>> POLICY BRIEF ISSN: 1989-2667

Nº 55 - SEPTEMBER 2010

The battle for Ukraine’s energy allegiance

Natalia Shapovalova

As the main route for Russian gas into Europe, Ukraine is vital to >> both European and Russian energy security. The European Union (EU) seeks to secure gas supplies through Ukraine by integrating its east - HIGHLIGHTS ern neighbour into the European energy market. is seeking to pre - vent EU-led reforms in Ukraine in order to secure stable gas export • Ukraine has taken some steps incomes and continue exerting power over its ‘sphere of privileged inter - to reform its energy sector and est’. Ukraine’s elite does not wish for reform, but maintaining the status integrate in the EU market, but quo is no longer tenable either. Ukraine is increasingly forced to choose reform goes too slowly; the between the energy security guarantees of the EU and Russia. country's energy sector remains ineffective, opaque and corrupt. UKRAINE MOVES CLOSER TO EUROPEAN ENERGY MARKETS... • Russia is looking to take over Ukraine's energy market: Ukraine’s new president Victor Yanukovych is often represented as pro- energy-inefficient Ukraine Russian in contrast with his predecessor Victor Yushchenko and ex- remains one of ’s prime minister . But in terms of relations with the largest client s. EU, his government has managed to fulfil some promises that were not upheld by his ostensibly pro-European predecessors. In July, the • Energy is in the centre of Ukrainian parliament adopted a new law on the Ukrainian gas sector, EU policy and aid to Ukraine, aligning Ukraine with EU requirements and legislation. but the EU's inconsistent external energy policy weakens Transposition of this law was necessary for Ukraine’s membership of the its leverage in the country. European Energy Community. The latter initiative was established between the EU and a number of countries in south-eastern Europe in order to extend the EU’s internal energy market beyond the bloc’s borders. The law harmonises Ukrainian legislation with EU gas market regulations (Directive 2003/55/EC concerning common rules for the internal market in natural gas and Regulation 1775/2005 on conditions for access to the THE BATTLE FOR UKRAINE’S ENERGY ALLEGIANCE

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>>>>>> natural gas transmission networks) and enables the that came with the 25-year prolongation of the creation of a more competitive gas market. The new Russian Black Sea Fleet’s stationing in the law envisages unbundling of gas exploration, trans - Crimea. portation and supply, and guarantees equal access of operators to gas networks. It is also set to strength - en independence of the national regulatory body in ...BUT RENT-SEEKING REMAINS order to eliminate political influence on the energy market. It remains to be seen whether the law will be imple - mented as fully as it should be. Experts point to a The adoption of this law means that Ukraine risk of hidden monopolisation. Unbundling and will become a member of the European Energy independent regulation of the gas market may exist Community in the next six months to a year, on paper only. This occurred previously with the according to the EU energy commissioner. As national regulator, which was in practice highly part of its membership obligations, by 2018 dependent on the government, even though legis - Ukraine will have to implement other elements lation envisages the opposite. of EU energy policy which regulate the electric - ity market and energy-related environmental Analysts say revenues from the gas price hike are issues. Membership will ensure the competitive - not slated to go towards government investment ness and transparency of Ukraine’s energy mar - into energy saving and infrastructure modernisa - ket, investments in modernisation of tion. The Ukrainian state oil and gas monopoly infrastructure and new technologies and thus is preparing to pay a gas debt worth 3 will reduce consumption and dependency on gas billion dollars – equivalent to 12.1 billion cubic imports. For the EU it will mean stable gas sup - meters, or 20 per cent of Ukraine’s annual gas plies from Russia through Ukraine. consumption – to RosUkrEnergo, a ‘middleman’ jointly owned by Gazprom and Ukrainian oli - Despite this advance, the state has maintained garch Dmyro Firtash. The latter was allegedly one its control over state-owned gas exploration of the main sponsors of Yanukovych’s presidential companies. They will be forced to sell gas to a campaign. RosUkrEnergo was established as an government company at a regulated price. This intermediary selling Russian and Central Asian allows the state to manipulate household energy gas to Ukraine back in 2004, when Yanukovych prices, which will further impede the develop - was prime minister and the current energy minis - ment of the gas exploration market. Further - ter, Yurii Boyko, was a key player at Naftogaz. more, the new law does not prevent foreign Experts say the company was founded to create monopolies, such as Russian Gazprom, from extra revenue for its stakeholders, both within the operating in the Ukrainian market. Ukrainian and Russian ruling elites. RosUkrEner - go’s already advantageous position in the Ukrain - The new Ukrainian government has also ful - ian market strengthened after the Ukraine-Russia filled another requirement set by the EU and ‘gas war’ of 2006. In 2009, Yulia Tymoshenko’s other international organisations such as the government reached a deal with Gazprom to International Monetary Fund (IMF). From remove the company from Ukraine-Russia gas August 2010, gas prices for domestic consumers trade. As part of the agreement, the government have increased by half, and a further hike is fore - gained possession of 11 billion cubic meters of its cast for 2011. In a desperate bid to secure an gas, located in Ukrainian gas storage. When the IMF loan and reduce the budget deficit, the gov - government in Kiev changed, RosUkrEnergo ernment dared to do what its predecessor did sued Naftogaz at the Arbitration Tribunal of the not. Yanukovych raised gas prices despite his Stockholm Chamber of Commerce, winning the April 2010 statement that an increase would not case. be necessary due to the ‘discounted’ gas price POLICY BRIEF - Nº 55 - SEPTEMBER 2010

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Analysts believe that the government will now pay Instead, Ukraine suggested creating a tripartite out, as it barely attempted to defend Ukraine’s inter - EU-Ukraine-Russia consortium, an idea that was ests in the courtroom. Presumably, under pressure discussed in president Kuchma’s time. The gov - from Gazprom, any evidence pointing to a link ernment indicated it was ready to implement a between RosUkrEnergo and the Russian monopoly joint EU-Ukraine declaration signed by Yulia – or, more accurately, to the latter’s control over the Tymoshenko in March 2009, in which Ukraine former – was discarded from the case, weakening promised to reform the energy sector and the EU Naftogaz’s position. Moreover, a Ukrainian court to participate in modernising Ukraine’s gas tran - approved the Stockholm court ruling, meaning that sit system. The EU has not yet reacted to Ukrainian authorities are obliged to comply. Yanukovych’s consortium proposal.

If the claimed gas is returned to RosUkrEnergo, Unlike the EU, Russia does not ask for liberalis - Ukraine will have to purchase more from Russia. An ing reforms. On the contrary, Russia benefits energy advisor for the opposition estimated that from an opaque and uncompetitive gas market in Gazprom would earn over 1 billion dollars as owner Ukraine. However, despite the leanings of the of half of RosUkrEnergo. Moreover, Naftogaz’s government, Ukraine feels insecure about Russian financial situation would decline still further. energy policy. Having lost control of the pipelines, the Ukrainian government will have no bargaining power over establishing prices for RUSSIA: STALLING UKRAINE’S ENERGY imported gas, and will be deprived of this impor - MODERNISATION tant source of rent. This explains why Yanukovych, despite his moves towards Russia’s The gas wars between Ukraine and Russia in 2006 outstretched arms, has not been eager to accept and 2009 led to Russian energy giant Gazprom edg - Putin’s proposal. ing into Ukraine’s Analysts say domestic market. Yanukovych’s soft ‘no’ has not prevented Russia Responding to the new from insisting on a merger between the Russian revenues from Ukrainian govern - and Ukrainian energy sectors. The two countries ment’s Russia-friendly have increased their cooperation vis-à-vis nuclear the gas price hike policy, the Kremlin has energy. Russia has offered Ukraine a 2 billion dol - are not slated to go changed its tactics lar credit to construct two additional reactors on from waging war to the Soviet-built nuclear power plant, which will towards government attempting a peaceful allow Russia to install its own technologies and takeover. In April supply uranium to Ukraine. The Ukrainian gov - investment into 2010, when the ink on ernment is also considering Russian investment in energy saving the gas-for-fleet deal the construction of a factory to produce nuclear had barely dried, Russ - fuel. and infrastructure ian prime minister offered Russia will keep looking for other ways gradually modernisation. Ukraine a Gazprom to edge its way into the Ukrainian gas market. It and Naftogaz merger may draw on its experiences in Belarus, where nominally as a means to invest in the modernisation state energy assets were acquired in lieu of Belaru - of Ukraine’s gas transit system. Yanukovych rebutted sian debts to Gazprom. Even though a merger has the proposal with a joke that such a deal would been discounted, Ukraine and Russia have be possible only if the two companies exchanged 50 launched talks on a possible joint venture per cent of their stocks – irrational given Gazprom’s between Naftogaz and Gazprom, to which the size. latter promises to contribute a gas field with a vol - ume of one trillion cubic metres. >>>>>> THE BATTLE FOR UKRAINE’S ENERGY ALLEGIANCE

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>>>>>> energy sector to secure transit and consumption, It is unclear exactly what kind of venture is under EU policy towards Ukraine and eastern neigh - negotiation and what Ukraine’s motivation is. Is bour states is largely based on a market and insti - its government serious about giving Russia access tutions approach. This means that the EU aspires to its pipelines in exchange for admittance to to extend its energy rules to Ukraine and make Russian gas exploration? Or is it merely negotiat - the Ukrainian energy market transparent and ing for a new intermediate company that will competitive. allow the Russian and Ukrainian elites to keep profiting from gas transit to Europe? In 2005, the EU and Ukraine signed a Memoran - dum of Understanding on energy cooperation. In Ukraine’s main fear is that its pipelines will 2007, the EU allocated 87 million Euros (includ - become redundant once the North and South ing 83 million in direct budget support) to assist Streams start carrying Russian gas to European energy reform in Ukraine: this accounts for more clients and bypassing Ukraine. The EU-driven than 60 per cent of total EU aid to Ukraine dis - Nabucco pipeline may also weaken Ukraine’s bursed via the European Neighbourhood and transit leverage. Still, Ukraine is rather supportive Partnership Instrument. In 2008, another 70 mil - of Nabucco, but openly opposed to the South lion Euros were allocated for the same purpose. Stream project that is pushed by Moscow. Additionally, in 2009 the European Commission Tymoshenko’s government even promoted the pledged its assistance in the modernisation of White Stream, an alternative route that would Ukraine’s gas transit system, subject to reform include Ukraine, but this project is long-since progress in the country’s energy sector. stalled. Although the EU supports Nabucco rather than South Stream, Russia has managed to However, despite the new gas market law, secure initial backing from almost all EU member Ukraine’s energy sector remains ineffective, states which also support Nabucco. This situation opaque and corrupt. So, why does EU policy bear is deeply troubling for the Ukrainian ruling elite. no fruit in Ukraine? To some extent, the unwill - ingness of Ukraine’s elite to reform is responsible. Russia is interested in controlling transit routes Regardless of the political party in power, rent- to Europe, but even more interested in preserv - seeking prevails and energy is used as a domestic ing its source of income from gas export. political weapon to secure electoral support. Europe’s diversification plans are gradually Energy resources lubricate the wheels of patron - becoming a more realistic threat to Russia. age. Successive governments see no rational or According to estimates, Ukraine also possesses normative motivation for change. approximately two trillion cubic metres of shale gas. However, the country needs foreign invest - But part of the responsibility also lies with the EU. ment and technologies to explore these reserves Its stance towards Ukraine is weakened by the lack and for this energy market reform is necessary. of a common EU position. After Putin announced Meanwhile, energy-inefficient Ukraine remains his Naftogaz acquisition plan, the only official reac - one of the largest gas consumers in the world and tion from the EU came from the energy commis - one of Gazprom’s largest clients. Russia is inter - sioner, who stated that a takeover of Ukraine’s gas ested in maintaining Ukraine as a client, which transit system would be a purely bilateral matter means keeping Ukraine’s energy sector old-fash - between Ukraine and Russia. This position contra - ioned and ineffective. dicted the EU policy towards Ukraine. A Gazprom–Naftogaz merger would mean the end of any market liberalisation and rule-harmonisation EU INCONSISTENCY plans by Ukraine. Ukraine would be unable to hold membership of the European Energy Community. While Russia is aiming to take over Ukraine’s There can be no illusions about this: Russia does POLICY BRIEF - Nº 55 - SEPTEMBER 2010

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not play the game by EU rules, instead using ener - The struggle between rent and reform does not gy as a political weapon. The EU is trying to pre - merely pertain to the energy sector. Gas has always vent state-run Gazprom from expanding its been the largest source of rent for Ukraine’s elite. monopoly into European markets. The Ukrainian The issue at stake is whether Ukraine will turn merger would only strengthen its monopoly posi - into a normal country governed democratically tion in gas transit to Europe. and developing towards a modern market econo - my, or will become part of Russia’s petrostate, The EU sends Ukraine misleading signals regard - nourishing the bigger country’s fading power. ing its supply diversification policy. The EU declares that it wants to decrease its dependence What can the EU do about it? Due to the trans - on Russian gas; yet North Stream will only deep - formation potential of its accession policy, the EU en that dependence. The EU energy commission - could help Ukraine to become an independent er says that there is no route more profitable and and democratic actor, but it has chosen not to do reliable than transit through Ukraine; yet so. While energy is a key policy area in EU- Gazprom has secured the support of European Ukraine relations, it suffers from the same prob - companies for the South Stream project. The lem as EU policy towards Ukraine in general: a Ukrainian government advocates a tripartite gas lack of strategic end-goals and insufficient incen - transit consortium offer on the table; yet the EU tives to provide forward momentum. continues its evasive, wait-and-see approach. In the short term, the EU should insist on imple - mentation of the joint declaration on modernisa - SOLUTIONS tion of the gas transit system. The tripartite EU-Ukraine-Russia consortium option is certain - Time is on Russia’s side. Ukraine feels under ly worth considering. A common and clear stance increasing pressure: it is running out of money, on the EU pipeline policy is needed. Finally, the and its pipelines are deteriorating while new EU should promote energy reform in a more routes that will bypass Ukraine are being built. responsible way. Budget aid and loans will yield The EU’s wait-and-see approach is actually dam - no results if they continue without strict condi - aging its own energy security. tionality and stringent monitoring of reform results. Formal legislative changes must be imple - From an energy security perspective, the EU is mented in practice; the EU must not be hood - interested in extending its rules into its neigh - winked by the mere adoption of drafts and bourhood. If Ukraine is integrated into the EU concepts as is often the case. Public scrutiny of market, this will serve as an encouragement to budget support should be part of the aid pro - Russia to modify its geopolitical approach. But if gramme. The solution to this enormously impor - Ukraine is absorbed by Russia, EU dependence tant policy challenge of Ukraine’s energy policy on Russia will only increase, depriving the EU of identity must be political in the broadest sense. its soft power in the neighbourhood.

From a wider foreign policy perspective, in the Natalia Shapovalova is researcher at FRIDE. case of a Russian takeover of Ukraine’s energy sec - tor, the EU’s influence on Ukraine will weaken across the board. As energy integration with Rus - sia will entail wider economic integration; Russ - ian business-state interests will dictate Ukraine’s policies and norms. There will be even fewer incentives for Ukraine to reform. e-mail: [email protected] www.fride.org