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A Note on NAFTOGAZ Pricing and the GOU Budget Deficit

Mack Ott, Economist, FINREP II consultant

The GOU, in its Stand-By Agreement with the IMF of March 2014, agreed not only to reduce its budget deficit, but also to reduce (or remove) energy price subsidies. Eliminating them could narrow the NAFTOGAZ deficit by $2.5 billion. However, if left unchanged, the current subsidies would raise the total GOU deficit to more than 10% of ’s GDP.

Ending the gas subsidies is the single market liberalization policy with the greatest beneficial impact for the Ukrainian economy.

Eliminating the subsidies would be accomplished by raising the natural gas tariff that NAFTOGAZ charges for natural gas consumed by households. Currently, the two lowest income groups of NAFTOGAZ customer households pay tariffs that are less than a quarter of the retail value of the delivered gas—$92/mcm versus the NAFTOGAZ wholesale price of $375/mcm. Adding the estimated transport and distribution costs, another $51/mcm, brings the total market price to $426/mcm. The GOU has pledged to reduce the subsidy to zero over three years. GOU has also pledged to compensate the lowest income households with cash transfers to offset the increased gas tariffs.

An estimate of the impact of tariff increase shows a decreased household demand for natural gas of about 7.0 bcm during the first year, as the higher price induces households to consume less. These subsidy reductions would continue over the next two years, reducing consumption by about 1.6 bcm and 1.0 bcm, respectively. Over the three-year price adjustment span, demand would be reduced by 9.6 bcm. This reduction would amount to more than a sixth of the pre-adjustment natural gas imports from . The reductions in gas demand would reduce the GOU budget deficit by $3.6 billion. The current account deficit would be reduced by the same amount as less gas is imported from Russia’s GAZPROM.

The offsetting cash compensation for households in the lowest income decile over the three years would cost a seventh of the value of the reduced gas consumption. Further, the reduced demand for natural gas would persist beyond the cash adjustment period. Even more intriguing, these savings reflect only the demand reduction—omitting the effect of price increases inducing a supply increase. Due to the rise in gas prices over the three- year adjustment, domestic production could rise by nearly 18 bcm, an increase valued at $6.3 billion. This rise in production would also persist after the adjustment period. This anticipation of more natural gas production is reflected in the exploration and development contracts signed between the GOU and (2013) and Chevron (2014).