EU TACIS

PROJECT TWINNING FICHE

Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC

EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

List of Acronyms

BCM Billion Cubic meters CAPEX Capital Expenditure CEER Council of European Energy Regulators CGM Competitive Gas Market CHP Combined Heat and Power CIS Commonwealth of Independent States CMU Cabinet of Ministers COLS Corrected Ordinary Least Squares CoM Cabinet of Ministers DEA Data Envelopment Analysis DSO Distribution System Operator EBRD European Bank of Reconstruction and Development ECSEE Energy Community of South East Europe ENP European Neighbourhood Policy ERGEG European Regulatory Group for Electricity and Gas ERRA European Regional Regulatory Association EU European Union GLAWG Gas Legal Approximation Working Group GoU Government of Ukraine GRWG Gas Regulatory Working Group IEM Internal Energy Market Mcm Million cubic meters MoU Memorandum of Understanding MFE Ministry of Fuel and Energy (Mintoenergo) MTE Medium Term Experts NERC National Electricity Regulatory Commission NRA National Regulatory Authorities Oblgaz Gas Distribution and Supply Company OPEX Operating (and maintenance) expenditures or costs PAO Programme Administration Office (overseeing Twinning Projects) PC Price Control PSC Project Steering Committee RAB Regulatory Asset Base REM Regional Energy Market RIT Resident Interpreter/Translator RTA Resident Twinning Advisor RTPA Regulated Third Party Access SFA Stochastic Frontier Analysis STE Short term Experts SWOT Strengths, Weaknesses, Opportunities, Threats TA Technical Assistance Tcm Thousand cubic meters TSO/DSO Transmission/ Distribution System Operator UAH Ukranian Hyrvnia (1 US$ approximates 5.05 UAH) WACC Weighted Average Cost of Capital

- 2 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

BASIC INFORMATION

1.1 PROGRAMME: TACIS

1.2 TWINNING NUMBER: UA08/PCA/EY/12

1.3 TITLE: Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC

1.4 SECTOR: Energy

1.5 BENEFICIARY COUNTRY: Ukraine

2. OBJECTIVE

2.1 OVERALL OBJECTIVE:

A more transparent, efficient and competitive Ukrainian Gas Market that functions in line with European Union (EU) best practices.

2.2 PROJECT PURPOSE:

The purpose of the project is to improve capacity within NERC to undertake the proper development and implementation of primary and secondary legislation, regulatory work and adaptive decision-taking.

2.3 CONTRIBUTION TO THE PARTNERSHIP AND CO-OPERATION AGREEMENT (PCA), EUROPEAN NEIGHBOURHOOD POLICY (ENP) and NATIONAL DEVELOPMENT ACTION PLAN

The Partnership and Cooperation Agreement between the European Communities and their Member States and Ukraine (PCA) stipulates that “Co-operation shall take place within the principles of the market economy and the European Energy Charter, against a background of the progressive integration of the energy markets in Europe”.

This co-operation shall include among others the following areas: • formulation of energy policy; • improvement in management and regulation of the energy sector in line with a market economy; • the introduction of the range of institutional, legal, fiscal and other conditions necessary to encourage increased energy trade and investment; • management and technical training in the energy sector.

Developed in the context of the recent enlargement of May 2004, the European Union (EU) adopted on 11 March 2003 a new framework for its relations with its neighbours, including Ukraine, which materialized in 2004 in the European Neighbourhood Policy (ENP). The ENP aims at reinforcing ties with neighbouring and partner countries by fostering the political and economic reform process and promoting closer economic integration, legal and technical approximation and sustainable development. In order to implement the ENP, an Action Plan was jointly adopted by the EU and Ukraine on the 21 February 2005. In this action plan Ukraine commits to:

• adopt an overall energy policy converging towards EU energy policy objectives; • gradually converge towards the principles of the EU internal electricity and gas markets;

- 3 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

• make progress on the development of energy networks, the transit of natural gas, energy efficiency and the use of renewable energy sources, among others.

The Action Plan was subsequently followed up with a Memorandum of Understanding (MOU)1 in December 2005 in which both partners agreed to integrate the electricity and gas markets into the EU IEM through … implementation of key elements of the acquis communautaire on energy, environment, competition and renewables…a level-playing field in terms of equivalent basic rules with respect to market access, infrastructure and opening, as well as compatible environmental and safety standards will facilitate substantial electricity trade between the EU and Ukraine…align[ing] its legislation with the relevant Community rules in line with the timetable envisaged in the annexes to the [draft] Energy Community Treaty of South East Europe (ECSEE).

Additionally, it was agreed that attempts would be made to …reform electricity tariffs and gas pricing, develop approaches to ease the impact of reforms on vulnerable customers, reduction of network losses, in particular transmission losses, an increase in energy efficiency necessary to abate demand, measures to ensure full payments for providing electricity and gas, diversity of supply, including energy substitution by, e.g., renewable energy sources, whilst maintaining a free market framework and optimisation of the energy mix in the electricity generation with a view to increase efficiency, environmental safety, operational reliability, and security of supply.

It was also agreed that by the end of 2006 to use best endeavours “…to establish or contribute to an Energy Regulatory Authority independent of the interests of the Gas industry, having, as a minimum, the responsibilities referred to in the EU Gas Directive 2003/55 and Gas TSOs having the tasks referred to, and fulfilling the criteria contained in the relevant articles of the EU Gas Directive with respect to their independence from other activities not related to transmission”.

Since then a number of Joint EU-Ukraine working groups have been established on nuclear safety, the integration of Electricity and Gas markets, security of energy supplies and the transit of hydrocarbons, the coal sector and energy efficiency and renewable energies. Recently, an EU progress report on the implementation of the MOU confirmed that a draft law had been prepared in 2007 that provided for the complete separation of the Energy Regulator (NERC) from the industries that it regulates and that efforts are underway to ensure that NERC is to be funded through a special fund under the state budget.2

3. DESCRIPTION

The focus of this Twinning project is to support the implementation of the objectives of EU-Ukraine Action Plan and the MoU. Specific direction for this focus came from an earlier preparatory project in 2005 to the “Strengthening of the Administrative and legal framework in the field of Energy regulation in Ukraine” project which aimed at identifying the main regulatory assistance needs of NERC.

This preparatory project recommended that the twinning project address the strengthening of NERC’s capacity in policy design and implementation in incentive regulation, quality of supply standards, unbundling of distribution and supply of a regulated tariff, transmission pricing and support to the harmonisation of energy legislation with the Acquis Communautaire.

1 The MoU is cited at www.ukraine-eu.mfa.gov/eu/en/news/detail/1345.htm

2 See the Second Joint EU-Ukraine Report: Implementation of the EU-Ukraine Memorandum of Understanding on Energy Cooperation during 2007 (dated 14 Sept 2007).

- 4 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

3.1 BACKGROUND AND JUSTIFICATION:

Current Gas Structure

The notable feature of the current structure of the gas sector is the dominance of a vertically and diagonally integrated company (VIC) which through its subsidiaries or associate companies – is in control of most of the activities along the gas chain ranging from exploration and production through to supplies to the end customer. The company - Naftogaz - was established in 1998 as a joint-stock company based on the 100% shares of the state joint- stock companies, created by a re-organisation of the companies within Naftogaz’s structure. The companies are not allowed to be privatised as stated in legislation.

Figure 1: Current Structure of the Gas Sector (as of June 2007)

Source: NERC

Import Production

Ukraine is the fourth largest importer of gas (excluding transit purposes) in the world. It has always relied heavily on imported gas to make up the difference between consumption requirements (around 76BCM/year) and domestic production (around 20BCM/year). Since January 2006 the imports of gas have been underpinned by a new set of arrangements agreed between Ukraine and Russia. Today, gas is bought by RosUkrEnergo and sold by a JV

- 5 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

UkrGasEnergo to customers in Ukraine.3 Both companies were established in 2006.4 The price of imported gas currently ranges around US$130/tcm at the border and the bulk of this imported gas is sold to Industrial Companies with an ability-to-pay these prices. Reconsideration, by the current GoU, of the role that RosUkrEnergo plays in the process of gas imports is currently in the pipeline and it is possible that significant changes will be made in this area over 2008/2009.

Domestic Production

The main producing companies are Ukrgasvydobuvannya, Ukrnafta and, in Crimea, ChornomorNaftogas.5 All 3 companies are under the ownership and control of Naftogaz. The companies produced around 96% of domestic production with a small number of foreign independent producers making up the rest.6 In 1975 Ukrainian gas production was 69 BCM, since then domestic production has been around 18-20 BCM/year.

Storage function

Ukraine has the largest storage facilities on the European continent. Around 34BCM of gas can be stored in 13 underground storage facilities across four separate locations. The transportation company, UkrTransGas operates 12 facilities and ChornomorNaftogas operate one facility in Crimea. The storage facilities located in western Ukraine are used to service exports and UkrTransGas has previously tried to sell storage capacity to customers in France, Poland and Germany but without success. Tariffs for storage are now set at $6.60/tcm comprising $3.6 for storage, $1.5 for injection and withdrawal. The main user of the Storage facilities is current Naftogaz, including Gazprom`s transit.

Transit Activity

The transit of gas through the “Drujba” and other pipelines to Western Europe comprises the main focus of European attention.7 Prior to 2005, there was a ten year contract from 2003 to 2013 agreed between Naftogaz and Gazprom to allow for the minimum transit of 110BCM/year. Gazprom paid for the “rent” of the pipeline partly with gas for use in Ukraine and partly in cash. In recent years, up to 10% of transit fees were paid in cash with the rest paid by a delivery to Ukraine of 23-25BCM. However, these fees never received by NAFTOGAS as they form part of settlement of accumulated debt. In 2006, around 114BCM were transported through the transit pipelines to Western Europe.8 Currently, NAFTOGAS receives the transit fee ($1.60 per tcm per 100 km distance) from Gazprom by cash, fixed during the period 2005 - 2009 in agreement between Gazprom and Naftogaz.

3 Under the terms of the 5-year import agreement (signed in January 2006) between Ukraine and Russia, Ukraine received 34 BCM of gas priced at $95/tcm at the Russian-Ukrainian border. In turn, the transit fee paid by Russia to transit Russian gas was increased to $1.6/tcm per 100km in 2007 and to $1.7/tcm per 100km in 2008. One consequence of this arrangement has been the loss to Naftogaz of its previously substantial market share of providing imported gas to industrial customers.

4 RosUkrEnergo is jointly owned by Gazprom and a number of Ukrainian businessmen while UkrGasEnergo is jointly owned by RosUkrEnergo and Naftogaz. 5 The first gas well was dug in 1910 in Western Ukraine with commercial production starting in 1924 in the Lviv region. Today there are over 12 producing gas fields with over 27% of gas coming from the 4 largest gas fields: Shebelynske (discovered in 1950s), Yablunivske, Zakhidno-Khrestyshynske and Melykhovske. Over 90% of the gas comes from the Dnieper-Donets basin in Eastern Ukraine and Ukrgasvydobuvannya is by far the largest producer (at 75% of domestic production). 6 The main independent producers are JKX Oil and Gas, Cardinal Resources and Regal Petroleum. 7 The transit system has pipelines running in parallel with multiple compressor stations serving these lines. This makes the entire system stable and reliable. However, the gas pipeline network is in poor condition with 66% of pipelines between 10-30 years old and some 21% of pipelines over 30 years old. Gas enters from 12 entry points along Russian border and Belarus and exits through 10 exit points. 8 In January 2007, the Fuel and Energy Ministry proposed to increase transit of gas to Europe to 122 BCM in 2007 (according to Energy Minister Yury Boyko). Ukraine is also borrowing $250 million from the EBRD to develop the transit system.

- 6 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Gas Transmission function

The two transmission companies are UkrTransgas and ChornomorNaftasgas which operates only in Crimea.9 The companies only operate the transmission pipelines as under law the pipelines are owned by the State and cannot be privatised. Ukrtransgaz manages the overall operational dispatch of gas passing through Ukraine. The company employs around 28,000 staff (see IEA Energy Policy Review 2006, p 204). The transmission system is connected to Russia, Moldova, Belarus, Romania, Hungary, Slovakia and Poland as well as to the EU gas pipeline networks through these countries.

Distribution function

The distribution of gas is undertaken mainly by regional gas companies (Oblgazes) although very recently (May 2007) a new company - UkrGasMereji - has received licences to both distribute and supply gas in the Chernivthi region. Like transmission pipelines, ownership of the pipelines lies with the State with the Oblgazes having rights to operate and transmission of gas (although newly constructed pipelines can be owned be privately owned). In 1998, Ukraine privatised most of its local gas distribution and Naftogaz is either minority or majority shareholder in most of them.10 Currently (as of May 2007), there are 52 companies licensed to distribute gas (and oil). Gas distribution networks amount to more than 300,000 km of pipelines and about 76% of towns and 32% of villages have access to natural gas supply.

Regulated Supply Function to Domestic Customers

The supply activity is both regulated and unrelated by NERC. Generally, the supply of domestically produced gas to end customers who are not industrial customers remains regulated with tariffs set by Cabinet of Ministries of Ukraine (KMU). Oblgazes are the main holders of supply licences to supply gas to the general population, Non-Industrial customers and other customers, located within the territory of the licensee. The tariffs or price of gas remains subsidized in so far as the customers are not contributing the full cost of the gas that is supplied. There are currently 51 Supply Licenses for supplying gas at regulated tariffs.

Unregulated Supply Function to Industry

381 licenses have been issued by NERC to supply and trading companies to operate as unregulated suppliers. However, UkrgasEnergo is an exclusive supplier of gas for Ukrainian customers. However, as from 8 January 2008, NERC has restricted the volume of gas supplies by UkrgasEnergo to 5,04 mcm per year and has allowed the supply of gas by independent gas suppliers who do not have more than 35% of the total volume of gas consumption in Ukraine.

Current status of relevant Gas Legislation and the Regulator

In early 2006, the Ministry of Fuel and Energy drafted a law on the natural gas market which focused on a path for the sector to become more competitive and to begin the process of approximating Ukrainian legislation with the EU Gas Directive 2003/55. To date, the law remains a draft and it is not yet clear whether and when the Rada might adopt the Law. Existing legislation that set out the policies of the gas sector include the Law on Oil and Gas (July 2001); the Law on Pipeline Transport (May 1996); the Law on Licensing Certain Types of Economic Activities (2000), the Law on Natural Monopolies (2000) and the Law on Protecting Economic Competition (2001).

In 1997 NERC’s responsibilities were widened to include the regulation of the gas sector and oil products regulation and currently, NERC receives its powers to regulate and monitor from the Presidential decrees, the Law on Natural Monopoly and other legal acts. Organisationally, NERC comprises a decision-making commission of five members

9 The transmission system comprises 37,600km of pipelines and 72 compressor stations. The throughput of gas pipelines is 290 BCM and 170BCM at exit points. 10 Naftogaz holds over 50% and between 10-50% of shares in 19 and 6 Oblgaz companies respectively.

- 7 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

(with six year periods of tenure, renewed once) supported by a body of technical and professional staff. Commissioners are appointed by the President of Ukraine and there are around 336 staff located in the central NERC office and 27 regional branches. 11

The main powers and duties of NERC in relation to specifically the gas sector are to:

• issue licences for natural gas transportation via trunk pipelines, distribution, storage, supply at regulated tariff, natural gas supply at the non-regulated tariff; • monitor compliance of the licence conditions of the Gas Companies; • regulation of the tariffs for the gas trunk and distribution business; • regulation of the storage tariffs for gas; • set out the price for Population (the price depends on the availability of meters and amount of gas consumption)sets maximum retail tariffs for domestic customers;

NERC does not set the transit price of gas which is subject to Intergovernmental Agreements and negotiations between Gazprom and other relevant parties.

NERC is a quasi-independent body and issues its own decisions.12 NERC operates the transmission and distribution of gas under cost-plus or rate of return regulation using detailed line-by-line analysis.

Privatisation Developments

The Privatisation legislation sets out a list of facilities that are prohibited from being privatized. These include trunk transmission and distribution gas pipelines and storage facilities. Most of the Oblgaz companies holding distribution and supply licences for a regulated tariff are presently privately owned companies. Currently, there are no formal plans to privatise additional or other state-owned businesses in the Gas Sector.

2nd EU Gas Sector Directive, ERGEG and CEER Developments13

In 2003 the second EU Gas Directive laid out the main milestones to promote greater competition, innovation and ultimately more cost-reflective prices in the gas sector. The provisions comprised the right of companies to get access to the transmission and distribution networks (known as regulated third party access), the need for the transmissions and distribution activities to be legally and functionally separated (or unbundled) from other commercial market activities (eg supply) where the functions were under the control of a vertically integrated company, the establishment of gas storage as a separately defined and competitive activity that should be available to third parties14, an accelerated timetable for complete market opening and the strengthened powers and duties of Regulatory Commissions to monitor competition in the gas market.

To accelerate the process to develop competitive gas markets, over the last few years the ERGEG supported by the CEER has sought to speed up regulatory cooperation between Regulators, speed up the unbundling of TSOs, create

11 The current Chairman is Mr V. Kalchenko (who was appointed in January 2008). 12 According to 14 Feb 2000 #133 Decree, decisions made at plenary sessions and operational meetings are decrees and orders/resolutions respectively. 13 The European Regulators' Group for electricity and gas (ERGEG), which the European Commission set up on 11 November 2003 by Decision 2003/796/EC, is an Advisory Group of independent national regulatory authorities to assist the Commission in consolidating the Internal Market for electricity and gas. Its Members are the heads of the national energy regulatory authorities in the 27 Member States. The CEER is a "not for profit association" which brings together the independent national energy regulators from the Member States of the European Union and European Economic Area and is a focal point for contacts between national energy regulators and is their interface at a European level with the European Commission, in particular DG Transport and Energy, DG Competition and DG Research, on energy issues. The aim of CEER is to facilitate the creation of a single competitive, efficient and sustainable internal market for gas and electricity in Europe. 14 The 2003 Gas Directive allows for negotiated TPA or regulated TPA for gas storage services and requires all non-household customers in EU MS being eligible to choose their supplier by July 2004 and extending to all Customers by July 2007.

- 8 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______greater transparency and information handling and the effective access to network capacity, develop a framework to ensure fair and non-discriminatory access to gas blending services and create four regional initiatives to accelerate the development of competition at a practical level and to promote liquid and competitive trading at and between gas hubs across the EU-MS.15

Against this backdrop, Table 1 below provides a comparison of the main Directive EU provisions or milestones and the status of the gas sector in Ukraine.

Table 1: Initial Comparison of Ukraine’s Gas Sector against some EU Directive provisions and Regulations Provision or EU Common Rules Ukraine Gas Sector Regulation Unbundling of TSO Legal & functional unbundling The two transmission companies are a subsidiary and requirement a JSCO established under Naftogaz. It is not clear that there is sufficient legal and functional unbundling to meet the EU requirement Unbundling of DSO Legal & functional unbundling Naftogaz is either a majority or minority shareholder requirement (except for DSOs in the majority of the 53 Oblgaz companies. The with less than 100,000 supply and distribution functions are undertaken by customers) same company and it is not clear whether appropriate cost allocation methodologies are applied to separate distribution and supply costs within each regulated company Market opening By July 2007 all customers can No market opening provided for in the current Gas choose their supplier Laws Tariff structure Entry Exit, Mixed or postalised Tariffs for TSOs and DSOs are not differentiated within the country ie they are postalised Access to TSO and Regulated Third party access No RTPA is provided for in the current legislation for DSO networks either transmission or distribution The third party access regulates only by procedure established by order of NAK “Naftogas” #79 of 26 March 2001 Access to Storage Negotiated or regulated Third Neither negotiated or regulated third party access to facilities party access Uktransgas’s or Chernomornaftogas’s storage facilities allowed within the current Gas Laws Role of the Range of Key competencies – As there is no competitive Gas market yet, NERC’s Regulator responsible for ensuring non- main duties focus on issuing of licences to gas discrimination, effective companies and to approving tariff methodologies for competition and efficient TSO, DSOs and storage. functioning of the market. Core duties related to network access and balancing Type of Regulation No specified in EU Directive. Cost plus regulation of gas tariffs for transmission, Regulation 1775/2005 (Art 3) distribution and for supply by regulated tariff suggests “efficient costs” to be (receiving domestically produced gas) taken into account in tariff setting along with the use of benchmarking of tariffs

15 The ERGEG initiatives are set out in an initial Discussion Paper E05-SEM-13-03 (21 November 2005) and a subsequent Conclusions Paper E06-GMI-02-03 (28 March 2006) on the “Roadmap for a competitive single gas market in Europe”. Both papers are available at www.ergeg.org

- 9 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Challenges: Main problems this project should overcome

The main justification for support to NERC in this twinning project arises from challenges it will face now and in the future through the implementation of a more transparent and competitive gas sector – the main ones of which are summarised below and further elaborated on in section 3.4 Challenge - Ukrainian Legislation/Regulation approximating towards EU Gas Legislations and Regulations It is debateable to what extent the vertically integrated company - Naftogaz - has unbundled its transmission and distribution companies from other competitive activities. Subsidiary and JSCO companies do exist to undertake these activities although it is unclear whether these subsidiary and associated companies have effective decision making rights with respect to the assets necessary to operate, maintain or develop the network and that the companies have a compliance programme with measures to ensure that a discriminatory conduct is excluded and adequately monitoring is in place to ensure continued non-discrimination. However, whether Naftogas had sought de facto to have legal and functional separation of the transmission and distribution activities from other commercial businesses, it does appear that provisions of Ukrainian legislation and resolutions of the Council of Ministers (CoM) do not yet explicitly define the legal status of business entities in the Gas sector, nor do they authorise legal and functional unbundling of the trunk transmission activity from other activities (eg exploration and production) and the distribution activities of the Oblgaz businesses from the supply businesses. In addition, it also appears that the Transmission and Distribution Companies lack instructions on appropriate cost allocation methodologies between costs incurred as part of the licensed activity and other unlicenced activities. The challenge is therefore to assist NERC to become familiar with the provisions of EU Gas Directive, EC Regulation 1775/2005 on conditions for access to networks, ERGEG and CEER regulations and to assist NERC in drafting its own amendments to the draft Gas Act (which will delineate the requirements for a legal and functional separation of transmission and distribution from other activities) and in developing an appropriate cost allocation methodologies to determine regulated and unregulated costs.

Challenge – Adoption of Incentive Based Regulation

As there is currently no competition for the supply of gas to industrial, commercial or domestic customers, one approach to increase the operational and investment efficiency of companies in the gas sector will be the use of incentive-based regulation by NERC along a combination of traditional cost analysis investigations and the use of benchmarking techniques.16 Such an approach is already underway in the regulation of Oblenergos in the electricity sector. One of the recommendations of the IEA Ukraine Energy Policy Review 2006 is to “improve regulation to stimulate efficiency: move from cost-plus tariffs toward regulation that provides incentives for cost reduction.17 This form of regulation is increasingly being practiced by the more proactive NRAs in EU Members States.18 The main challenge is therefore to support NERC in adopting and implementing the use of multi-year incentive based price cap regulation in setting revenues and hence tariffs. Such an approach involves the determination of allowed revenues or prices for licencees over a long period – possible 3 to 5 years ahead. This procedure avoids the burdensome requirement to calculate tariffs every year and provides licencees with a degree of stability that is not present under a cost of service regime. However, it is important that real and effective support is provided to NERC by the MS-Partner in implementing this form of regulation rather than a regurgitation of the basic principles of incentive-based regulation – in the mode of a workshop or two.

16 It should be noted in this context that incentive based regulation (“price caps”) of network access charges can be an effective instrument to considerably reduce the incentives and possibilities for integrated companies to shift costs from the supply business to the network business. Incentive based regulation, apart from its other advantages, can thus be an effective instrument to reduce the risk of cross-subsidisation. 17 See Chapter 5 (page 202), Energy Policy Review, 2006. 18 In addition out of 23 OECD and leading developing countries it was found that 13 countries had price controls periods of 3 to 5 years (see T. Jamasb & M. Pollitt, 2001 Benchmarking and Regulation: International Electricity Experience Utilities Policy Vol 9, 3, p107-130).

- 10 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Challenge – Incorporation of Benchmarking as a complementary technique

Some specialists within NERC are already familiar with benchmarking (which is a comparison of firms’ actual performance against some pre-defined reference) in the electricity sector to assist in determining X efficiency factors and the ongoing Electricity Twinning project will also transfer greater knowledge about this approach to NERC. The challenge in this project is to apply the use of appropriate benchmarking techniques of either the total or operational costs of Oblgaz companies which will assist NERC in determining appropriate incentives for distribution companies to become more efficient and transparent. Some academic and practical research is available on benchmarking of gas distribution companies which the MS Partner and NERC can tap into. 19 However a more extensive and detailed analysis of the effects of the different types of approach and methods within these approaches is still needed to confirm how and where benchmarking should be applied in the process. This is because efficiency values are often sensitive to the parametric or non-parametric nature of the technique and method (eg COLS, DEA) that can be used by NERC. The focus is therefore to assist NERC in improving existing data collection procedures, extending the data sets to panel (ie. time series and cross-sectional) data and potentially developing the use of panel data to predict Oblgaz companies expected costs and developing operational procedures which would allow for the phased withdrawal of detailed line-by-line reviews of licencees’ costs as part of the tariff-setting process.

Challenge – Development of Quality of Service Standards/Supply for the Gas Customer

One of the impacts of using incentive based regulation is the incentive it provides to licencees to maintain or improve the quality of service provided to customers. This arises due to the direct link between incentives to reduce costs and the costs associated with providing different levels of quality of service. Although some support was provided to NERC in the TACIS project (Support and Strengthen the Energy Market Reform and Assessment of the Energy Sector Sustainability) in 2003 in this field, further assistance is still needed to assist NERC in developing and implementing a quality of service programme simultaneously with the development of incentive-based regulation. The importance of such a programme is also addressed in a World Bank review in 2004.20 A strategy is needed that sets out the objectives, process, resources, implementation steps and expected results of a quality regulation programme consistent with the thrust of the development of quality regulation adopted in IEM. This will include defined quality standards on reliability, voltage quality and customer service to be adopted by licencees and monitored and assessed by NERC.

Challenge – Improvements to existing Social Protection schemes

Allocative efficiency requires that tariff structures should reflect the relative costs imposed by differing users of the gas distribution network and that the basis of charges should be related to the drivers of network costs. Network charges in Ukraine are lower for residential than other customers, are uniform across the networks of individual enterprises and are applied solely on an average unit charge basis. Each of these aspects is likely to lead to allocative inefficiency. Such cross-subsidies have historically been common in many EU countries as a means of addressing concerns about the affordability of energy supplies for poorer customers. However, as well as the inefficiencies they create, they are often very poor at doing so. Subsidising all consumption by household customers benefits larger consumers, who are also normally the richest, while leaving network companies disinclined to expand service to new household customers-who are often the poorest living on the peripheries of urban areas.

19 See M. Farsi, M. Filippini & M. Kuenzle “Cost Efficiency in the Swiss Gas Distribution Sector”, Working paper No 36, Centre for Energy Policy and Economics (CEPE), Zurich,Oct 2004. N. Hrovatin, J. Zoric and G.C. Scarsi (2005) “European Gas Distribution Benchmarking and the need for EU-wide Data Harmonisation”, www.snf.no/iaee2005/7thIAEEEuropeanEnergyConference/Tuesday20August30TH/ConcurrentSessionsIII/GasContracts/N. Hrovatin,G.C.ScarsiandJ.Zoric.pdf R.Carrington, T.Coelli and E.Groom “International Benchmarking for Monopoly Price Regulation: The case of Australian Gas Distribution” Journal of Regulatory Economics, vol 21 (2), 2002 20 See Ukraine: Key Challenges Facing the Gas Sector Paper, World Bank, Sept 2003.

- 11 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Cross-subsidies are increasingly being eliminated within the EU.21 This does not mean that Regulators within the EU are unconcerned about the affordability of gas supplies. However, there are more efficient means of ensuring access to affordable energy supplies for poorer customers than introducing non-cost reflective tariffs for all customers. These include rising block tariffs, voucher mechanisms (where poorer households are individually identified and receive subsidies (directly or indirectly) to cover part of their gas purchase costs) and income-related payments (where poorer households are individually identified and receive increased welfare payments, but are able to determine whether to use these to purchase additional gas supplies or for other purposes). The challenge in this project is to assist NERC to understand the nature of public service obligations permitted under the EU Gas Directive, assess the different social protection schemes used by EU regulators and develop a computerised model which will identify the net costs of the existing social protection scheme to the Ukrainian economy and all customer classes, the costs of other possible social protection scheme options and a concomitant paper which will provide recommendations on a future social protection scheme that is either more efficient than existing scheme(s) as well as the mechanism to move towards cost-reflective tariffs.22

Challenge – NERC’s capability to implement the Twinning Project A SWOT (strengths, weaknesses, opportunities, threats) analysis of the capability of NERC in implementing the Gas Twinning Project is set out below. The commitment of the NERC to the Gas Twinning Project, coupled with the need for detailed knowledge and hands-on experience that the twinning partner will supply, make the NERC the ideal project beneficiary.

Strengths Weaknesses • Regulator of gas sector since 1997 (9 years • MS Partner minimises the provision of training and experience) implementation-modelling so mitigating full benefits to • Quasi-Independent Regulator with strong NERC powers, capable management and specialists • Historic focus on US-style cost-plus regulation with • History of collaboration with international detailed line-by-line analysis of costs specialists to strengthen NERC’s regulatory • Lack of independence due to reliance on State budget rules • Lack of English language capabilities (among majority • Committed to absorbing EU type regulatory of management/staff) results in less dissemination and practices absorption of other international regulatory knowledge • Some (but limited) English speaking capacity • Possible lack of transfer of project benefits to other • Connected to EU-wide Regulatory fora staffs outside the Gas Legal Approximation Working through ERRA membership and observer Group (GLAWG) and Gas Regulatory Working Group status in the ECSEE Treaty (GRWG) due to weak communication and dissemination mechanisms

Opportunities Threats • To lobby for practical implementation of the • Ability of Govt to interfere in regulatory decisions Gas Sector reform process within Ukraine • Ability of powerful Industry organisations to lobby • To set standards for other Regulatory bodies against regulatory orders & decisions in acting progressively in drawing on the best Practices of the EU Regulatory system

21 It should be noted in this context that incentive based regulation (price caps) of network access charges can be an effective instrument to considerably reduce the incentives and possibilities for integrated companies to shift costs from the supply/production business to the network business. Incentive based regulation, apart from its other advantages, can thus be an effective instrument to reduce the risk of cross-subsidisation.

22 The GoU has recognised that it should raise energy prices to stimulate energy-effi ciency improvements and attract the necessary investment to the sector. The Energy Strategy to 2030 states that one of Ukraine’s main tasks is assuring the coverage of production costs to create conditions for the sustainable development of energy companies. NERC began raising electricity and gas tariffs in May 2005, but tariffs for households and some other consumer groups have not yet reached cost recovery levels

- 12 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

3.2 LINKED ACTIVITIES:

Since 1996, several technical assistance projects have supported reforms in the energy sectors with most focused on supporting the wider restructuring programme in the electricity market and latterly, the development and implementation of the WEM Development Concept. Projects that have addressed support to the Gas Sector have included the following.

Previous Gas Technical Assistance Projects supported by EU TACIS

In Jan 2003 - March 2005 Europeaid 113551/C/SV/UA/9EU TACIS Study - Support and Strengthen the Energy Market Reform and Assessment of the Energy Sector Sustainability. Consultants BCEOM (France), Franklin (France), Ademe (France), Exergia (Greece) advised both the MFE and NERC. The project focused some of the TA on NERC’s use of tariff methodologies for HV transmission tariffs and cost allocation between distribution and supply, a best practice EU grid code, drafting amendments to law on Natural Monopoly, Regulation and a proposal for a Gas Law, improvements to NERC’s website and a varied training programme (which included Study Tour to French Regulator). At NERC’s request, work on the gas sector was wound down in 2004.

Reform of Ukraine Gas Transit Network Operations – Phase III – Europeaid / 119460 /C/SV/UA (Euro 3 million budget under TACIS Regional Action Programme 2002, 16 months) - this project involves a technical, financial and legal due diligence or review of the operation of the gas transit network. The Consultants were SWEDCO, Fichtner and Gaffney Cline among others.

Other EU Twinning Project in the Energy Sector

Regulatory and Legal Capacity Strengthening of the Electricity Regulation in NERC. (Euro 1.2 million budget). This Electricity Twinning project started in May 2007 and the EU MS Partners are the Italian Regulatory for Electricity and Gas in consortium with E-Control (Austria) and the Energy Regulatory Office (Czech Republic). The objective of this twinning project is to promote the institutional strengthening of the NERC and assist in the longer term development and implementation of international best practice of regulation as practiced in the electricity sector consistent with progress in and the ongoing developments in the EU Electricity Market. The project is likely to be completed in mid-2009.

Energy Projects supported by other Donors

These projects have focused on the electricity rather than gas sub-sector.

World Bank Activities

The World Bank remains a key institution supporting energy sector reforms in Ukraine. Since 2000, the following activities are in progress, under preparation or have been recently completed:

PPIAF-managed Study – Development of the Framework to support the Implementation and Regulation of a Full-scale Competitive Wholesale Electricity market of Ukraine (PPIAF grant US$342,000, Other finance US$70,000) - Consultants ECA (UK), Branan (Russia), Denton Wilde Sapte (UK) and TransEnergo Consulting (Ukraine) worked with NERC to implement the regulatory and institutional framework envisioned by the WEM Development Concept. The study assisted NERC in drafting legal documents, developing mechanisms to implement policies and solutions outlined by the Concept, addressing issues of concern to private investors, reviewing tariff and pricing issues, market monitoring tools and methods, administrative practices and procedures and understanding of hedging contracts.

World Bank HydroPower Rehabilitation Project (budget USD 3 million). Technical assistance under this project comprises five components. The final part is relevant in so far as it includes provision of support to NERC to implement the WEM Development Concept. NERC chairs the Inter-Agency Commission (IAC) charged with its

- 13 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______implementation (based on an action plan approved by CoM in 2004). The previous project helped NERC to define the implementation stages in terms of the key steps involving timing, organisational responsibility and technical assistance needs.

USAID Activity

Major support from the USAID to NERC came in 1999 – 2003 in the Energy Regulatory, Legal and Market Development Support Project (IQC EEU-I-99-00033-00, TO OUT-EEU-I-800-99-00033-00). Consultants Hunton & Williams provided TA on legal drafting (regulation 133-p), independence strengthening, procedures for tariff application reviews, designing a new DSO and retail tariff methodology, modification to the flow of funds algorithm in WEM, collection and non-cash payments, the development of WEM Development Concept and the privatisation programme in 2001 (through a related but separate USAID project overseen by Deloitte Touche Tohmatsu).

Some reports from the study can be downloaded from http://kiev.ballonoffconsulting.com

Other Work

Started in April 2005 and funded partly by the EC is the UCTE-IPS/UPS Electricity Transmission System Study (www.ucte-ipsups.org). The main objective is to investigate the feasibility of a future synchronous interconnection of the electricity transmission systems of UCTE and IPS/UPS in order to support further developments of electricity markets. The results of the study are expected in 2008.

3.3 RESULTS:

By the end of the Project, two Mandatory Results will be achieved.

Mandatory Result 1 – Current regulations are assessed, revised, amendments/new regulations developed for a better regulated gas market and ensuring greater protection of the rights of customers. Mandatory Result 2 – Knowledge and skills of respective NERC management and staff are enhanced enabling them to implement their tasks at a higher level.

3.4 ACTIVITIES

This project comprises 7 components related to the specific project purpose above.

Inside each Component are a series of activities which if implemented correctly and in full will lead to the Mandatory Results set out in Section 3.3.

COMPONENT 1: Project Support and Language Training

The objective of this component is to establish the critical project working bodies (institutions) that will oversee and lead the different components. As a Twinning Project on Electricity Regulation in NERC is currently underway and scheduled to complete in 2009, it is important to develop working procedures and outcomes that do not duplicate and overlap with each other and common information and knowledge that can be shared between the two Twinning Projects.

- 14 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Work Scope

Activity 1.1: Establishment of Working Groups

The MS Partner will establish the GLAWG to lead and undertake all activities in Component 2 supported by MS- STEs and the GRWG to lead and undertake the activities in Component 3 and 4 supported by the MS-STEs. Both Groups will be chaired by the RTA who is to be permanently based in the Beneficiary’s offices. When present in Ukraine, the STEs will also participate in the meetings of the GLAWG and GRWG. Excluding the RTA and STEs, the GLAWG will comprise up to 10 staff and the GRWG will comprise up to 10 staff.

The two Working groups (GLAWG and GRWG) will meet at least once a week during the implementation of the project and minutes of meetings in English and Ukrainian will be kept, and circulated to all members of each relevant Working group within 3 days of each meeting.

The RTA will be responsible for all coordination, logistical and operational matters regarding the establishment and operation of the two Working Groups.

Activity 1.2: Opening Workshops

The RTA will organise a 1 day Workshop by NERC’s Legal and Oil & Gas Dept on legal, regulatory and market developments/trends/issues in the Ukrainian Gas Market and a 1 day Workshop by MS Contractor on legal, regulatory and market developments/trends/issues in EU Gas Market.

Activity 1.3: Coordination and liaison with the Electricity Twinning Project

The MS Partner will understand the progress, results/findings and problems in the Electricity Regulation Twinning Project and will set up an appropriate liaison/coordination mechanism so that appropriate issues, findings, results and problems encountered in the Electricity Regulation Twinning Project are notified to the Gas Regulation Twinning RTA, GLAWG and GRWG. There will be a 1 day Workshop by Electricity Twinning MS Project Leader, RTA and Key Expert on progress, results/findings and problems in the Electricity Regulation Twinning Project to the Gas Regulation MS Contractor RTA, STEs, GLAWG and GRWG.

Activity 1.4: Language Training

The MS Partner will organise a bespoke English language training service on gas sub sector specialised terminology for the GLAWG and GRWG participants in NERC. The gas sub sector has specialised terminology and it is quite difficult to obtain high quality translators with detailed knowledge of the Gas sector and of sufficient calibre to allow freeflowing discussions between all the Working Group members and the Member State Experts. Accordingly, it is important to have the GLAWG and GRWG participants as close to fluent in English as possible in order to communicate effectively with the MS Administration Experts. The MS Partner might sub-contract an accredited Ukraine-based Language Training Institute23 to provide a training for 12 months of the project. The Ukraine-based training Institute will be contracted within 3 weeks of the contract being signed by the MS and the Beneficiary and training will commence within 5 weeks of the start of the project. Training and classes will be held at the NERC Office. Training aids and audiovisuals will be provided by the Language Institute. The Language Training Institute will be certified by the MS Contractor as meeting the required competencies for training Ukrainian staff in the “immersion” method of English and will provide a training achievement certificate to all participants at the end of the project.

23 If no Ukraine-based Language Training Company is available for this assignment then the MS Administration may recruit and contract with one or more individual certified and qualified Language Trainers who are not related to any members of the MS Partner and/or Consortium or to any members of NERC Management and/or staff.

- 15 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Outputs

Activities Deliverables/Outputs Activity 1.1 An operational and functional GLAWG and GRWG Activity 1.2 1 day Workshop by NERC’s Legal and Oil & Gas Dept on legal, regulatory and market developments/trends/issues in the Ukrainian Gas Market

1 day Workshop by MS Contractor on legal, regulatory and market developments/trends/issues in EU Gas Market

Activity 1.3 1 day Workshop by Electricity Twinning MS Project Leader , RTA and Key Expert on progress, results/findings and problems in the Electricity Regulation Twinning Project to the Gas Regulation MS Contractor RTA, STEs, GLAWG and GRWG Activity 1.4 Specialised Language training course offered to GLAWG and GRWG Participants

COMPONENT 2: Review and approximation of EU Natural Gas Legislation

The objective of this component is to continue the donor-focused process of supporting the approximation of the Ukrainian legal energy framework with the Acquis Communautaire. There has already been some work undertaken in this broad area and the first step will be to understand what level of approximation has been reached and what still needs to be done from the perspective of NERC’s obligations and responsibilities. It is likely that there will be a need to develop deeper knowledge and capacity within NERC to support the transposition process of the Energy Acquis Communautaire into national legislation. As a number of state bodies and Committees have greater involvement in much of approximation process, this work will address specifically those areas for which NERC is responsible within the context of the role of an EU Regulator and within the existing set of responsibilities accorded to it by Ukrainian legislation.

Work Scope

Activity 2.1: MS Partner experience in transposing EU Gas Directive legislations – Study Tour

The GLAWG and MS-STEs will undertake a one-week study tour to the partner institution of the twinning Member State to; • understand the process that was completed in that Member State to comply with the Gas-related parts of the Acquis Communautaire; • understand the working methods and procedures of the Member State Gas Regulator with a focus on all legal aspects; • Within the Study Tour, to receive training courses and information from Member State STEs on: o EU Energy policy - development and interpretation; o Articles of the 2003/55/EC Gas Directive (June 2003) o EC Notes to support the approximation of the Gas Directive 2003/55/EC o Requirements of the Regulation (EC) No 1775/2005 (Sept 2005) on conditions for access to the Natural Gas Transmission Networks o Articles of the 2004/67/EC Directive on measures to safeguard Security of Supply o Main ideas of the competition Acquis Communautaire including legislation and regulations covering the prevention, restriction or distortion of competition, the abuse of dominant positions in the electricity and gas markets and any government support such as subsidies, which distorts or threatens to distort competition in the electricity and gas markets. • To study and oversee procedures in situ in which the Legal Department of the Member State Regulator is involved.

- 16 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Activity 2.2: Approximation of EU Gas Directive and related Legislation

The GLAWG and MS-STEs will as closely as possible approximate the Gas Directive 2003/55/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in Gas into Ukrainian national legislation and to establish an approximation procedure inside the GLAWG by: • undertaking a screening of the national legislation in the field of Gas leading to development of Compliance Tables in tabular format; • preparing an Analysis Report on the gap findings. The report will reflect the findings of the compliance tables in the field of Gas legislation and regulation; • setting up a roundtable forum with representatives of all NERC´s Departments, discussing and commenting on the gap findings; • preparation of proposals concerning the bringing in of legislative changes to support the approximation of Ukrainian legislation to EU legislation in the Gas sector; • public discussion of the explanations of NERC concerning the content of the prepared changes to legislative acts in support of approximation of the Ukrainian legislation to EU legislation in gas sector.

Activity 2.3: Database Library of translated EU Gas Legislation & Regulations

The GLAWG and MS STEs will set up an electronic internal Database Library containing all relevant Natural Gas EU policy, Natural Gas regulation, primary and secondary legislation, international trading and tariff regimes and to translate the legislation into Ukrainian using the Resident Interpreter/Translator (RIT)

Outputs

Activities Deliverables/Outputs Activity 2.1 Focussed training (minimum 2 days workshop) on provisions of the EU Gas Directive 2003/55, Regulation 1775/2005, Security of Supply Directive 2004/67 and the outputs of the ERGEG and CEER Working Programmes for 2007 and 2008 Study Tour in EU Gas policy successfully undertaken with NERC participants (10 persons attending). Discussion of the process of dispute settlement procedures Activity 2.2 Compliance Tables and Gaps Analysis Report drafted, Debate Forum carried out, legislative amendments drafted, Development of legislation Analytical report of the need for approximation of the Ukrainian legislation to the EU legislation in the gas sector Activity 2.3 Documents are identified, collected, translated and organised into a database.

COMPONENT 3: Development of the Building blocks of Multi-Year Incentive-Based Gas Regulation and Benchmarking

Before the starting the implementation of incentive-based regulation it is important that NERC is familiar with the standard methodological building blocks that comprise incentive-based regulation. The aim of this component is therefore to introduce each part of the methodology and to develop or reinforce NERC’s understanding in the purpose of each part of the process. The costs which firms are allowed to recover are built up from their operating costs, a depreciation allowance representing the amortisation of their investment and a return on their investment. The return is calculated as the firm’s cost of capital multiplied by its regulatory asset base (RAB). This is summarised in Figure 2 below.

- 17 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Figure 2: Calculation of Regulated Revenues under Best Practice Incentive-based Regulation of unbundled regulated Companies

RAB Regulatory asset base

New Opening RAB Depreciation + = Closing RAB - Investment

Cost of Allowed RAB x = Capital Return

Allowed Depreciation Operating Return Allowed + (return of + = Costs (return on revenues investment) investment)

Work Scope

Activity 3.1: Training on the determination of WACC/allowed return

The RTA and MS STEs will provide training and draft a report on the approaches taken by EU and non-EU Regulators to calculate and approve the WACC for Gas Distribution Companies. The allowed return on investment is determined by the cost of capital. A variety of approaches exist to determine the cost of capital. One means is to link the cost of capital to some external benchmark. This is simple and transparent to apply, but the outcome may bear little relation to the actual cost of capital of the firm under review. Alternatively, a variety of models can be applied such as the capital asset pricing model (CAPM), the dividend growth model (DGM) or the arbitrage pricing model (APM). These each provide estimates of the cost of capital specific to the firm. However, each also suffers from theoretical weaknesses (although they remain the best available) as well as requiring access to data from stock and bond markets of a type that may not be available in Ukraine.

Activity 3.2: Training on Regulatory Assets Base (RABs) and future Capital Investments

The RTA and MS STEs will provide training and draft a report on the various techniques undertaken by different EU Regulators to determine RAB. If prices are to encourage efficient use of assets the RAB should equal the value of the assets to the firm, i.e. the lower of the cost of replacing the existing gas pipelines with optimal gas pipelines and the market value of the assets as determined by a discounted cash flow valuation. Since market values rely on the expectation of future regulated prices, in practice replacement costs are used to determine the RAB. This rule faces a number of practical difficulties. In the case of old gas pipelines or countries with high inflation the replacement value of assets may be significantly higher than the book value of assets implying that significant price rises are required. Alternatively, technological progress may mean that the optimal replacement cost of a network is significantly lower than the book value of assets, thereby stranding some of the firm’s assets. To dampen the risk of using replacement values to determine the RAB, historic values could be used for existing assets and new assets could be incorporated into the RAB at replacement cost. In this way the RAB would gradually move towards replacement costs over time. Capital expenditure over the period of a price control must be included in the RAB and inevitably actual capital expenditure will differ from that forecast at the time of setting the price control. Firms should be allowed to retain the benefits resulting from lower capital expenditure as the result of efficiency improvements which leave service quality unaffected. However, at further tariff review NERC could clawback lower capital expenditure resulting from a failure to make necessary investments.

- 18 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Activity 3.3: Training on benchmarking techniques of Gas Distribution Businesses

The RTA and MS STEs will provide training on the implementation of the different benchmarking approaches used by Regulators. Within and outside the EU, Regulators are increasingly moving towards the benchmarking of either individual cost blocks, such as operating costs, or even total costs, against other regulated firms. This movement has been driven by a number of factors. These including overcoming the problem of information asymmetry between managers, who will always know more about the costs of their business, and Regulators by using evidence on the cost levels obtained by other firms. It also includes the ability to measure changes in total cost levels over time, thus giving a measure of expected future productivity growth, which makes forecasting future costs (particularly important with incentive-based price regulation) a much simpler exercise. An important factor has been the greater incentives for efficiency improvements under benchmarking. Benchmarking allows a firm to retain the benefits of reducing costs below the benchmark level, providing strong incentives to beat it and thereby to reduce the benchmark for other regulated firms. By contrast, assessing the costs of individual firms means no firm has an incentive to reduce its own costs, because it will not be able to retain the benefits.

Activity 3.4: Training on regulating an efficient OPEX and X efficiency factors

The RTA and MS STEs will provide training and draft a report on the approaches taken by EU Regulators to determine efficient path of operating costs and X efficiency factors. The primary regulatory issue involved in the inclusion of operating costs into allowed revenues is in determining their efficient level. EU Regulators have tended to either adopt a ‘top down’ or ‘bottom up’ approach or a combination of the two. In a top down approach, firms are benchmarked against a number of comparators in order to compare the level of operating costs required to deliver outputs such as kWh of gas distributed or the number of customers served. Top down approaches provide a powerful tool to assess the efficient level of costs. However, they may be criticised for taking insufficient account of the uniquness of the conditions faced by each individual firm. Bottom up approaches address this by looking at the cost elements of a firm on an individual basis (e.g. labour cost, cost of each piece of equipment). In doing so they tend to increase regulatory costs, lead to a tendency for regulators to become involved in ‘micro-management’ of firms and to second-guess management and fail to capture the trade-offs that may exist between operating and capital costs.

Outputs

Activities Deliverables/Outputs Activity 3.1 Training of GRWG (1/2 day Workshop) on the forms of approaches undertaken by different EU Regulators to determine WACC

Report on the different WACCs used by EU Regulators for the return on investment for distribution and transmission companies (minimum 15 Regulatory bodies compared)

Activity 3.2 Training of GRWG (1 day Workshop) on the various techniques undertaken by different EU Regulators to determine RAB

Report on the different approaches taken to determine RAB and future CAPEX (minimum 15 Regulators) Activity 3.3 Training of GRWG (1 day Workshop) on the forms of approaches undertaken by different EU Regulators to benchmark total and operating costs of distribution companies

Report on the different parametric and non-parametric models to undertake benchmarking of distribution companies with recommendations for its use by NERC (minimum 15 Regulatory bodies compared)

Activity 3.4 Training of GRWG (1 day Workshop) on the forms of approaches undertaken by different EU Regulators to determine efficient path of operating costs and X efficiency factors

- 19 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Report on the different approaches taken to determine efficient OPEX and X efficiency factors (minimum 3 Regulatory bodies compared)

COMPONENT 4: Implementation of Incentive based Regulation and benchmarking of Gas Distribution Businesses

Building on knowledge gained from the preceding component, the aim of this component is to support NERC in moving away from cost of service type regulation of the gas sector towards an incentive-based approach that is being adopted by more advanced EU regulators. This involves transferring its annual tariff review cost-plus regulatory approach to an incentive-based multi-year price cap regulation and to start to use benchmarking techniques within the incentive-based regulation. Currently, cost plus or rate of return regulation is practiced within NERC to set the transmission and distribution tariffs, among others, and little progress has been made to adopt, in practice, incentive- based price regulation. Price or revenue cap regulation is increasingly being adopted by EU Regulators and is supported within the ECSEE and EU IEM. This form of regulation typically sets allowed tariffs for a number of years ahead based on a forecast of future costs over this period including an allowance for expected efficiency improvements. If the licencee is able to reduce actual costs below forecast levels then it is able to retain the additional profits until the next price review, giving it an incentive to look for efficiency savings. The budget of the Twinning project should include funds to cover relevant software on benchmarking to implement this component.

Activity 4.1: Study Tour to EU MS’s NRA to see Incentive based Regulation and Benchmarking in operation

The training will also include two Study Tours to National Regulatory Authorities in two different EU MS. The focus of the Study Tours will be to allow NERC Staff to fully engage with Staff of the NRAs in assessing the operation and use of incentive-based regulation and benchmarking by the NRAs after training provided in Component 3.

Activity 4.2: Development of a methodology of Incentive-Based Regulation for Oblgaz Companies

The MS STE will develop a methodology of Incentive Based Regulation for Oblgaz companies. The MS STE will develop a multi-year incentive based regulation regime across the Oblgaz companies. The exercise will encapsulate:

• development of an allowed revenue review process; • development of data collection templates, • development of an multi-year incentive-based price regulation model; • development of an implementation plan for introduction of incentive based regulation for Oblgaz companies.

Activity 4.3: Development of Benchmarking methodology

Based on existing data availability and the analysis undertaken in Component 3, the MS STEs will provide data collection templates, data collection and analysis and appropriate benchmarking techniques to assist in modelling the total or operating costs of the Oblgaz companies. A variety of benchmarking methodologies have been developed over the last 5 years. Their application is supported by an extensive academic literature and a number of free and commercial software tools. The greatest challenges in benchmarking Gas Distribution businesses in Ukraine will be obtaining consistent data across the different distribution businesses and ensuring that the measured performance differences are the result of differences in efficiency, rather than operating environments (for example, customer density or mix). It remains the case that benchmarking is most powerful when applied to firms undertaking the same activity in the same country. However, relatively few countries are able to achieve this ideal and there has been increasing work in recent years on developing appropriate mechanisms to benchmark efficiency across firms in differing industries and countries. Regulators have also encouraged industry restructuring to increase the number of comparators. For example, the UK Regulator was a vigorous supporter of the separation of the distribution business

- 20 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______of the gas transmission enterprise into eight new regional businesses, four of which were subsequently privatized. Decisions on the appropriate benchmarking approach in Ukraine and its incorporation into the tariff review process will be dependent on the extent to which reliable and consistent data across a number of comparators can be obtained, and how this data can be best used.

Activity 4.4: Roundtable Discussion and recommendations

The MS STEs will discuss the methodology of the implementation of incentive-based regulation and the use of benchmarking in a round table workshop to the Companies and will make recommendations for any subsequent improvements to the process by the end of the project. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

Outputs

Activities Deliverables/Outputs Activity 4.1 Participation by GRWG in 2 Study Tours to different EU-MS Activity 4.2 Report on the development of Incentive Based Regulation of Oblgaz companies Activity 4.3 Report on the development of Benchmarking techniques Activity 4.4 Round table discussion of the drafts of the Incentive Based Regulation methodology and Benchmarking techniques. Participants will include the Government and others interested parties

COMPONENT 5: Development of a Quality of Service/Supply Regulation System for the Gas Distribution Businesses

This component’s focus is support NERC with the development of a pilot project of the monitoring of the quality of gas supply performance standards. The more experienced among the EU Regulators are increasingly taking on responsibilities for setting two types of quality regulation standards. These involve the development of overall or average standards of service which are not specific to individual customers and the development of minimum or guaranteed standards of service which apply to individual customers. The regulators then establish targets for licencees and make an assessment of performance on an annual basis. The targets and when available the actual performance of licencees in relation to these standards are published (often on websites)

A comparison between Gas distribution businesses can be made to see how NAFTOGAZ-owned gas distribution companies and third party owned gas distribution businesses perform across different standards of service. This helps customers and increases benefits to them in providing them with more information to make choices. Increasingly, financial penalties are being made against licencees who fail to reach targets with compensation being directed to customers through future lower tariffs or one off financial payments. Progress with extending the quality of service programme may also been made with integration of elements of quality regulation directly into incentive based price cap regulation without completely foregoing the use of service standards. This is a natural progression but relies on the availability of a robust data collection programme.

Activity 5.1: Training on establishing Quality of Supply Standards and Performance

The GRWG will undertake training on specific modules to support its work in implementing a Gas Quality Pilot Study. The training modules, to be provided by the RTA and STE, will comprise training on the development of overall and minimum quality of gas service standards, the development of performance targets and financial compensation values.24 A case study will be presented on 3 countries in the EU illustrating the best practice use of gas quality service standards.

24 Technical standards on different gas qualities are addressed in separate standards in Ukraine.

- 21 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Activity 5.2: Development of a monitoring system of quality of service/supply for gas distributing companies

The MS STE will develop a monitoring system of the quality of service/supply for Oblgaz companies, including the development of: - a methodology to evaluate quality of service/supply for the gas distributing companies. - Data collection templates to be issued by NERC about quality of service /supply for gas distributing companies; - Procedures for registration of gas supply interruptions; - a methodology to calculate the losses (damages) to customers as result of gas supply breaks - a methodology to determine the financial compensation for losses (damages) to customers as result of gas supply interruptions.

This activity includes also the implementation of a pilot project of monitoring of quality of service /supply for gas distributing companies.

Activity 5.3: Roundtable Discussion and recommendations

The GRWG will discuss the results of the Pilot Study of quality of service/supply monitoring for gas distributing companies. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

Outputs Activities Deliverables/Outputs Activity 5.1 Completion of different training modules in part of quality regulation in the Gas Sector applied by 3 EU MS Activity 5.2 Implementation of the monitoring of the quality of gas supply performance standards Activity 5.3 Round table discussion on implementation of the quality of service standards for gas supply. Participants will include Government and others interested parties

COMPONENT 6: Tariffs and Social Protection Transition Schemes Assessment

The objective of this component is to strengthen NERC’s knowledge and capability to consider the mechanisms of different social protection schemes and to understand how other EU Regulators have managed the transition process in their countries of moving the gas sector towards the use of more efficient social protection schemes and/or directing regulated companies away from tariffs embedded with cross-subsidies towards more cost-reflective tariffs.

Allocative efficiency requires that tariff structures should reflect the relative costs imposed by differing users of the gas distribution network and that the basis of charges should be related to the drivers of network costs. By doing so, tariffs will signal to customers the costs that they impose on the network. Actions by customers that reduce their own costs, such as shifting to alternative locations or changing the timing of their consumption, will also reduce total network costs. Conversely, non-cost reflective tariffs will tend to increase network costs and/or reduce social welfare.

Cross-subsidies between customer types will lead to customers charged prices in excess of the costs of supply to look for cheaper alternatives, which may cost more than the actual costs of supplying them through the gas distribution network, while customers charged less than their costs of supply will tend to increase consumption, potentially to levels which the network cannot support with consequent rationing. Network expansion may be curtailed as the tariffs paid by new customers do not cover the full costs of connecting them.

Cross-subsidies are increasingly being eliminated within the EU. In all cases, large users pay the same or less than smaller users. This does not mean that regulators within the EU are unconcerned about the affordability of gas

- 22 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______supplies. However, there are more efficient means of ensuring access to affordable energy supplies for poorer customers than introducing non-cost reflective tariffs for all customers. These include: • Rising block tariffs, where smaller levels of consumption are charged at a lower rate on the assumption that poorer households will generally consume less energy, with the difference being recovered by increased charges for higher consumption blocks.

• Voucher mechanisms, where poorer households are individually identified and receive subsidies (directly or indirectly) to cover part of their gas purchase costs.

• Income-related payments, where poorer households are individually identified and receive increased welfare payments, but are able to determine whether to use these to purchase additional energy supplies or for other purposes. Moving down the range of options implies increased efficiency in targeting poorer households and in directing subsidies where there are needed, but also increasing complexity and administrative costs. This complexity and cost is greatly lessened where a social security system already exists and can be used to identify poorer households eligible for subsidies. It is not always desirable for subsidies to be funded from general tax revenues, particularly where only a small part of the population is supplied by the subsidized service. Reliance on government budgetary funding may introduce uncertainties as to the level and timing of subsidy payments and may be politically difficult to sustain where it involves all taxpayers providing funds which only benefit a limited group of customers. Instead, it may be more appropriate to raise funds from within the industry itself. One possible mechanism for this is some form of universal levy on all customers.

Work Scope Activity 6.1: Ukrainian and EU MS Social Protection Mechanisms

The GRWG and MS STEs will draft a detailed report on the (i) existing social protection scheme(s) in operation in the Gas sector, (ii) social protection schemes used in different EU MS in the gas sector (if data is not available, then analysis of the schemes operating in the electricity sector should be undertaken) and (iii) a critical appraisal and review of how EU 27 Regulators (or other equivalent institutions) have managed the transition towards more efficiently- operated social protection schemes and/or the removal of cross-subsidies and the implementation of cost-reflective prices in their Gas Sectors.

Activity 6.2: Determination of Social Protection Costs Model

The MS STEs, supported by GRWG, will develop a computerised model which will identify the net costs of the existing gas social protection scheme to the Ukrainian economy and all customer classes and a concomitant paper which will provide recommendations on a future social protection scheme that is either more efficient than existing scheme(s) as well as the mechanism to move towards cost-reflective prices. Activity 6.3: Study Tour to assess transition mechanism implemented by EU NRAs

To assist it in the implementation of more efficient social protection schema and gas tariff structures the GRWG will also visit and meet with 3 relevant Member States where the Regulators in those Member States have successfully developed and overseen the implementation of efficient social protection schemes and/or moved the industry away from cross-subsidies towards more cost-reflective tariffs. The Study Tour will comprise formal presentation/discussion by each Member State to the members of the GRWG of the approaches taken by the Regulator in that Member State to manage the transitional process towards cost-reflective tariffs as well as the mechanisms of different social protection schema.

- 23 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Activity 6.4: Roundtable Discussion and recommendations on social protection transition process

On its return, NERC, technically supported by the MS STEs and GRWG, will hold a 1 day Roundtable discussion with invitations to the Gas Industry, Government, Parliamentary representatives and the ECD to discuss the options and recommendations on social protection schemes and the costs and benefits of moving towards cost-reflective tariffs in the Gas sector. Based on the results of the Roundtable NERC will propose concrete recommendations to improve the existing social protection scheme infrastructure. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

Outputs

Activities Deliverables/Outputs Activity 6.1 Report on existing Social Protection Schemes and review of transition towards cost-reflective prices undertaken by EU Regulators Activity 6.2 Development of a computer model that identifies the cost of social protection Activity 6.3 Study Tour by GRWG of 3 EU MS to investigate social Protection Schema and transition path towards cost-reflective tariffs Activity 6.4 Round table discussion and development of recommendations concerning the implementation of a transitional path away from social protection schemes. Participation in the roundtable will include Government and other interested parties

COMPONENT 7: Selected support on an effective Legal and Functional unbundling process

The objective of this component is to support NERC’s capability to develop the unbundling process in the Gas Sector when it comes. In the 2003 EU Gas Directive it is emphasised that regulators are required to ensure equal non-discriminatory access to the transmission and distribution gas pipelines as it is important to separate the natural monopoly part of the business (Transmission/Distribution) from potentially competitive parts (supply business). In Ukraine, this issue complements efforts to encourage greater transparency and information sharing as well as greater efficiency in operations undertaken by distribution (and transmission) companies. In EU Directive 55/2003, vertically integrated companies are defined as businesses performing at least one of functions of transmission or distribution and at least one of the functions of generation or supply (of gas). On that basis, Oblgaz companies are deemed to be vertically integrated companies. Having separate licences and tariffs for different activities is not sufficient to comply with the Directive. That means that the Oblgaz companies will need to have separate audited financial accounts for each business activity. In addition, to comply with the Directive they will need to have separate management and independent decision-making capabilities. Ideally, separate legal businesses need to be created although this can be within a holding company.

Assistance to NERC could therefore be provided through support to drafting guidelines setting out the requirements for legal and function unbundling and to specify the requirements in the licencees of Distribution and Supply activities.

Activity 7.1: Regulatory Procedures

The MS STEs, working with the GRWG, will develop recommendations for a methodology to unbundled the costs and revenues in the distribution and supply activities under the Regulated Tariff regime with the aim of avoiding cross-subsidies between the distribution and supply licensees under the Regulated tariff. The work will also include recommendations for an appropriate method of the modern book-keeping and allocation of the costs and revenues of different kinds of activities.

Activity 7.2: Training on Unbundling Requirements

To support NERC in its understanding of and capacity to monitor the unbundling process, the MS STE will undertake training of GRWG on the unbundling requirements of the EU Gas Directive and the approach to approximating these provisions into Ukrainian legislation.

- 24 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Activity 7.3: Guidelines to monitor unbundling

The MS STEs will draft Guidelines for NERC to use as a set of procedures to effectively monitor the legal and functional unbundling requirements of the 2003 EU Directive and how Companies can comply with them.

Outputs

Activities Deliverables/Outputs Activity 7.1 Unbundling of costs and revenues of gas distributing and supply activities on regulated tariff Activity 7.2 Workshop on Unbundling Requirements of EU 2003 Gas Directive Activity 7.3 Round table discussion and development of recommendations for legal unbundling of gas distribution and gas supply companies on a regulated tariff. Participants will include Government and other interested parties

To comply with the Mandatory Results, it is essential that the outputs/deliverables of the twinning project (eg all technical reports, workshop presentations) are published and freely accessible in full in English and Ukrainian on NERC’s website by the completion of the project.

3.5 MEANS/INPUT FROM THE MS PARTNER ADMINISTRATION:

Indicative time inputs by the Project Leader, RTA and Short term Experts of the MS Partner Administration are given below:

Category Description Month Day Inputs in BC Inputs MS-PL Project Leader - To be agreed during Contracting Stage RTA Resident Twinning Adviser 24 - STEs All STE Experts 571

3.5.1 PROFILE AND TASKS OF THE MS PROJECT LEADER

MS Project Leader (minimum of 3 days per month in MS country and as many days as required in Ukraine)

Role and tasks:

The Project Leader will detail, coordinate and control the overall thrust of the project, lead the activities of the Project and ensure the achievement of the mandatory results and be responsible for the implementation of the project. He is expected to devote a minimum of 3 days per month to the project in his home administration and not in Ukraine. This cost is covered by the Twinning Management Uplift amount. In addition, he should coordinate, from the Member State side, and with the Resident Twinning Adviser, the Project Steering Committee (PSC), which will meet in Ukraine at least every three months. He is expected to provide a total of 24 days in Ukraine based on 3 days every 3 months for the working life of the project (24 months).

The MS Project leader shall: • be a long-term civil servant from the Member State Gas Regulation with necessary experience in a leading position in gas sector regulation; and

• have education and experience in the field of project management, institutional issues and organisation of Gas Regulation.

- 25 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Profile:

Qualification and skills • Good English communication skills, both spoken and written. • Command of Russian or Ukrainian would be a strong asset. • Good inter-personal skills.

General professional experience • Long term civil servant from the MS Administration • Minimum 10 years of professional experience • Experienced Project manager, demonstrating good record in organisational leadership, staff motivation and communication. • Experience in the development and implementation of Gas Regulatory Projects

3.5.2 PROFILE AND TASKS OF THE RTA

A Resident Twinning Adviser (RTA) on Gas Regulation will provide advice and technical assistance to the NERC Commissioners and staff, coordinated through NERC’s Department of International Relations and EU Coordination, on clarifying, defining and helping implement those requirements of the EU internal gas market, which are relevant for NERC to comply with the Acquis Communautaire in its regulatory practice.

The RTA will ensure that best European regulatory know-how will be fed into the decision making process at NERC. Part of the work shall consist of preparing case studies. This will be coordinated by the RTA who will also coordinate all training activities. Both the RTA and STEs will be responsible for conducting all training activities, be it for senior or junior staff. Subject to availability and with the agreement of the Chairman of NERC, the RTA and STEs shall provide advice to NERC’s Commissioners.

Resident Twinning Adviser (24 months)

The Resident Twinning Adviser (RTA) will provide 24 months input on site (including leave). The RTA's assistant will be remunerated by the Twinning budget.

Role and tasks:

The RTA will be responsible for the day-to-day co-ordination and implementation of the project. His background will be broad-based covering economic regulation and general legislative issues. He will lead the Gas Regulatory Working Group (GRWG) and oversee specifically Components 1 to 7. The RTA will also support the Gas Legal Approximation Working Group (GLAWG) in Component 2.

The RTA will based full-time in an office in NERC and will liaise closely with his Counterpart in NERC.

Profile:

Qualification and skills • University high level education in Economics, Engineering, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian is strongly recommended. • PC Computer literacy. • Excellent inter-personal and team leadership skills. .

- 26 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

General professional experience • Civil Servant from an EU MS Administration. • Minimum 10 years of professional experience. • Experienced manager, demonstrating good record in organisational leadership, staff motivation and communication. • Strong analytical and managerial background. • At least 2 years experience of the transition economies of the CIS would be beneficial.

Specific professional experience • At least 5 years experience in a management role in a Gas Regulatory Body in the EU. • Experience in developing, coordinating and conducting training programmes for a Gas Regulatory Body in an EU MS would be an asset

3.5.3 PROFILE AND TASKS OF THE SHORT TERM EXPERTS

In order to provide the full range of expertise that is necessary a minimum of 8 short term experts will complete the activities supported by the RTA. The short term experts will be from the Regulatory Body/ies in the Member State(s) or from other Public Sector Institutions.

STE 1: EU Gas Lawyer

Role:

The Short term EU Gas Lawyer will be responsible for leading the work within the Gas Legal Approximation Working Group (GLAWG) and drafting the required amendments stipulated in Component 2.

Profile:

Qualification and skills • University Degree in Law • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • Knowledge of transition economy legal structures would be an asset.

General professional experience • Be an employee of a public administration body (eg Ministry of Justice) in an EU MS. • Minimum 10 years of professional experience. • At least 5 years in providing legal services and advice/guidance to Gas Regulatory Bodies.

Specific professional experience • Experience with EU Energy legislation and Regulations in an EU MS

STE 2: Legal Gas Expert

Role:

The Short term Legal Gas Expert will be responsible for supporting the legal work in Component 2. He will also contribute to undertaking the gas training activities on site and leading the Legal Study Tour in Component 2.

- 27 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Profile:

Qualification and skills • University Degree in Law • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • Knowledge of transition economy legal structures would be an asset.

General professional experience • Be an employee of a public administration body in an EU MS. • Minimum 10 years of professional experience. • At least 2 years direct experience in providing legal services and advice/guidance in the Gas sector to Gas Regulatory Bodies.

Specific professional experience • Experience of assisting Ministries and other Institutions in the EU to transpose EU Electricity Directive into national legislation

STE 3: Incentive Based Regulation & Gas Tariffs Expert

Role:

The Short term Incentive Based Regulation and Gas Tariffs Expert will be responsible for training the elements of Incentive Based Regulation in Component 3 and leading the implementation of multi-year incentive-based regulation in Component 4. He will also contribute to supporting the capacity building of the GRWG.

Profile:

Qualification and skills • University high level education in Economics, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy • Good inter-personal skills

General professional experience • Be an employee of a MS public administration body • Minimum 10 years of professional experience. • Strong analytical and managerial capability • At least 2 years experience of the transition economies of the CIS would be beneficial.

Specific professional experience • At least 2 years experience in a incentive-based pricing and tariff regulation role in an Gas Regulatory Body in an EU MS. • Experience in developing, coordinating and conducting pricing and tariff training programmes for an Gas Regulatory Body in an EU MS..

- 28 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

STE 4: Incentive Based Regulation Financial Modelling Expert

Role:

The Short term Incentive Based Regulation Financial Modelling Expert will be responsible for developing the data collection templates, programmes and financial modelling underpinning the implementation of the multi-year incentive-based regulation in Component 4. He will also contribute to the training of GRWG in familiarising themselves with the building blocks of Incentive Based Regulation as indicated in Component 3..

Profile:

Qualification and skills • University high level education in Economics, Engineering, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy • Good inter-personal skills

General professional experience • Be an employee of a MS public administration body • Minimum 10 years of professional experience. • Strong analytical and managerial capability

Specific professional experience • At least 2 years experience in developing financial models of incentive-based pricing and tariff regulation in a Gas Regulatory Body in an EU MS. • Experience in developing, coordinating and conducting pricing and tariff training programmes for an Gas Regulatory Body in an EU MS.

STE 5: Gas Benchmarking Expert

Role:

The Short term Gas Benchmarking Expert will be responsible for developing the benchmarking methodologies, analysis and models within Component 4. He will also undertake the training of the GRWG in benchmarking techniques in Component 3.

Profile:

Qualification and skills • University high level education in Economics, Engineering, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy • Good inter-personal skills

General professional experience • Be an employee of a MS public administration body • Minimum 10 years of professional experience. • Strong analytical and managerial capability

- 29 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Specific professional experience • At least 2 years experience in using benchmarking methodologies and techniques in a Gas Regulatory Body in the EU MS. • Experience in developing, coordinating and conducting benchmarking training programmes for an Gas Regulatory Body in an EU MS.

STE 6: Gas Quality Regulation Expert

Role:

The Short term Gas Quality Regulation Expert will be responsible for developing and establishing a monitoring system of quality of regulation standards and customer protection programme and implementing these activities within the RWG in Component 5. He will also contribute to the development of the Quality Regulation Action Plan, technical papers and undertaking some of the training activities on site.

Profile:

Qualification and skills • University high level education in Economics, Engineering, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy • Good inter-personal skills

General professional experience • Be an employee of a MS public administration body • Minimum 10 years of professional experience. • Strong analytical and managerial capability

Specific professional experience • At least 2 years experience in developing and operating Quality regulation methodologies, techniques and programmes in a Gas Regulatory Body in an EU MS. • Experience in developing, coordinating and conducting quality regulation training programmes for an Gas Regulatory Body in an EU MS.

STE 7: Social Protection Expert

Role:

The Short term Social Protection Expert will be responsible for reviewing and modelling the social protection schemes as set out in Component 6. He will also undertake some of the training activities on site.

Profile:

Qualification and skills • University high level education in Economics, Engineering, Business or Accounting • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy • Good inter-personal skills

- 30 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

General professional experience • Be an employee of a MS public administration body • Minimum 10 years of professional experience. • Strong analytical and managerial capability

Specific professional experience • At least 2 years experience in analysing and reviewing social protection schemes and programmes in the Gas Sector in an EU MS. • Experience in the modelling or managing the modelling of costs and benefits of social protection schemes for a Gas Regulatory Body or other Body in an EU MS.

STE 8: Legal and functional Unbundling Expert

Role:

The Short term Legal and functional Unbundling Expert will be responsible for providing advice, training and operational support for the unbundling process to be promoted and overseen by NERC in Component 7. He will also develop and undertake training on site.

Profile:

Qualification and skills • University high level education in Accounting, Business Economics or Law. • Excellent English communication skills, both spoken and written. • Command of Russian or Ukrainian would be an asset. • PC Computer literacy. • Good inter-personal skills.

General professional experience • Be an employee of a MS public administration body. • Minimum 10 years of professional experience. • Strong analytical and managerial capability.

Specific professional experience • Experience in providing advice and guidance on the unbundling process as dictated under the EU Gas Directive 2003/55. • Experience in developing, coordinating and conducting training on the unbundling requirements for a Gas Regulatory Body in an EU MS. • Experience in drafting guidelines for procedures to effectively monitor the legal and functional unbundling of the EU Directive 2003/55 requirement.

4. INSTITUTIONAL FRAMEWORK

Responsible Institution in the Beneficiary Country: National Electricity Regulatory Commission of Ukraine 19, Smolenska St, Kyiv, 03680 Ukraine

- 31 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Contact Point:

Mr. Valery Tsaplin Head of Strategy and Energy Market Development Department Phone/Fax: +380 44 241-90-49 +380 44 454-70-81 E-Mail: [email protected]

5. BUDGET

Euro 1,2 million

6. IMPLEMENTATION ARRANGEMENTS

6.1 – Implementing Agency

The Implementing Agency who will be responsible for the tendering, contracting and accounting of this twinning project will be the European Commission Delegation to Ukraine.

The person in charge of this project at the Delegation of the European Commission to Ukraine is

Ms. Olga Simak Project Manager on Energy and Nuclear Safety Delegation of the European Commission to Ukraine 10, Kruhlo-Universytetska St Kyiv, Ukraine 01024 Tel.:+380 44 3908010 Fax:+380 44 2534547 e-mail: [email protected]

6. 2 – Main counterpart in Ukraine

BENEFICIARY INSTITUTION PROJECT LEADER (BC PL)

The Beneficiary Institution Project Leader (BC PL) will act as the counterpart of the Member State PL and will ensure close co-operation the overall steering and co-ordination of the project, ensuring the operational dialogue and the backing at political level.

The BC PL's position as Commissioner/Member of NERC will ensure his ability to mobilise the necessary staff in support of the efficient implementation of the project.

He will also coordinate the Project Steering Committee (PSC) from the Beneficiary Institution side.

The Beneficiary Institution Project Leader will be:

Mr V. Mercushov Commissioner/Member National Electricity Regulatory Commission of Ukraine 19, Smolenska St., Kyiv, 03680 Ukraine

- 32 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

BENEFICIARY INSTITUTION RTA COUNTERPART (BC RTA)

The Beneficiary Institution RTA Counterpart will be:

Mr. Valery Tsaplin Head of Strategy and Energy Market Development Department National Electricity Regulatory Commission of Ukraine 19, Smolenska St., Kyiv, 03680 Ukraine Phone/Fax: +380 44 241-90-49 +380 44 454-70-81 E-Mail: [email protected]

6.3 – Contracts

Only one contract is foreseen for this Twinning project.

7. IMPLEMENTING SCHEDULE (INDICATIVE)

7.1 Launching of the call for proposals July 2008 7.2 Start of project activities March 2009

7.3 Duration of the Implementation Period (WorkPlan)

24 months

8. SUSTAINABILITY

Institutionalising the results of the project within NERC will assist in sustaining the benefits of the project after the completion date. Areas open to institutionalising include the transfer of data, information, models and results to databases that can be accessed by NERC staff, the continued promulgation of training of key activities through a train-the-trainers philosophy imbued within the MS Partner and the greater dissemination of the project outputs and results through NERC’s website.

9. CROSSCUTTING ISSUES

Equal Opportunity

Equal opportunity principles and practices in ensuring equitable gender participation in the project will be guaranteed. Male and female participation in the project will be based on the relevant standards of the EU and will be assured by official announcements published to recruit staff needed for the project. The main criteria for recruitment of the RTA, STEs will be based on appropriate qualifications and experience in similar gas projects regardless of gender.

10. CONDITIONALITY AND SEQUENCING

Contributions expected from the Beneficiary include: • Strong involvement/ commitment of NERC staff at all levels,

- 33 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

• Assigning/employing indispensable personnel to activities connected with the project, • Ensuring co-ordination between institutions connected with the project, • Ensuring a legal framework for the introduction of changes resulting from the project, • Ensuring access to indispensable information and documents, • Ensuring sufficient development of computerisation within NERC, • Supply office rooms, including computers, telephone, internet access, printer, photocopier to MS experts, • Providing suitable venues and equipment for training sessions that will be held under the project, • Designating a NERC counterpart for each MS expert.

COMMITTEES

Project Steering Committee

A Project Steering Committee (PSC) will be established for the control and supervision of the project activities and the mandatory results. The Steering Committee will meet after the submission and review of the interim reports and will submit by the end of the meeting (as recorded in the minutes of meeting) an approval/not approval of the reports. Official minutes of the PSC meetings will be kept in both Ukrainian and English and distributed to all members of the PSC within 15 working days after each PSC meeting.

ANNEXES

Annex 1: Logical Framework Analysis

Annex 2: Indicative Project Implementation Schedule

Annex 3: List of Relevant Gas Legislation and Resolutions

Annex 4: List of Acquis Communiatiare (Energy)

- 34 - EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Annex 1: Logical Framework Matrix

Overall Objectives and Project Purpose Annex 1 Logical Framework Analysis: Regulatory and Legal capacity strengthening of Gas Regulation in NERC. Twinning number: UA08/PCA/EY/12 Overall objective Measurable indicators Means of verification Assumptions

A more transparent, efficient and competitive Ukrainian Gas Market 1. Evidence of greater competition in 1. Analyses and articles of Official Not relevant that functions in line with European Union (EU) best practices the production and supply of gas to Organisations and Industry press wholesale and retail customers articles 2. Wholesale and retail gas price setting 2. Analysts Reports and articles is transparent to external 3. Governmental and Parliamentary parties/analysts/media Reports 3. Customers can choose their gas supplier, remain with the preferred supplier and terminate the supply- contract without substantial costs 4. All customers pay for the costs incurred to produce, distribute and supply gas to them Project purpose Measurable Indicators Means of verification Assumptions 1. Qualitative improvements in NERC’s 1. NERC Orders and Resolutions 1. Effective MS PL To improve the capacity of NERC to undertake the proper implementation of gas regulation issued engagement development and implementation of primary and secondary 2. Quantitative changes (resources, 2. Effective BC PL and BC legislation, regulatory work and adaptive decision-taking people, procedures) by NERC to RTA participation and implement its regulation of the Gas cooperation sector 3. An effective and efficient MS RTA with capable project management and coordination skills 4. Sufficient time, effort and resources committed by GLAWG and GRWG to assisting and working closely with the MS STEs 5. Timely disbursement 6. Effective Professional implementation 7. Good quality outputs delivered on time 8. Continued involvement of the MS RTA.

35 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Mandatory Results Measurable indicators Means of verification Assumptions 1. Appropriate number of 1. GLAWG Meeting minutes 1. NERC remains Mandatory Result 1 -Current regulations are assessed, revised, assessed,, revised regulations 2. Submission records of draft committed to amendments/new regulations developed for a better regulated gas market and amendments/new amendments strengthening NERC’s and ensuring greater protection of the rights of customers. regulations discussed within 3. Interim Reports of PL independence & NERC 4. PSC Meeting minutes autonomy 2. Appropriate number of 5. Feedback evaluation sheets 2. GLAWG members are assessed, revised regulations 6. All Outputs (eg Protocols, able to draft amendments ands amendments/new reports/amendments etc) 3. Participants able to attend regulations submitted to CoM in published in English and Training Workshops the fields of tariff Ukrainian on NERC website 4. Time & Resources methodologies, benchmarking commitments are properly techniques, approaches to managed quality to quality of service or 5. Participants shows active supply regulation, social interest in improving protection schemes and adaptive & business unbundling management skills & knowledge

1. Improving results of assessment 1. Protocols of the assessment 1. NERC remains committed Mandatory Result 2 - Knowledge and skills of respective NERC of NERC management and staff 2. GLAWG Meeting minutes to adopting EU best practice management and staffs are enhanced enabling them to implement their (including GRWG and 3. GRWG Meeting minutes in gas regulation within and tasks at a higher level. GLAWG) between the periods 4. Interim Reports of MS PL after the project timeline of the start, the middle and the 5. PSC Meeting minutes 2. Staff able to attend Training end of the project in the field of 6. Feedback evaluation sheets (training) Workshops Incentive-based regulation, 7. All Outputs (eg Reports etc) 3. Time & Resources Benchmarking of Gas published in English and Ukrainian commitments are properly Distribution Companies, on NERC website managed Quality Regulation Standards 4. Staff shows active interest in and Procedures, Social improving adaptive & Protection Transition Schemes, business management skills functional unbundling & knowledge procedures, Specific English Language, EU gas legislation requirements

36 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Component 1: Project Support and Language Training Activities Measurable Indicators Means of verification Assumptions Activity 1.1: The MS Partner will establish the GLAWG and the GRWG. 1. No of meetings/participants at 1. GLAWG Meeting minutes 1. Staff able to attend Training GLAWG 2. GRWG Meeting minutes Workshops Activity 1.2: The RTA will organise a 1 day Workshop by NERC’s Legal 2. No of meetings/participants at 3. PSC Meeting minutes 2. Time & Resources and Oil & Gas Dept on legal, regulatory and market GRWG 4. No of Feedback evaluation commitments are properly developments/trends/issues in the Ukrainian Gas Market and a 1 day 3. No of man-days, STEs and sheets (training) managed Workshop by MS Contractor on legal, regulatory and market milestones established in the final 3. Staff shows active interest in developments/trends/issues in EU Gas Market Work Programme improving adaptive & business 4. No of coordination meetings & management skills & Activity 1.3: The MS Partner will set up an appropriate ongoing liaison structure knowledge liaison/coordination mechanism with the Electricity Regulation Twinning established with the Electricity Project. Twinning Project 5. No of participants in training Activity 1.4: The MS Partner will organise English language training programmes service on gas sub sector specialised terminology for all management and staff in NERC. The MS Partner might sub-contact an accredited Ukraine-based Language Training Institute to provide a training for 12 months of the project.

Component 2: Review and Approximation of EU Natural Gas Legislation Activities Measurable Indicators Means of verification Assumptions Activity 2.1: To undertake a one-week study tour to the partner institution 1. No of meetings/participants at 1. GLAWG Meeting minutes 1. NERC remains committed of the twinning Member State to; GLAWG 2. Submission records of draft to strengthening NERC’s • understand the process that was completed in that Member 2. No of meetings on Reviews of amendments independence & autonomy State to comply with the Gas-related parts of the Acquis Acquis Communautaure 3. Interim Reports of PL 2. GLAWG members are able Communautaires; 3. No of training programmes 4. PSC Meeting minutes to draft amendments • understand the working methods and procedures of the completed 5. No of Feedback evaluation 3. Staff able to attend Training Member State Gas Regulator with a focus on all legal aspects; 4. No of secondments realized sheets (training) Workshops • Within the Study Tour, to receive training courses and within GLAWG 4. Time & Resources information from Member State STEs on: 5. No of amendments drafted commitments are properly

o EU Energy policy - development and interpretation; 6. No of amendments accepted managed

o Articles of the 2003/55/EC Gas Directive (June within NERC 5. Staff shows active interest in 2003) 7. No of amendments submitted to improving adaptive & o EC Notes to support the approximation of the Gas CoM business management skills Directive 2003/55/EC & knowledge o Requirements of the Regulation (EC) No 1775/2005 (Sept 2005) on conditions for access to the Natural Gas Transmission Networks

37 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

o Articles of the 2004/67/EC Directive on measures to safeguard Security of Supply o Main ideas of the competition Acquis Communautaire including legislation and regulations covering the prevention, restriction or distortion of competition, the abuse of dominant positions in the electricity and gas markets and any government support such as subsidies, which distorts or threatens to distort competition in the electricity and gas markets. • To study and oversee procedures in situ in which the Legal Department of the Member State Regulator is involved.

Activity 2.2: To as closely as possible approximate the Gas Directive 2003/55/EC into Ukrainian national legislation and to establish an approximation procedure inside the GLAWG by: • undertaking a screening of the national legislation in the field of Gas leading to development of Compliance Tables in tabular format; • preparing an Analysis Report on the gap findings. The report will reflect the findings of the compliance tables in the field of Gas legislation and regulation; • setting up a roundtable forum with representatives of all NERC´s Departments, discussing and commenting on the gap findings; • preparation of proposals concerning the bringing in of legislative changes to support the approximation of Ukrainian legislation to EU legislation in the Gas sector; • public discussion of the explanations of NERC concerning the content of the prepared changes to legislative acts in support of approximation of the Ukrainian legislation to EU legislation in gas sector.

Activity 2.3: To set up an electronic internal Database Library containing all relevant Natural Gas EU policy, Natural Gas regulation, primary and secondary legislation, international trading and tariff regimes and to translate the legislation into Ukrainian using the Resident Interpreter/Translator (RIT)

38 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Component 3: Development of the Building blocks of Multi-Year Incentive-Based Gas Regulation and Benchmarking Activities Measurable Indicators Means of verification Assumptions Activity 3.1: To provide training and draft a report on the approaches 1. No of meetings/participants at 1. GRWG Meeting minutes 1. NERC remains committed to taken by EU and non-EU Regulators to calculate and approve the WACC GRWG 2. Interim Reports of PL developing and strengthening for Gas Distribution Companies. 2. No of attendees at each 3. PSC Meeting minutes use of Incentive Based Workshop & feedback 4. No of Feedback evaluation Regulation Activity 3.2: To provide training and draft a report on the various 3. Participation by NERC in ERRA sheets (training) 2. Staff able to attend Training techniques undertaken by different EU Regulators to determine RAB. Conference 5. Check on NERC’s website to Workshops 4. No of Workshops delivered verify reports have been 3. Time & Resources Activity 3.3: To provide training on the implementation of the different 5. No of reports delivered produced by target deadline commitments are properly benchmarking approaches used by Regulators. 6. No of reports published on managed NERC’s website by the target 4. Staff shows active interest in Activity 3.4: To provide training and draft a report on the approaches deadline improving adaptive & business taken by EU Regulators to determine efficient path of operating costs and management skills & X efficiency factors. knowledge

Component 4: Implementation of Incentive Based Regulation and benchmarking of Gas Distribution Businesses Activities Measurable Indicators Means of verification Assumptions Activity 4.1: To undertake two Study Tours to National Regulatory 1. No of meetings/participants at 1. Endorsement of Benchmarking 1. NERC remains committed to Authorities in two different EU MS. The focus of the Study Tours will be GRWG by Chairman strengthening NERC’s tariff to allow NERC Staff to fully engage with Staff of the NRAs in assessing 2. No of Workshops delivered 2. Interim Reports of PL regulatory approaches the operation and use of incentive-based regulation and benchmarking by 3. No of attendees at 1st Study Tour 3. PSC Meeting minutes 2. GRWG and other staff able to the NRAs after training provided in Component 3. 4. No of attendees at 2nd Study Tour 4. No of Feedback evaluation attend Training Workshops 5. Submission of Incentive Based sheets (training) 3. Time & Resources Activity 4.2: To develop methodology of Incentive Based Regulation for Regulation Model to NERC 5. Check on Website for commitments are properly Oblgaz companies. The MS STE will develop a multi-year incentive based 6. Submission of data templates for recommendations and managed regulation regime across the Oblgaz companies. The exercise will Benchmarking endorsement 4. Staff shows active interest in encapsulate: 7. No of Training Sessions improving price regulation and • development of an allowed revenue review process; completed benchmarking skills & • development of data collection templates, 8. No of users trained on computer knowledge • development of an multi-year incentive-based price regulation model 5. Good availability & accuracy of model; 9. Publication of recommendations data on costs of Oblgaz from Roundtable and Companies to validate the • development of an implementation plan for introduction of endorsement on NERC’s website benchmarking modelling incentive based regulation for Oblgaz companies

Activity 4.3: Based on existing data availability and the analysis undertaken in Component 3, to provide data collection templates, data collection and analysis and appropriate benchmarking techniques to assist in modelling

39 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

the total or operating costs of the Oblgaz companies.

Activity 4.4: To discuss the Draft methodology of the Incentive Based Regulation and Draft methodology of Benchmarking and to make recommendations for any subsequent improvements to the process by the end of the project. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

Component 5: Development of a Quality of Service/Supply Regulation System for the Gas Distribution Business Activities Measurable Indicators Means of verification Assumptions Activity 5.1: The GRWG will undertake training on specific modules to 1. No of meetings/participants 1. QR Meeting minutes 1. NERC remains committed to support its work in implementing the Gas Quality Regulation Pilot Study. 2. No of attendees at Workshop & 2. Interim Reports of PL strengthening the regulation of The training modules, to be provided by the RTA and STE, will comprise feedback 3. PSC Meeting minutes quality of service/supply training on the development of overall and minimum quality of gas 3. No of Workshops delivered 4. No of Feedback evaluation monitoring of Oblgaz service standards, the development of performance targets and financial 4. No of Training Sessions sheets (training) Companies. compensation values. A case study will be presented on 3 countries in the completed 5. Check on the Website 2. Staff able to attend Training EU illustrating the best practice use of gas quality service standards. 5. Publication of endorsement on Workshops NERC’s website 3. Time & Resources Activity 5.2: Development of a monitoring system of quality of commitments are properly service/supply for gas distributing companies, including the draft of: managed - a methodology of evaluation of quality of service/supply for 4. Staff shows active interest in the gas distributing companies. improving Quality regulation - Forms of reports to NERC about quality of service /supply for skills & knowledge gas distributing companies; - Procedures of registration of gas supply interruptions; - Methodology of the losses (damages) evaluation made to customers as result of gas supply breaks - Methodology of losses (damages) compensations to customers as result of gas supply breaks because of gas distributing companies. This activity includes also the implementation of monitoring of quality of service /supply for gas distributing companies. Activity 5.3: The GRWG will discuss the results of the Pilot Study of quality of service/supply monitoring for gas distributing companies. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

40 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Component 6: Tariffs and Social Protection Transition Assessment Activities Measurable Indicators Means of verification Assumptions 1. No of meetings/participants 1. QR Meeting minutes 1. NERC Board remains Activity 6.1: The GRWG and MS STEs will draft a detailed report on 2. No of attendees at Workshop & 2. Interim Reports of PL committed to improvement to the (i) existing social protection scheme(s) in operation in the Gas feedback 3. PSC Meeting minutes Social Protection Schemes sector, (ii) social protection schemes used in different EU MS in the gas 3. Production of the reports on existing 4. No of Feedback evaluation consistent with removal of sector (if data is not available, then analysis of the schemes operating in social protection schemes and EU sheets (training) cross-subsidies. Staff able to the electricity sector should be undertaken) and (iii) a critical appraisal MS Social Protection schemes attend Training Workshops and review of how EU 27 Regulators (or other equivalent institutions) 4. Delivery of Social Protection Cost 2. Time & Resources have managed the transition towards more efficiently-operated social model commitments are properly protection schemes and/or the removal of cross-subsidies and the 5. No of Participants on Study Tour managed implementation of cost-reflective tariffs in their Gas Sectors. 6. No of Training Sessions completed 3. Staff shows active interest in 7. Delivery of recommendations from improving adaptive & business Activity 6.2: The MS STEs, supported by GRWG, will develop a Roundtable management skills & computerised model which will identify the net costs of the existing 8. Publication of recommendations on knowledge social protection scheme to the Ukrainian economy and all customer NERC’s website classes, the costs of other possible social protection scheme options and a concomitant paper which will provide recommendations on a future social protection scheme that is either more efficient than existing scheme(s) as well as the mechanism to move towards cost- reflective tariffs. Activity 6.3: To assist it in the implementation of more efficient social protection schema and gas tariff structures the GRWG will also visit and meet with 3 relevant Member States where the Regulators in those Member States have successfully developed and overseen the implementation of efficient social protection schemes and/or moved the industry away from cross-subsidies towards more cost-reflective tariffs.

Activity 6.4: NERC will hold a 1 day Roundtable discussion with invitations to the Gas Industry, Government, Parliamentary representatives and the ECD to discuss the options and recommendations on social protection schemes and the costs and benefits of moving towards cost-reflective tariffs in the Gas sector. Based on the results of the Roundtable NERC will propose concrete recommendations to improve the existing social protection scheme infrastructure. The discussion and recommendations will be annotated and published on NERC’s website in English and Ukrainian before completion of the project.

41 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Component 7: Selected support on an effective Legal and Functional Unbundling process Activities Measurable Indicators Means of verification Assumptions Activity 7.1: The MS STEs, working with the GRWG, will develop 1. No of meetings/participants 1. Meeting minutes 1. NERC remains committed to recommendations for a methodology to unbundled the costs and 2. No of Guidelines 2. Interim Reports of PL legal and functional revenues in the distribution and supply activities under the Regulated 3. No of training programmes 3. PSC Meeting minutes Unbundling of the Gas Sector. Tariff regime with the aim of avoiding cross-subsidies between the 4. No of participants in training 4. No of Feedback evaluation 2. Staff able to attend Training distribution and supply licensees under a regulated tariff programme sheets (training) Workshops 5. No of mandays by STEs 3. Time & Resources Activity 7.2: To support NERC in its understanding of and capacity to commitments are properly monitor the unbundling process, the MS STEs will undertake training managed on the unbundling requirements of the EU Gas Directive and the approach to approximating these provisions into Ukrainian legislation.

Activity 7.3: The MS STEs will draft Guidelines for NERC to use as a set of procedures to effectively monitor the legal and functional unbundling requirements of the 2003 EU Directive and how Companies can comply with them.

42 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Annex 2: Indicative Project Implementation Schedule

Implementation of Twinning Activities by Month Months M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 Activity 1.1 Activity 1.2 Activity 1.3 Activity 1.4 12 months maximum language training Activity 2.1 Activity 2.2 Activity 2.3 Activity 3.1 Activity 3.2 Activity 3.3 Activity 3.4 Activity 4.1 Activity 4.2 Activity 4.3 Activity 4.4 Activity 5.1 Activity 5.2 Activity 5.3 Activity 6.1 Activity 6.2 Activity 6.3 Activity 6.4 Activity 7.1 Activity 7.2 Activity 7.3 RTA arrival Project Preparation Project Start Qtrly Reviews Legend Component 3 Component 5 Component 7 Component 4 Component 6 Contingency

43 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Annex 3: List of relevant Gas Sector Legislation and Resolutions

Name of Law Description/Focus Date of Law passed

Presidential Decree # 853 Gas market reform 19 Aug 1997 objectives/gradual separation of activities

PD# 151 On reforming Oil & Reformation of the Oil and gas 25 Feb 1998 Gas Complex Sector

CoM Resolution#747 Establishment of Naftogaz as 25 May 1998 JSCo

CoM Resolution#1173 Establishing subsidiaries taking 24 July 1998 on separate activities (production, transport, storage and selling)

PD 1257/98 Established licencing of gas 17 Nov 1998 activities (storage, supply, transportation)

Law on Oil & Gas Storage & Trunk pipeline 12 July 2001 regulation

Law on Pipeline transport Law creates legal framework for 15 May 1996 trunk and distribution pipelines for transporting gas among others). Privatisation of gas pipelines is prohibited

Law on Licencing some Types Sets out the need for licencing 1 June 2000 of Economic Activity of transportation, storage, supply of the natural gas and oil transportation

Law on Natural Monopolies Sets out state regulation of 20 April 2000 and PD 335/98 natural monopolies 21 April 1998

Law on Protection of Procedures for determining 11 January 2001 Economic Competition monopolies, anti competitive activities, market concentrations, exemptions

CoM Resolution# 1729 About provision of customers 27 December 2001 by natural gas

44 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Name of Law Description/Focus Date of Law passed

CoM Resolution#1697 Concerning the improvement of 8 December 2006 gas supply mechanism for residential customers

Order # 79 of Naftogaz Procedures for access to gas 26 March 2001 Ukraine transportation network

NERC Resolution #90 Adoption of licence’s conditions 30 September 2005 for storage of natural gas

NERC Resolution# 856 Trunk transportation pipelines 30 Sept 2005 regulation business conditions on Gas and Oil transportation

NERC Resolution #859 Adoption of licence’s conditions 30 September 2005 for gas distribution business

NERC Resolution #73 Adoption of licence’s conditions 25 August 2005 for suppliers at the Non- Regulated Tariff

NERC Resolution #693 Adoption of licence’s conditions 25 August 2005 for suppliers at the Regulated Tariff Law on Prices & Pricing and Set out NERC powers to 3 December 1990 CoM Resolution #1548 regulate gas storage, transportation, retail prices and 25 December 1996 supply for gas, price cap for residential and budget organisation

NERC Resolution #1682 Sets out single tariff on trunk 19 December 2006 and distribution pipelines

NERC Resolution#701 Sets out pricing methods for 22 June 2000 pumping and storage tariffs

CoM Resolution # 424 Set out NERC’s price regulation 8 June 2005 of Gas Transmission

NERC Resolution #984 Sets out pricing methodology to 4 Sept 2002 gas trunk transmission tariffs

Law on Comprehensive This programme outlines 7 February 2002 Programme on establishing measures for improving transit Ukraine as a Transit Country in along different infrastructure. 2002-2010 Proposes reconstruction and

45 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Name of Law Description/Focus Date of Law passed modernisation of gas pipelines

(among oithers) CoM-659 Comprehensive Action plan of Comprehensive Programme on establishing Programme on establishing Ukraine as a Transit Country in Ukraine as a Transit Country in 16 November 2002 2002-2010 2002-2010 implementation

46 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

Annex 4: List of the Acquis Communautaire (Energy)

The key elements of the Acquis comprise Treaty provisions and secondary legislation concerning in particular competition, state aid and the Internal Energy market (IEM) (including directives on electricity, gas, price transparency, gas and electricity transit, hydrocarbons, licensing, emergency preparedness including security stock obligations, nuclear energy, energy efficiency and environmental rules).

• EU Treaty of Rome 1957 (originally the energy sector was not mentioned in the EC Treaty. As a result of the Maastricht Treaty on European Union for the first time some energy policy provisions were explicitly included).

• Treaty on European Coal and Steel Community (ECSC), (April 1951) - (created the first common energy market for coal and steel with common objectives and institutions. It also marked the start of European integration. The objectives included ensuring that consumers had equal access to production sources, offering undertakings incentives to improve their production potential and promoting the development of international trade). (Certain practices were declared incompatible with the common market, such as import and export duties or discriminatory and restrictive measures. At present state aids under Article 95 of the ECSC Treaty are possible only when they contribute to further progress towards greater competitiveness (with the aim of dismantling such aids), solving social and regional problems caused by reduced production or promoting the introduction of environmental protection standards in the coal industry.)

• Treaty on European Atomic Energy Community (EAEC) (Mar 1957) - (was to bring together the efforts which had previously been made by the individual Member States to promote nuclear power and to facilitate the development of an effective nuclear industry by creating new institutions on the territory of the Member States. Euratom loans are also now being used to improve the safety and efficiency of nuclear power stations in some countries of central and eastern Europe).

• Trans-European Energy Networks provisions, labeling appliances, efficiency standards for rational use of energy, renewable energy and innovative energy technologies, see Communications (i.e. for Synergy, SAVE, Altener and Joule-Thermie programmes).

• Council Directive 90/547/EEC of 29 October 1990 on the transit of electricity through transmission grids. • Council Directive 91/296/EEC of 31 May 1991 on the transit of natural gas through grids. • Commission Directive 95/49/EC of 26 September 1995 updating the list of entities covered by Directive 91/296/EEC on the transit of natural gas through grids. • 96/391/EC :Council Decision of 28 March 1996 laying down a series of measures aimed at creating a more favourable context for the development of trans-European networks in the energy sector. • 736/96/EC Council Regulation of 22 April 1996 on notifying the Commission of investment projects of interest to the Community in the petroleum, natural gas and electricity sectors. • Decision no.1 254/96/EC of the European Parliament and of the Council of 5 June 1996 laying down a series of guidelines for trans European energy networks. • Commission Regulation No 23 86/96 of 16 December 1996 applying Council regulation No

47 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

736/96 of 22 April 1996 on notifying the Commission of investment projects of interest to the Community in the petroleum, natural gas and electricity sector. • Directive 96/92/EC of the European Parliament and of the Council of 19 December 1996 concerning common rules for the internal market in electricity (OJ L 027 30.01.1997 p.20). • Decision No.1 047/97/EC of the European Parliament and of the Council of 29 May 1997 amending Decision No.1 254/96/EC laying down a series of guidelines for trans European energy networks. • Directive 98/34/EC of the European Parliament and of the Council of 22 June 1998 laying down a procedure for the provision of information in the field of technical standards and regulations. • Directive 98/30/EC of the European Parliament and of the Council of 22 June1998 concerning common rules for the internal market in natural gas (OJL/204, 21.0, p.1). • Directive 98/48/EC of the European Parliament and of Council of 20 July 1998 amending Directive 98/34/EC laying down a procedure for the provision of information in the field of technical standards and regulations. • 1999/791 /EC: Commission Decision of 8 July 1999 concerning the application of the United Kingdom of Great Britain and Northern Ireland for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1 999) 1551/1) (OJ L 319 11.12.1999 p.1). • 1999/792/EC: Commission Decision of 8 July 1999 concerning the application of France for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/2) (OJ L 319 11.12 1999 p.6). • 1999/793/EC: Commission Decision of 8 July 1999 concerning the application of Luxembourg for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/3) (OJ L 319 11.12 1999 p.12). • 1999/794/EC: Commission Decision of 8 July 1999 concerning the German application for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/4) (OJ L 319 11.12 1999 p.18)

• 1999/795/EC: Commission Decision of 8 July 1999 concerning the Austrian application for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/5) (OJ L 319 11.12 1999 p.30). • 1999/796/EC: Commission Decision of 8 July 1999 concerning the application of the Netherlands for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/6) (OJ L 319 11.12 1999 p.34). • 1999/796/EC: Commission Decision of 8 July 1999 concerning the application of the Spanish Government for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/7) (OJ L 319 11.12 1999 p.41).

48 EU TACIS – Regulatory and Legal Capacity Strengthening of Natural Gas Regulation in NERC ______

• 1999/796/EC: Commission Decision of 8 July 1999 concerning the Danish application for a transitional regime under Article 24 of Directive 96/92/EC of the European Parliament and of the Council concerning common rules for the internal market in electricity (notified under document number C(1999) 1551/8) (OJ L 319 11.12 1999 p.41). • Decision No.1720/1999/EC of the European Parliament and of the Council of 12 July 1999 adopting a series of actions and measures in order to ensure interoperability of and access to trans-European networks for the electronic interchange of data between administrations (IDA). • Directive 2000/55/EC of the European Parliament and of the Council of 18 September 2000 on energy efficiency requirements for ballasts for fluorescent lighting (OJ L 279 01.11.2000 p.33). • Directive 2001/77/EC of the European Parliament and of the Council of 27 September 2001 on the promotion of electricity produced from renewable energy sources in the internal electricity market. • Green Paper, Final Report, Communication from the Commission to the Council and the European Parliament. Final Report on the Green Paper “Towards a European Strategy for the security of energy supply” 26.6.2002, COM (2002) 312 final. • Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity and repealing Directive 96/92/EC. • Regulation (EC) No 1228/2003 of the European Parliament and of the Council of 26 June 2003 on conditions for access to the network for cross-border exchanges in electricity (Text with EEA relevance). • Directive 2003/55/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in natural gas and repealing Directive 98/30/EC. • Conclusions of all sessions of the European Electricity Regulatory Forum (Florence Forum). • Conclusions of all sessions of the European Gas Regulatory Forum (Madrid Forum). • Conclusions of all sessions of the South East Europe Electricity Regulatory Forum (Athens Forum). • Presidency conclusions of the Lisbon European Council, 23 and 24 March 2000. • Energy Community of South East Europe (ECSEE) Treaty (signed 25 October 2005).

49