free third-party access to infrastructure, which requires provision to all gas suppliers of non-discriminatory access to gas transmission and gas distribution networks.

    • In addition, it established principles for the regulation of the activities of network operators. An independent and professional market regulator is responsible for establishing transparent tariffs for these operators in accordance with clear procedures.

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    FINALIZING REFORMS

    Adopting the necessary legislation


    With the introduction of the Law "On Natural Gas Market" in the second half of 2015, a number of regulations were adopted that are essential for the creation of a competitive and efficient gas market. However, some provisions of the secondary legislation still require significant changes and harmonization with the new law and European energy legislation. In particular, this relates to the implementation of the EU standard network codes.

    Finalizing the reform of Naftogaz corporate governance system


    An important component of gas sector reform is the corporate governance reform of Naftogaz, which is currently a major player in most market segments. The gas sector reform plan approved by the Cabinet of Ministers in March 2015 requires the corporate governance system of Naftogaz to be reformed and brought into line with OECD guidelines for state-owned enterprises. This transformation began in 2015 and is expected to be finalized in 2017 (see Strategy and Reform — Corporate Governance).

    Price reform

    Conclusion of arbitration proceedings with Gazprom


    Gazprom's refusal to pay entry/exit tariffs set by the NEURC, its blocking of the interconnectors at the border between Ukraine and the EU (including Slovakia), as well as the obstruction of the TSO unbundling, make it impossible for Ukraine to fully implement the requirements of the Third Energy Package.

    Naftogaz is currently a party to the transit contract with Gazprom which expires on 1 January 2020. While performing its obligations under the contract, Naftogaz acts as the TSO.
    According to Ukrainian legislation, Naftogaz is not a licensed operator of the gas transmission system. Furthermore, according to European and Ukrainian energy legislation, gas transmission activity cannot be combined with production and supply.


    According to the position of the ACER (Agency for the Cooperation of Energy Regulators), the existence of any long-term transit contracts does not constitute grounds for the preferential or selective application of the Third Energy Package.


    On the other hand, according to the requirements of the Energy Charter, to which Ukraine is a signatory, it cannot introduce legislation that would pose a threat of the removal or reduction of natural gas transit before the resolution of the dispute in court.


    In this situation, the only way to fully implement the requirements of the Third Energy Package in Ukraine is to resolve the issue in court. Naftogaz has included the following requirements in its claim against Gazprom under the existing gas transit contract:


    • Ensuring non-discriminatory access of third parties to gas transmission infrastructure (the requirements of the Code of the Gas Transmission System and application of non-discriminatory tariffs for gas transmission);
    • Unlocking the main interconnectors with neighbouring gas transmission systems to eliminate "bottlenecks" that limit the free flow of gas across the borders of Ukraine;
    • Remove legal barriers to unbundle the TSO function.


    Naftogaz claims that, in particular, it should be entitled to unilaterally replace the contractor under the contract with the TSO to meet the requirements of current legislation of Ukraine (see Strategy and Reform — Security of Gas Supply).

    Structure after separation

    Unbundling of gas transmission from supply and production


    The unbundling of gas transmission function is one of the instruments for creating a transparent and efficient gas market in Ukraine. An independent and professional TSO is necessary to ensure the confidence of market participants in the transmission system and to increase competition.


    The Third Energy Package, including Directive 2009/73/EC, establishes a clear mechanism to eliminate discrimination and restrictions on the right of free access to the transmission system, including through the separation of the system management from the management of the production and supply of natural gas ("unbundling").


    By joining the treaty establishing the Energy Community, and also by concluding the Association Agreement with the EU, Ukraine has committed to these requirements and to the implementation of one of the approved unbundling models.


    Work on the development and coordination of the plan to unbundle the gas transmission function from Naftogaz continued throughout 2015. A detailed unbundling plan was approved by the Ukrainian government in July 2016.


    This plan envisages the complete unbundling of the TSO activities from the Naftogaz group according to the ownership unbundling (OU) model.


    In line with the restructuring plan approved by the Cabinet of Ministers of Ukraine on 1 July 2016, the next phase in the reform of the gas transmission system operator should be as follows:

    • Establishment of the PJSC "Trunk pipelines of Ukraine", a new entity to perform the TSO functions, managed by the Ministry of Energy and Coal Indusry of Ukraine;

    • Implementation of a corporate governance system in line with the OECD principles for state-owned enterprises. A professional and independent supervisory board and executive body will be responsible for the effective and transparent management the TSO; 

    • Comprehensive analysis of assets, technical, human and other resources required for the effective operation of the PJSC "Trunk Pipelines of Ukraine" to be transferred to the new operator;

    • Adoption of legislation to implement the requirements of the Third Energy Package to unbundle transmission activity at the level of public authorities;

    • Transfer of key gas transmission assets in favour of the new TSO and, accordingly, the full launch of its operation. This is to take place 30 days after the final decision in the arbitration between Naftogaz and Gazprom comes into force (expected in the first half of 2017). As the gas transportation system of Ukraine is public property and is not subject to privatization, the newly established TSO is to be entitled to concession rights;

    • The plan also stipulates a number of measures to reform the gas storage activities. A comprehensive analysis of underground storage facilities is to be performed by 1 July 2017 to determine the most effective model for the use of these assets, as well as measures to create a separate storage facilities operator run by the Ministry of Energy and Coal Industry of Ukraine.

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