Ukraine: trends and opportunities in the energy sector

July 2013 | SPECIAL REPORT: Infrastructure & project finance

Financier Worldwide Magazine

Due to its unique geographical location and its gas storage capacity, Ukraine plays a key role both in the European and global fuel and energy markets. On the one hand, Ukraine is an energy-dependent country with insufficient volume of its own conventional energy sources (oil and gas). On the other hand, Ukraine is important for the global energy markets, being a major transit centre for exports of Russian oil and natural gas to both eastern and western Europe.

Recent advances in energy sector legislation are clear signs that it continues to grow. Over the past couple of years, especially in 2011, Ukraine has taken serious steps towards reforming its energy legislation. Privatisation in the electricity and gas sectors, opportunities for involvement in the extraction of fuel resources, accession to the energy community, and the promotion of ‘green’ energy all suggest that a close look at the Ukrainian energy market would likely attract the interest of investors.

Privatisation in the DSO sector

Article 6 of the Electric Power Industry Law regulates property rights in the electric power industry. Power generation facilities may fall under different forms of ownership. The list of power generation facilities that are not subject to privatisation will be approved by the Supreme Council of Ukraine upon provision of the Cabinet of Ministers of Ukraine (CMU). Privatisation of facilities in the electric power industry is undertaken in accordance with the laws of Ukraine on privatisation.

In early June 2010, the President of Ukraine announced a program of economic reforms for the years 2010 to 2014, which envisaged the privatisation of regional electricity distribution companies (‘Oblenergos’) and of energy generation companies. As a result, in 2011 the process of privatising the power generating and power distributing companies with state-owned stakes was commenced, whereby 25 to 50 percent of the state-owned shares of certain Oblenergos would be sold. Meanwhile, where possible, the state maintained blocking shareholdings (25 percent + 1 percent). Further, in October 2011, the CMU issued a Decree that entrusted Naftogaz with a mandate to further privatise the Oblgas by offering more state-owned shares for sale. According to this Decree, Naftogaz needs to ensure that at least 25 percent of all but 12 of the NJSC companies remain state-owned. For the 12 companies not required to remain state-owned, the state-owned stake will be sold entirely.

Changes in energy and gas market system – vertical integration and unbundling

On 16 July 2010, the President signed the Natural Gas Market Law. Among the principles set out in the Law, and complying with European standards, is the separation of functions regarding the transportation, distribution, supply and storage of natural gas. A transit operator is not allowed to perform activities concerning production and supply of natural gas, while a distribution operator may not enter the markets of natural gas production, supply, storage and transportation. If a transit or a distribution operator is a constituent part of a vertically integrated company, it must be legally and organisationally separated from the company’s other activities that are not directly connected with transportation or allocation of natural gas.

The Natural Gas Market Law implements another significant principle: the opening up of the gas market – the main condition for establishing real competition. Opening the market means guaranteeing the right of consumers to freely select gas suppliers, which requires equal access to the market for both companies already existing in the market and for new entrants.

Another important principle provided in the Natural Gas Market Law is equal opportunities for third parties to gain access to the gas transmission system and underground gas storage in Ukraine. According to Article 7, entities operating in the natural gas market have equal rights of access to the integrated gas transmission system of Ukraine.

Further, in November 2012, the Draft Law of Ukraine on Operating Principles of the Electricity Market (the ‘Draft Electricity Market Law’) passed its first reading in parliament. The main purpose of the draft law is to liberalise the wholesale electricity market (WEM) and create effective competition within the energy market. The Draft Electricity Market Law also provides for non-discriminatory and transparent access to the main, interstate or local power networks, as well as nondiscriminatory access to the electricity market. Access to the network capacity of interstate power networks is provided to all energy suppliers and producers of electricity. Energy distribution companies must provide non-discriminatory access to local power networks on the electricity market.

TSO gas pipeline consortium

On 26 April the Verkhovna Rada registered draft law No. 2937 ‘On the introduction of amendments to certain legislative acts of Ukraine to reform the National Joint-Stock Company Naftogaz of Ukraine’. The bill proposes removing from the Ukrainian legislation a ban on the privatisation of gas pipelines. The document also allows privatisation of the state-owned Naftogaz of Ukraine national joint-stock companies’ subsidiaries engaged in the transportation of gas via mainline pipelines and storage of gas in underground storage facilities, as well as enterprises, institutions and organisations created as a result of their reorganisation. The initiators of the draft law explained such amendments. The explanation letter to the draft law says that the proposed document shall be adopted in line with demands from the European Union regarding liberalisation of the gas market based on Ukraine’s membership in the European Energy Community.

If the draft law is adopted, it will provide a basis for the gas consortium to be established. Thus, Ukrainian authorities assert that the establishment of a trilateral consortium with the participation of Russian and European companies on a parity basis is appropriate and will allow the country to raise funds to modernise the transport system and boost its reliability and throughput capability. But the specific structure and the participating parties to the consortium have not yet been chosen.

Development of renewable energy

In 2012, significant amendments to the renewable energy legislation were introduced with draft law No. 10183, adopted by the parliament on 20 November 2012. The new Law extends the scope of the Law on the Electric Power Industry. It introduces a coefficient of 2.3 for the electricity produced from biogas. It also amends the definition of biomass so that it excludes ‘products’ from its scope. Amendments also concern coefficients for electricity produced by solar objects, which have been decreased.Also, the document differentiates small hydropower stations in accordance with their installed capacity and increases coefficients for the electricity produced by small hydropower plants.

An important innovation stipulated by the document is the green tariff for individuals. For electricity produced from solar energy by power facilities fixed on roofs of private houses, with a rated capacity less than 10kW, in volumes exceeding consumption by such households, the green tariff will be awarded. Such electricity is produced without any licence. The NERC shall define the procedure for the purchase of and payment of such electricity, which will be carried out by energy supply companies.

In addition, the Law amends the local content requirement regarding the required share and calculation procedure. The updated version of the Law provides for fixed shares of the local component elements for each kind or type of object producing alternative energy. The Law envisages a number of elements and operations to be performed in Ukraine, which count towards the local content requirement. It appears that to achieve an appropriate local content requirement in a renewable project, a power plant operator applying for a green tariff must satisfy those combinations of elements, which results in compliance with the respective requirement.

Conclusions and outlook

The Ukrainian energy sector is undergoing a complex transformation. As a member of the European Energy Community, it must implement the energy chapter of the EUaquis communautaire in full, including the Third Energy Package. The signing of the European Union Association Agreement and creation of a free trade area with Ukraine are also being discussed.

Ukrainehas huge biomass potential and the largest agricultural market in Europe. It also has access to the Black Sea. Its biomass potential could be used for biofuel production and, further, Ukraine has good conditions for producing wind and solar energy, especially in southern Ukraine and Crimea. The Ukrainian government is encouraging investment into the establishment of bioenergy facilities by offering benefits to producers, among which is the green tariff.

Ukrainealso operates one of the world’s largest natural gas transportation systems, but because of its reputation as an unreliable transit country, its transit business is in decline. To make matters worse, on 8 November 2011, the first line of the North Stream pipeline was inaugurated, and the construction of the South Stream pipeline should be completed by 2015. Both pipelines are diversifying Russian gas routes away from Ukraine, directly connecting Russia with Germany and western Europe. Meanwhile, Ukraine is trying to negotiate a lower gas price with Russia.

A pending issue is the unbundling of Naftogaz. The company will be divided into several separate companies, where production will be separated from transportation. The Draft Law on the Reform of the Oil and Gas Sector is still under consideration.

Taking the foregoing into account, the energy sector is alive and developing. Obviously, further development of the sector will depend on the investment climate in Ukraine. Currently, investors consider local content requirements to be a serious obstacle to implementing renewable energy projects in Ukraine; investors still, however, show great interest in the Ukrainian market, since effective legislation provides them with sufficient incentives and competitive green tariffs.

Wolfram Rehbock is a senior partner and Maryna Ilchuk is a lawyer at Arzinger. Mr Rehbock can be contacted on +38 044 390 55 33 or by email: wolfram.rehbock@arzinger.ua.

Wolfram Rehbock and Maryna Ilchuk

Arzinger