Tuesday, 9 February 2016

Why did EBRD hardly manage to get Ukraine off a so-called gas needle?

The process of the EU-Ukraine Association is nearing completion of an important stage. Most member states have already ratified the Association Agreement. However, the number of problems related to Ukraine have by no means become smaller. On April 6, 2016, the Dutch voters will answer the question "Are you for or against the law approving the treaty of association between the European Union and Ukraine?" Opinion polls show that turnout will exceed expectations, and the majority will vote against. A recent Maurice de Hond poll revealed that 73% of the Dutch population are willing to vote against the association with Ukraine. Greece gave a similar signal delaying the ratification process.

It would seem that these two European countries are very different in terms of their present economic situation. At the same time, apparently, there is an equal understanding in both states regarding the association with Ukraine that they don't think it's fair to use your own people's money to subsidize a country that's shown itself to be really bad at basic state functions.

Now, the criticism of the Government of Ukraine from Brussels is stronger as well as requirements to solve more actively the pressing economic problems. Ukraine for its part behaves itself as if there is nothing to bother responding appropriately to what was said, and continues to ask for more and more money.

The issue about continued financing has become a permanent part of the agenda at talks of the European Commission with Ukraine

When Vice-President for Energy Union Maroš Šefčovič was in Davos for the World Economic Forum 2016, he held bilateral meeting with Natalia Jaresko, Ukraine's Minister of Finance. One could easily predict that this time as usual Natalia Jaresko at the talks in Davos raised questions about financing of the state-owned company "Naftogaz" and granting aid for support of macroeconomic stability in Ukraine.


EBRD First Vice-President Phil Bennett and Minister of Finance of Ukraine Natalie Jaresko signed a government guarantee agreement on EBRD loan

A noteworthy detail is that financing of the state gas monopoly "Naftogaz" was that particular question, which was brought to the forefront of many other problems. This has happened despite the alleged success achieved in the gas sector of Ukraine. Ukraine's President Petro Poroshenko, mentioning the key achievements of 2015 during the first press conference in the new year, said, "We got off of the Russian gas needle."

Indeed, the supplies of Russian gas to Ukraine, which had been ongoing for decades, were stopped in autumn of last year. Let us recall that the Russian company "Gazprom" halted gas supplies to Ukraine on November 25, 2015 because Kyiv did not make advance payments for gas. This took place despite the fact that the prepayment for gas was one of the terms of a binding protocol to secure gas supplies for the winter period from the 1st of October until the end of March 2016 signed by the European Commission together with Ukraine and Russia.

Given the situation, we can readily draw the conclusion that the actual reason for the declared getting off "the gas needle" and refusal to perform the protocol, for which the European Commission had spent so much effort, is rather ordinary. There were no necessary financial means for Ukraine's gas purchases in Russia.

Getting off the gas needle Ukraine is directly descending into the financial noose
However, the main intrigue is that Ukraine decided not to purchase gas from Russia not only because of the lack of its own funds, but also in conformity with the conditions put forward by European lenders. October 23, 2015, in Berlin EBRD First Vice-President Phil Bennett and Ukraine’s Minister of Finance Natalie Jaresko signed a government guarantee agreement on EBRD loan to finance the purchase of gas of the company "Naftogaz". According to media reports, the funds in the amount of $ 300 million are intended for the purchase of about 1 bcm of gas on the western border of Ukraine. In short, the condition of the loan, if the money comes from Europe, in this case gas should be from here too.

It is also specified in the Berlin Agreement that within three years the company "Naftogaz" may partially return the loan and then again re-borrow this amount. Thus, within three years the EBRD provides Ukraine with an opportunity to repay partially its debt and borrow new funds. In principle, it may only aggravate the already deteriorating state budget and the rising public debt in Ukraine. It will tighten even worse the financial noose around Ukraine.

Among other things, we must not forget that the EBRD money, before returning to the European gas traders will have to go through the maze of corrupt Ukrainian state gas monopoly as it was publicly acknowledged by past court cases. Obviously, with this in mind, the Bank is trying to insure itself, putting prerequisite for the provision of the loan that the Government of Ukraine should implement the Action Plan on corporate governance reform in the company "Naftogaz". According to this plan a corporate restructuring at "Naftogaz" envisages the creation of a supervisory board of five directors in which there are only two to be appointed by the Government of Ukraine. The other three members of the Board have got a status of independent directors. Candidates for the supervisory board's independent members will be selected with the assistance of the Odgers Berndtson Group, which is engaged in the executive recruitment and international executive search. It is important to underline that the Odgers Berndtson's services will be paid by the EBRD, which is evidently very interested in introducing their tried-and-trusted representatives to monitor operations of the company "Naftogaz".

However, many would probably agree that it would be less risky to do the opposite - first get rid of the old corporate structure of the company replacing it by a new one, and only after that to lend the money.

Financial noose is really bad, but the reverse gas noose may be even worse

None of us would be surprised by the EBRD's special concern for future of its assets. However, who should consider the public interests in this case? A general question, which arises here, is how much the EU citizens should worry that Ukraine would continue sinking into bankruptcy with the growing sovereign debt. On the one hand, this is bad, that there is a clear risk of debt accumulation up to the point when Ukraine as a chronic borrower will be even heavier hanging on our pockets for a long time asking for more and more new loans and trying to restructure the old ones. In fact, this can turn into a kind of hole in the pocket, which will make the EC countries lose money that are especially necessary now in order to overcome the worst migration crisis, not to mention many other problems.

Meanwhile, this does not confine just to the grim prospects for emergence of such "a hole in the EU countries pocket". Because, on the other hand, the attempts to justify the gas purchases by Ukraine on the border with the EU by referring to allegedly more competitive prices do not look convincing. According to www.oilprice.com, the average price of both EU and Russian gas imported to Ukraine in the third quarter of 2015 fell by 2 USD from the previous quarter to 226 USD per 1,000 cubic meters.

We should not lose sight of the geographical origin and particular technical transmission of reverse gas eastward across the western border of Ukraine. It is the same Russian gas from the Ukraine's transit pipelines, which European traders purchase and then resell back to Ukraine. There is no question that conducting gas reverse flows to Ukraine is a profitable business for Slovakia's Eustream, Germany's RWE or the other European gas supply companies. They have gained a good opportunity for making money thanks to the loan provided the EBRD to Ukraine.

However, it is clear that the reverse supply of gas from Europe may continue as long as the money of the EBRD loans or other lenders are available. This reliance on external loans indicates that the reverse gas supplies for European companies can hardly be regarded as a strategic business because as soon as financial support runs out, such a business will be over too. The consequences of such a "game of reverse gas" might be more unfortunate for the EU countries receiving Russian gas by transit through Ukraine.

The pursuit of reverse operations will lead to strategic miscalculation in ensuring security of supply

The matter in question is related to the basic characteristics of the Ukrainian gas transport system. Particular attention should be paid to that the gas transit pipelines in Ukraine were designed in the Soviet times to transport gas in one direction only - from the east toward the EU border. These pipelines are similar to single-track railways. There are no second strings through the Ukraine's territory for reverse flow of gas. Therefore, reverse gas may not actually achieve Ukrainian consumers. The special short pipelines were built across the border to ensure reverse flow of gas. They are connected to the main transit pipelines in two places. The first connection is in the EU in order to take gas for reverse flow while the second connection is on the Ukrainian side of the border, where this reverse gas comes back to the transit pipeline over and over because there is no further route deep into the territory of Ukraine. This reverse circuit forms a cross-border ring of pipes, compressors and other equipment, where gas can circulate as much as long.

Probably you are curious to find out how in this case Ukraine meets its domestic needs for gas, if the reverse scheme is not capable to do it. Russian gas that passes through the Ukrainian territory under transit agreements for the EU imports are used for internal consumption in Ukraine. In this case, offtake of transit gas from Russia is compensated by means of returning to Europe that reverse gas, which is purchased on the EU border under the EBRD loan.

Undoubtedly, circular transmission of gas inside a cross-border "multi-reverse" ring requires certain costs. Someone, of course, may argue that in theory it would be cheaper just to divide the funds earmarked for gas purchases, between European traders on the western border and the Russian supplier on the east instead of carrying these additional costs for a physical multi-reverse of gas. However, that would contradict one of the basic terms of the EBRD loan, which, as we remember, determines the place of gas purchases from the EU on the western border of Ukraine.

This means that the EBRD loan granted to Ukraine with the condition of gas purchasing only on the EU border can just contribute to stability of gas supplies temporarily, but does not address the key issues related to long-term balanced provision of Ukrainian consumers with natural gas. In addition, the loan conditions ruled out the possibility of choosing between gas purchases on the western and the eastern border of Ukraine based on price competition that therefore turns to an additional competitive advantage for our European gas traders.

Let us imagine what would happen if the agreement between Russia and Ukraine on gas transit to Europe is not prolonged after 2019, when the current transit agreement expires. In that case on one hand a transit gas will not be longer available for domestic consumption in Ukraine and on the other hand this country will be able to apply the transit pipeline system vacated after 2019 for transporting gas from Europe. However, the question arises, where European traders will take gas for Ukraine in the absence of transit gas from Russia, as the reversal circuit on the border will become useless. Potentially, it is possible to provide gas supplies to Ukraine from other sources, but that will push the prices up and would be fatal to Ukrainian economy suffering badly from poor creditworthiness.

Here is the conclusion that without transit flows of Russian gas to Europe it will be much more expensive to ensure constant gas supplies in Ukraine over a long period. Is that not a strategic miscalculation that we are going to welcome Ukraine as a new associate member of the EU taking on ourselves in addition to everything else its huge burden of outstanding issues on financing of energy supplies? As regards the EU security of gas supply through the Ukrainian transit route, without Russian gas this problem will disappear by itself.

It is apparent that in reality Ukraine is unable "to get off the gas needle" or, to be exact, off the transit gas pipeline system, to which this country has been rigidly tied throughout history of gas supplies from Siberia to Europe.

Why does Brussels instead of openly admitting the growing problems of gas supplies to Ukraine, just push up the Ukraine's public debt, thereby only delaying a proper response to these growing challenges?
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