Reform of the Ukrainian gas sector

September 2015 | EXPERT BRIEFING | SECTOR ANALYSIS

financierworldwide.com

The Ukrainian gas sector has faced turbulent times over the last 12 months – with the country experiencing the loss of gas deposits, disputes with Russian Gazprom, a significant increase in rental payments and new initiatives to decrease rental payments. All of these events have had a double-sided effect on the sector – some gas producers decided to sit out while the Ukrainian government was pushed to act immediately.

Ukraine has managed to diversify its gas supply via reverse gas flows from the EU. At the same time, the Ukrainian government has concentrated on the long-awaited reform of the gas market.

The ambitious reform will cover a step-by-step rise of consumer prices, the termination of cross subsidisation, the unbundling of Naftogaz, free access of new players to the gas market, the transformation of the Energy Commission (NERC) into an independent market regulator, and the integration of the Ukrainian gas transportation system into the EU gas market. The reform will also be accompanied by the smooth implementation of the Third Energy Package, as well as with the development of a new Ukrainian legal framework within the gas sector. The reform will be led by the Energy Ministry which is cooperating closely with the Energy Community Secretariat.

Reform of Naftogaz

Currently Naftogaz is a vertically integrated oil and gas company fully owned by the Ukrainian state through the Energy Ministry. Companies within the Naftogaz group produce more than 90 percent of the entire volume of oil and gas of Ukrainian origin, which allows Naftogaz to fully enjoy its monopoly at the Ukrainian gas market. For many commentators this situation must be changed. The Ukrainian government is planning a far-reaching reform of the state monopoly which will include the restructuring of Naftogaz by unbundling the company, the introduction of input-output tariffs, subsidies system reform, the introduction of a single wholesale gas price for all consumers, the approval of new corporate governance principles, and the incorporation of companies-operators of the gas transportation system and gas storage.

The restructuring process should begin in October 2015 and may take around two years. Intensive preparation for the restructuring process has already started. The reorganisation of Naftogaz will be followed by the unbundling of its gas transmission activities from gas production, supply, storage and distribution. To date, gas transmission activities have been carried out by Ukrtransgaz (a subsidiary of Naftogaz) which is only formally independent from the company.

According to the Natural Gas Market Law, the government is free to choose one of the unbundling models, in particular ownership unbundling (OU) or the independent system operator (ISO) model. The OU model requires not only the separation of transmission from other activities, but also a corporate restructuring of companies involved in such activities. At the same time, in contrast to the ISO model, the OU model allows the gas transportation system owner to hold its operator status and fully control over gas transmission activity. The ISO model allows for the maintenance of the current corporate structure of a vertically integrated holding, subject to a transfer of operation of the gas transportation system to the ISO. Currently, the unbundling model has not been chosen by the government and it is not clear whether Naftogaz will lose its unofficial status of a gas transportation system operator, a process which is carried out by its subsidiary Ukrtransgaz. Although the decision will be taken by the government, Naftogaz most likely will insist on choosing the OU model.

Reform of the Energy Commission

The Energy Commission’s activity will be governed by a separate law. The draft law was prepared by the Energy Ministry in collaboration with the Energy Commission, and was approved by the Energy Community Secretariat. Currently the draft law is awaiting its adoption by the Ukrainian parliament.

The key issue to be reflected in the law is full independence of the Energy Commission (both political and financial). Political independence should be guaranteed through a competitive selection of the commissioners. The involvement of representatives of the Energy Community Secretariat would serve to guarantee a transparent selection procedure. Moreover, commissioners will be more independent when adopting decisions of the Energy Commission, since approval by other state authorities will not be required.

The financial independence of the Energy Commission will be secured by the separation of its budget from other expenditures of the Ukrainian state budget. At the same time, according to the current version of the draft law, the Energy Commission’s budget will be financed by gas market players through a new tax which may lead to a further increase in gas prices.

The new law will enhance the position of the Energy Commission as a market regulator. In particular, the Energy Commission will be authorised to conduct scheduled and unscheduled audits, handle complaints, impose penalties and act as an arbitrator in disputes between gas market players.

The role of the Energy Commission as the gas market investigator remains ambiguous. According to the current version of the draft law, the Energy Commission will have no powers to carry out investigations as suggested by the Energy Community Secretariat, and will only monitor the market instead. Energy market investigations will be conducted by the competition regulator (the Antimonopoly Committee of Ukraine) upon request of the Energy Commission. At the same time, according to the Natural Gas Market Law, the gas market regulator is authorised not only to initiate but also to carry out gas market investigations. We assume that the investigative powers of the Energy Commission may be set in the final version of the draft law.

The global changes provided by the gas sector reform will have a huge impact on the gas market and should make it more attractive for new players.

Dr Oleksiy Feliv is a partner and Nika Varvaryuk is a lawyer at Gide Loyrette Nouel. Dr Feliv can be contacted on +380 44 206 0980 or by email: oleksiy.feliv@gide.com. Ms Varvaryuk can be contacted on +380 44 206 0980 or by email: nika.varvaryuk@gide.com.

Dr Oleksiy Feliv and Nika Varvaryuk

Gide Loyrette Nouel