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Russia can win in Ukraine without a single shot

The reform of the gas system in Ukraine is crucial for the country’s stability. It is also important for Poland that the slowdown of reforms in Kyiv ends with the success of the reformers.

October 7, 2016 - Wojciech Jakóbik - Articles and Commentary

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The war in Ukraine began in March 2014 when Russia illegally annexed the Crimean Peninsula. With a few exceptions, international society did not accept the operation, which was followed by Russia’s offensive in eastern Ukraine. While the situation at the front has calmed down, Ukrainian soldiers attacked by Russian forces keep dying and Kyiv still does not control its eastern border.

Despite the difficult political and military situation, Ukraine has undertaken many reforms aimed at facilitating its development. One of them is the reform of the gas sector in line with the provisions of the European Union’s third energy package. Ukraine joined the Energy Union, which is the foreign dimension of the EU’s energy policy, and the government in Kyiv declared its intention to implement relevant reforms. On its part, Brussels promised the necessary political, expert and financial support.

In April 2015, Ukraine’s Verkhovna Rada voted in a law on gas market. One of its elements was demonopolisation of the sector through the division of the state-held Naftogaz into extractive, transmission and distribution companies. It has been an element of ownership unbundling, guaranteeing the development of liberal gas market in accordance with the provisions of the third package. Subsidies to gas bills for households and the public sector, which were a significant burden to Ukraine’s struggling budget, are meant to be gradually reduced.

According to the Warsaw-based Centre for the Eastern Studies (OSW), without the marketisation of gas prices it would be impossible to repair Ukraine’s public finances. At the same time, the more effective use of natural gas will allow for reducing dependence on imports from Russia and the influence of Gazprom on Kyiv’s policies. Then the further reform of the gas sector in line with EU regulations will be possible and, in the longer run, its integration with the European system.

Thanks to gas integration with the EU, Ukraine will become a stable intermediary in Russian gas supplies to Europe. It will also translate into political stability in the country as well as better conditions for other, equally important reforms, such as those regarding anti-corruption, the judiciary and administration. The gas reform in Ukraine will become the key element of general integration with the EU, which lies in Poland’s interest.

From the Polish perspective, Ukraine integrated with the EU moves away from Russia’s geopolitical threat, taking from Poland the burden of being EU’s eastern border. A well-functioning gas sector in Ukraine is the guarantee for preventing gaps in gas supply, for which it would be difficult to blame Russia’s Gazprom and expect compensation, as Russia would put the blame on Ukraine.

It is also an opportunity to use Ukraine’s gas infrastructure to build a regional gas market. Poland would like to re-export LNG from Świnoujście port and the resources from the planned Norwegian corridor also to Ukraine, which would increase the profitability of the investments. The Poland-Ukraine pipeline, the construction of which is planned for 2017, is meant to have a capacity of eight billion cubic metres a year, which is hard to ignore. Poland uses such an amount in three year quarters.

The condition for the successful creation of a regional market is gas reform in Ukraine. The country’s creditors such as the International Monetary Fund, the European Commission and the United States, require progress in return for further tranches of the loan, which Ukraine uses also to purchase gas outside of Russia. Since November 2015 Kyiv has not imported the resource from Gazprom. The danger of the withdrawal of the West’s support is the tool disciplining Ukrainian authorities by the actors investing in the country.

The reform is also meant to free Ukraine from post-Soviet mechanisms and has encountered strong opposition in the country. Naftogaz carries a history of corruption that has continued since independence. It was only the governments of Arseniy Yatseniuk and his successor, Volodymyr Groysman, which decided to introduce changes to eliminate the endemic corruption.

Naftogaz’ dues were covered with obligations sold to the state treasury, which was one of the main reasons for the increase in budget deficit from two per cent of the GDP in 2008 to seven-nine per cent in years 2009 – 2014. In 2014 it reached 110 billion hryvnias, which is seven per cent of the country’s GDP. The IMF wants to reduce the deficit in Naftogaz to 0.2 per cent of the GDP in 2016. However, the changes require a painful increase in gas prices after removing the subsidies, which is unpopular with the public. Moreover, they require excluding oligarchs from profits, which has caused protests of interests groups represented in Ukraine’s government.

On July 1st, 2016, the Ukrainian government accepted Naftogaz reorganisation plan. At the same time, Kyiv has invited Western companies to privatise the anticipated operator of transit pipelines and the company managing storage facilities. Ukraine has the biggest storage capacity in the world, reaching 31 billion cubic metres. The ownership unbundling of Naftogaz was meant take place. However, it never happened.

On September 22nd the government decided to transfer responsibility for the company to the Ministry of Economic Development and Trade. Earlier, conflict erupted after it was revealed that Ukrtransgas (the operator of storage facilities belonging to Naftogaz) was to fall under the control of the same resort. The undetermined status of the daughter-company was supposed to be the reason, but the idea collapsed after it was heavily criticised by Energy Union’s office.

The transfer of the oversight of a gas company to the Ministry of Development conflicts with agreement with the EU, according to which it was supposed to be under the supervision of the Ministry of Energy and Coal Industry, as well as the OECD standards of company management. The Union also reminded itself about the failure of ownership unbundling and it is currently unclear if this will freeze Western support.  

In response to the issues related to the gas reform, the US vice president Joe Biden warned President Petro Poroshenko in Kyiv that in the case of reform failure, Ukraine can become a scapegoat in the crisis with Russia. He also stated that Western European states only wait for a pretext to lift sanctions imposed on Russia as a result of the annexation of Crimea and the war in Donbas. He reminded that if the United States is to grant new credit guarantees to Ukraine, the reform has to succeed.

Russia continues its policy of blaming Ukraine for the problems in gas supplies to the EU. It rejects the responsibility of Gazprom for the political decisions to reduce or seize gas supplies, which the EU felt most strongly during the crises in 2006 and 2009.

At the same time, the lack of reform lets Russia portray Ukraine as a failed state and encourage Western countries, which are increasingly reluctant to support Kyiv, to work out common solutions to Ukraine’s issues. If such a scenario continues, Russia will be able to get away with the illegal annexation of Crimea and the war in Donbas. It will also gain more influence on the future of Ukraine. The Minsk agreements between Moscow, Paris, Berlin and Kyiv, which have become the basis for discussions about resolving the crisis, have been a similar success of Russia, although they were never observed by the Russian forces occupying eastern Ukraine.

With losing the gas reform, Ukraine could lose its Revolution of Dignity, which was supposed to be squashed by Russia’s military campaign in the east of the country. In such a scenario, the West, which invests a lot of funds in Ukraine, will also lose and Poland will be left without the Ukrainian stabiliser in the east. Polish PGNiG (Polish Petroleum and Gas Mining) will then lose the prospective market for the gas from its LNG terminal and Norway, which will compromise its attempts to create a competitive market for non-Russian gas in the region of Central-Eastern Europe.

Wojciech Jakóbik is an energy analyst at Jagiellonian Institute and editor-in-chief of economic portal biznesalert.pl.

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