2. Stocktaking of Ukraine’s Policy Framework for Investment in the Energy Sector
This chapter reviews Ukraine’s current policy and regulatory framework for investment in the energy sector, including key policy reforms implemented to support the country’s integration with Europe’s energy markets. The chapter assesses the laws, regulations and incentive schemes that the government has adopted to operationalise the Energy Strategy of Ukraine until 2035 and to improve the country’s energy efficiency, security and competitiveness. It evaluates the challenges faced by private investors in the upstream, midstream and downstream energy industries and provides recommendations to address them.
Ukraine has undertaken a wide range of institutional, economic and regulatory reforms to increase the role of market forces in the energy sector and advance its integration with the European Union. Some of these reforms have been based on the commitments that Ukraine acquired by becoming, in 2011, a Contracting Party to the Energy Community Treaty, namely the legislative frameworks that enable private participation in the electricity and gas sectors. Additionally, in 2017, the government launched the “Energy Strategy of Ukraine until 2035” (ESU 2035) as an overarching policy to increase the share of renewables in the energy mix, and to achieve energy efficiency, security, competitiveness and greater integration with the EU energy space.
Ukraine has worked hard to reform its power and gas sectors by opening the energy industry to private investments, but the transformation of the country’s energy sector to a fully-fledged competitive energy market remains incomplete. Although the government has increased the participation of private investors and opened the electricity and gas markets, both industries remain largely distorted by a range of regulatory measures, including price caps, cross-subsidisation, non-transparent calculation of imbalances and heavy participation of state-owned enterprises. Ukraine has the capacity to reduce market distortions by reforming certain elements of the power and gas market designs that currently undermine competition, such as deregulating prices for households.
Ukraine is at a critical juncture in terms of advancing policies that will put the country on a path to achieve sustainable development and carbon neutrality. Ukraine’s biggest challenges to unlocking the private investments to finance sustainable energy projects that will lead to sustainable development and carbon neutrality are the regulatory and financial uncertainty faced by renewable energy producers, along with direct subsidies for coal-fired power generation, which in 2019 reached EUR 476 million. The recent and rapid increase of renewable energy capacity due to generous feed-in tariffs created financial and operational challenges for the power sector, including fast accumulation of arrears and legal disputes that increased the perception of risk among investors. These issues notwithstanding, the government has an opportunity to transform the energy sector into a green and sustainable industry by advancing policies that foster investments in renewables, energy efficiency and disruptive energy technologies. Specifically, Ukraine should strengthen policies and regulations that promote the use of auctions for renewable energy, the adoption of incentives that allow higher flexibility in the energy market, the introduction of new technologies like green hydrogen, bio methane or battery storage, the enhancement of ancillary services; the reduction of its dependence on coal, and the synchronisation of Ukraine’s electricity and gas systems with European markets by 2023. The adoption of these policies would enable the full synchronisation of Ukraine’s energy sector with the EU and imply the adherence to the objectives of the European Green Deal, which seeks to make Europe the first carbon-neutral continent.
The policies that Ukraine designs and implements to attract private investments should consider the impacts of the COVID-19 crisis on the energy sector. Utilities and Transmission System Operators (TSO) of electricity and gas, which were already burdened by incomplete sectoral reforms prior to the pandemic, have faced revenue shortfalls due to falling demand, price caps and reduced collections from residential and commercial users. Hence, receiving technical support, both in terms of policy design and implementation, as well as financing from the European Union, IFIs and other bilateral partners will be key for advancing essential reforms that could help to foster investments in Ukraine’s energy sector.
Investment in Ukraine’s energy sector takes an important place in the country’s FDI
FDI has been playing a prominent role in Ukraine’s economic development. According to the most recent World Bank data on FDI, in 2019, net FDI inflows amounted to USD 5.8 billion, equivalent to approximately 3.8% of the country’s GDP.1 In addition, the energy sector is one of the most attractive sectors for investment. For instance, in the 2020 World Investment Report, the main sectors attracting FDI in Ukraine in 2019 were mining, electricity, and gas along with real estate, finance, and information and communication technologies. In addition, in 2017, approximately USD 250 million were invested in Ukraine in solar energy, which is almost double the solar energy investment for 2016.2
Energy production and consumption
Ukraine’s energy sector boasts abundant coal, natural gas and produces all fossil fuels. In 2018, the country produced 14.4 million tonnes of oil equivalent (Mtoe) of coal, 16.5 Mtoe of natural gas and 2.3 Mtoe of crude oil. The country’s total primary energy supply (TPES) was dominated by four energy resources: coal (30%), natural gas (28%), nuclear (24%) and oil (14%) (Figure 2.1) (International Energy Agency, 2020[1]).
Ukraine’s national energy production covers 65% of the country’s total energy demand. This notwithstanding, the country still needs to meet most of its oil and derivative demands through imports. Ukraine heavily depends on imports for around 83% of its oil consumption, 33% of its natural gas and 50% of its coal for industrial and coking usage. In 2018, Ukraine imported 8.5 Mtoe of natural gas, 13.8 Mtoe of coal and 10.4 of oil products (International Energy Agency, 2020[1]).
Source: (IEA, 2019[2])
Ukraine possesses substantial conventional and unconventional hydrocarbon resources. Proven reserves of natural gas equate to 1.1 trillion cubic meters (tcm), more than 400 million tonnes (Mt) of gas condensate and 850 Mt of oil reserves. Hydrocarbon resources in Ukraine are concentrated in three regions: the Carpathian region in the west, the Dnieper-Donetsk region in the east and the Black Sea-Sea of Azov region in the south (International Energy Agency, 2020[1]).The Dnieper-Donetsk region accounts for 80% of proven reserves and approximately 90% of gas production, while the Carpathian region has 13% of proven reserves and 6% of production. The remaining 6% of proven reserves are in the southern region, where production is conducted both onshore and offshore on the shallow shelves of the Black and Azov Seas (International Energy Agency, 2020[1]).
In 2019, the overall trend in oil production in the country remained negative and Ukraine continued to rely on oil imports to cover its national demand. The most important oil companies in Ukraine, Ukrnafta and Ukrgasvydobuvannya, are both part of Naftogaz Group and extract 90% of the total national share of production, however, they are characterised as having limited investment resources (Naftogaz, 2019[3]).
The Ukrainian petroleum market is heavily dependent on imports. In 2019, 75% of the domestic demand was met by petroleum imported primarily from Belarus and Lithuania. Since the petroleum market is import dependent, the price of petroleum fluctuates with the exchange rate and quotations for oil products on international exchanges (Naftogaz, 2019[3]).
In 2019, Ukraine was the fourth largest producer of gas among European countries (Naftogaz, 2019[3]). The country’s gross gas production amounted to 20.7 billion cubic metres (bcm). Ukrgasvydobuvannya, the main gas production company in the Naftogaz group, produced 13.6 bcm, Ukrnafta produced 1.2 bcm and private companies operating in the country reached a production of up to 4.6 bcm. While Ukraine is a major producer of gas, its national production does not meet the national consumption. Thus, 14.2 bcm of gas was imported exclusively from the European market, of which Naftogaz imported 50.2% and roughly fifty private companies imported 48.9% in 2019 (Naftogaz, 2019[3]).
Source: (Naftogaz, 2019[4])
Ukraine has the largest gas transit infrastructure in the world (International Energy Agency, 2020[1]). Historically, 40% of Russia’s gas supply to the EU has been supplied through Ukraine. In 2019, the transit volume in Ukraine was 89.6 bcm, which is 2.8bcm more than in 2018. However, there have been reductions in gas transit volumes since Gazprom decreased the annual amount of gas transit through Ukraine, from 90 bcm to 65 bcm (Naftogaz, 2019[3]). This decreasing trend will be exacerbated after the Nord Stream 2 and TurkStream pipelines are put into operation. These new pipelines pose risks for Ukraine’s energy sector as they divert traditional gas supply routes where Ukraine occupies a central position as transit corridor between Russia and Europe, although Germany has committed to support Ukraine’s energy transition as a remedy (Financial Times, 2021[5]). Ukraine has the second largest gas storage capacity in Europe (European Business Association, 2020[6]). The 13 underground storage facilities have a total working capacity of 30.9 bcm per year and Ukrtransgaz operates 12 of these facilities (Naftogaz, 2019[3]).
Ukraine’s abundant coal reserves account for more than 90% of their total fossil fuel reserves. However, a number of coal mines are currently in nongovernment-controlled areas (NGCA) and the government has no oversight or control over those assets. Reserves of anthracite and bituminous coal are estimated at 32 giga tons (GT), ranking Ukraine sixth in the world for hard coal reserves (International Energy Agency, 2020[1]). Most of the coal in Ukraine is produced in the Donbass region – Donetsk Coal Basin – located in eastern Ukraine, in the regions of Donetsk, Luhansk and Dnipro. However, intensive mining for more than a century in the Donbass region has exhausted the best deposits (CMS, 2020[7]).
Traditionally, the mix in the electricity sector in Ukraine consisted of coal, nuclear, and hydropower, but a rapid increase in the share of renewable energy has taken place in recent years. Of the total installed power generation capacity, estimated at 54.3 GW, about half (27.9 GW) consists of thermal power plants (TPPs), with coal-fired power plants accounting for 90% of the TPPs. Nuclear power plants (NPPs) account for 26.7% (13.8 GW) of the installed capacity, while hydro power plants (HPPs), including pumped storage HPPs, represent 12% (6.3 GW) of the total installed capacity. Overall electricity production in 2019 was 154.0 TWh, of which 150.2 TWh was consumed domestically while electricity exports and imports were 6.5 TWh and 2.7 TWh, respectively. Four nuclear power stations comprising 15 reactors supply more than half of Ukraine’s total electricity. The remaining electricity comes from coal fired TPPs (30%), natural gas fired combined heat and power (CHP) plants (8%), and HPPs (7%) (World Bank, 2020[8]).
Upstream Oil and Gas sector
Ukraine’s Law on Oil and Gas provides the legal conditions for companies to participate in the oil and gas industry, as well as defining the regulatory basis of oil and gas exploration, production, transport, storage and the use of oil and its derivatives. The Law mandates that corporations should govern their upstream activities in accordance with the Subsoil Code of Ukraine and the Law on Production Sharing Agreements (Government of Ukraine, 2004[9]).
The Law on Oil and Gas establishes that companies holding permits to extract oil and gas have the right to search and explore new deposits within the subsoil area allocated in the permit. These explore and production (E&P) permits shall be granted through an auction process by the State Service for Geology and Subsoil of Ukraine (SSGS). It is possible to be denied a permit if the SSGS determines that the company does not meet the requirements of the tender, however, the E&P permits can only be deemed invalid if declared so by a competent court. Suspension and revocation of E&P permits are determined by the SSGS under a series of longstanding provisions. If a suspension or revocation action is enforced, affected companies have the legal right to challenge the authority’s act in court (Government of Ukraine, 2004[9]).
In March 2018, the Parliament of Ukraine, Verkhovna Rada, passed a Law on Deregulating the Oil and Gas Industry (Government of Ukraine, 2018[10]). This law simplifies the regulatory procedures in the country’s oil and gas sector, unlocking private investments and increasing the production of hydrocarbons, so that Ukraine can achieve energy security. It streamlines permits for the extraction of oil and gas, simplifies land allocation by introducing a new type of easement for the construction of oil and gas extraction facilities and cancels certain fees for the extension or reissuance of special permits for subsoil use.
Although some reforms have been implemented in the oil sector, the country still lacks legislation on stockpiling oil, as is required by the Energy Community Treaty. Ukraine relies heavily on oil imports from neighbouring countries to meet its national demand. Crude oil imports, sourced increasingly from Azerbaijan and Kazakhstan, supply the country’s sole operating refinery, the Kremenchug facility (US Energy Information Administration, n.d.[11]). Considering that Ukraine only has a small stockpile of oil, a limited production of oil barrels per day and the fact that it imports 90% of its oil consumption (International Energy Agency, 2020[1]), it is imperative to approve stockpiling regulations. The availability of oil reserves will help create a stable and efficient internal market of oil and its derivatives. Additionally, it will regulate the use of strategic oil stockpiles in case of a supply disruption or any mandates enforced by the State Reserve Agency.
Natural Gas Market
In 2015, the Law on Natural Gas Market was enacted with the objective of harmonising Ukraine’s gas sector with the EU principles (EU Neighbours, 2018[12]). The participants in the natural gas market in Ukraine, in accordance with the law, are the gas transmission system operator (GTSOU), gas distribution system operator, gas storage facilities operator, LNG installation operator, wholesaler, wholesale buyer, supplier and consumers (Government of Ukraine, 2015[13]).
The law sets the regulatory basis for the unbundling of storage, LNG terminals and distribution system operators, if they were part of a vertically integrated undertaking. Moreover, the law creates private sector access to gas transmission, distribution and supply networks. Allowing private companies to sell gas to any consumer, including households (Government of Ukraine, 2015[13]). The Law on Natural Gas Market ensures equal rights to access gas transmission and distribution systems, LNG installations and gas storage facilities, ultimately allowing private companies to participate in the wholesale and supply markets (Government of Ukraine, 2015[13]). This law requires companies to obtain a licence from NEURC if they want to perform economic activities related to transport, distribution, storage, supply and management of LNG installation services. The only activity that does not require a licence is wholesaling and purchasing gas. It also mandates companies willing to participate in exploration and production activities to obtain licences, permits or a production sharing agreement (PSA).
In order to operationalise their gas transmission system, gas distribution system and gas storage codes, which set the basis for standard natural gas transmission, distribution and storage contracts, Ukraine adopted new reforms in 2015 (Government of Ukraine, 2015[14]) (Government of Ukraine, 2015[15]). Additionally, to effectively liberalise the gas market, the Ukrainian National Energy and Utilities Regulatory Commission (NEURC) set competitive transit, storage and distribution gas tariffs, which are comparable to those in Western and Central Europe.
In March 2019, NEURC successfully implemented one of the key reforms in the gas industry of Ukraine, as the natural gas market switched from monthly to daily balancing. To increase transparency, GTSOU launched an online information exchange platform to enable daily balancing. This makes it possible to determine the differences between gas input and output, to and from the transmission system (Energy Community Secretariat, 2019[16]). Daily balancing incentivises gas companies to self-regulate their own imbalances, which has a positive impact on the development of the wholesale gas market, thus, increasing the attractiveness of Ukraine’s gas industry to investors (NEURC, 2019[17]).
In January 2020, after five years of constant reforms, the unbundling of the gas sector was completed. From this date, natural gas transportation activities were no longer performed by the SOE Naftogaz. The Ukrainian transport system is now operated by a new state-owned company, Gas Transmission System Operator of Ukraine (GTSOU), which was unbundled from Ukrtransgaz in line with EU market principles. GTSOU is a wholly owned subsidiary of JSC Main Gas Pipelines of Ukraine, which is owned by the Ministry of Finance. With the unbundling, Ukrtransgaz is the gas storage facilities operator and GTSOU is only engaged in natural gas transmission.
GTSOU and Naftogaz confirmed that private companies are able to book transit capacity in the pipelines (US-Ukraine Business Council, 2020[18]). Moreover, the gas market reform has prompted the participation of private companies in Ukraine’s mid and downstream gas activities. NEURC informed that, in 2019, 347 private companies were operating in the wholesale market, 408 companies in transmission activities and 449 corporations in storage (NEURC, 2019[17]).
Undoubtedly, one positive effect of the Law on Natural Gas Market is increased competition with the entry of new players, including foreign ones such as the German companies RWE and Uniper, Polish incumbent PGNiG and Swiss trading companies Axpo and DXT Commodities (Atlantic Council, 2020[19]).
Coal Extraction
The 1999 Law on Mining allows private and public companies to operate coal mines by obtaining a special permit (licence) for subsoil use, which is issued in accordance with the Subsoil Code. In addition, the Law on Mining foresees the possibility of privatising mining assets at the request of the State Property Fund and the approval of the Cabinet of Ministers (Government of Ukraine, 1999[20]).
Restructuring Ukraine’s coal industry has been more difficult and politicised compared with other energy sub-sectors. In the past two decades, the government has managed to close several highly uneconomic coal mines, but more actions are necessary to transform the country from a coal-based economy to a carbon neutral one. According to the Energy Strategy of Ukraine until 2035, Ukraine envisaged reforming the coal sector by closing unprofitable mines, doing transparent and competitive privatisation, and establishing coal markets. Unfortunately, this has not happened at the planned time (Energy Community, 2020[21]). As a consequence, of the 300 mines that Ukraine possesses, profitable ones in the past have been either privatised or transferred to long-run concessions, predominantly to DTEK. The remaining mines are owned by SOEs whose operations are subsidised by the state of Ukraine (International Energy Agency, 2020[1]).
Electricity Generation and Transmission
Power generation and transmission in Ukraine have a strong participation of state-owned enterprises. Regarding electricity generation, Ukraine owns and manages all Nuclear Power Plants (NPPs), which are operated by the state-owned company Energoatom. Similarly, all major Hydro Power Plants belong to the fully state-owned joint-stock company UkrHydroenergo. Thermal Power Plants (TPPs) are grouped into five regional companies - Donbassenergo, Dniproenergo, Centrenergo, Zakhidenergo, and Skhidenergo. Only Centrenergo is still under state control, while a majority of the shares from the other four TPPs are owned by DTEK. Until 2018, renewable energy (RES) generated by private investors accounted for a small portion of the electricity produced, but generous Feed-In-Tariffs for RES with no capacity caps resulted in over 8 GW of RES capacity being installed by the end of 2020. Concerning electricity transmission, the national transmission network is owned by the state and operated by the state-owned Electricity Transmission System Operator (ETSO) Ukrenergo.
Wholesale Electricity Market
Since the mid-1990s, the government has begun working towards the creation of a wholesale electricity market and to unbundle electricity generation, transmission and distribution (OECD, 2019[22]). In 2017, the Law on Electricity Market was adopted to further reform the power sector. This law was designed to comply with the EU’s Third Energy Package and to integrate Ukraine’s Electricity Transmission System Operator (ETSO) into the European Network of Transmission System Operators for Electricity (ENTSO-E).
The Law on Electricity Market sets the rules to assist in making the power market more competitive; through introducing contracts in the wholesale electricity market (WEM), adopting a market-based pricing structure, reinforcing unbundling, stressing the autonomy of regulators, securing the independence of the ETSO - Ukrenergo and promoting investment in infrastructure (Table 2.1). It legally replaces the single-buyer model, which had operated since 1996, with more competitive elements, including the establishment of bilateral contracts between market participants, along with day-ahead (DAM), intra-day (IDM) markets, balancing market, and ancillary service market, where participants can trade electricity freely. The law also stipulates the introduction of non-discriminatory tariff settings and free supplier choice (Government of Ukraine, 2017[23]). Although the Law on Electricity Market has set the regulatory basis for the new wholesale electricity market since 2017, it was not until July 2019 that Ukraine successfully switched from a single-buyer model to a new wholesale electricity market model.
Source: (OECD, 2020[24]) and (NEURC, 2019[17])
However, in June 2019, a judgment of the Constitutional Court declared several provisions of the Law to be unconstitutional, specifically those related to NEURC’s institutional set up and its independence (Energy Community, 2020[25]). On December 2019, the Rada adopted a new “Law on Amendments to Some Legislative Acts of Ukraine to Ensure Constitutional Principles in the Fields of Energy and Utilities”, transforming the energy regulator from an independent authority to a central executive body subordinated to the CMU. The amendments also transfer the rights to name NEURC’s leadership to the CMU. Regarding the ability to select the leading representatives of NEURC, the CMU integrated a committee including members of the Rada and the Ministry of Energy on June 2020, breaking the principle of independence required by the mandates of the EU acquis.
After the 2019 legal changes, NEURC was defined as a collegial body that supervises and controls the activities of business entities in the energy and utilities sectors. While performing its functions and powers, NEURC shall be free of influence from central authorities, local governments, business enitities, political parties, public associations, trade unions or any other entities. If any actor contravenes this principle, they are subject to administrative and criminal liability (NEURC, 2019[17]).
Source: OECD Snapshot on Energy Report (OECD, 2019[22])
The main tasks of NEURC are to ensure the effective functioning and development of markets in the energy and utilities sectors, to promote effective market opening in the energy sector to all suppliers and to ensure non-disciminatory access to networks and pipelines. Additionally, the NEURC promotes the integration of the electricity and natural gas markets of Ukraine with the European Union, which ensures the protection of consumers’ rights to goods and services in the fields of energy, of adequate quality and at reasonable prices. NEURC is also responsibe for promoting cross-border trade in electricity and natural gas and for ensuring investment attractiveness for infrastructure development, implementing pricing and rate policy in the energy and utilities sectors, as well as promoting the implementation of energy efficiency measures through the increase of energy production from renewable sources. This helps to create favourable conditions for attracting investments in the development of energy markets, while simutaneously promoting competition in the overall energy market (NEURC, 2020[26]). At this time, one of the most crucial roles of NEURC is to improve the mechanism of control over functioning of wholesale energy market segments to avoid any manipulations and abuse of market power. In this regard, Ukraine is set to implement European rules on wholesale energy market integrity and transparency as outlined in EU Regulation No. 1227/2011, commonly known as REMIT, which will provide NEURC with additional power and functions to identify and penalise the specific offences in the wholesale electricity and gas markets (CMS, 2020[27]).
NEURC has legal power to assign licences to companies that perform economic activities in the power, district heating, oil and gas industries. As of January 2020, NEURC had registered 2 412 valid licences, of which 1 462 were for the electricity sector, 679 for the oil and gas sector and 171 for district heating. Once licences are granted, NEURC conducts scheduled and unscheduled on-site inspections to business entities participating in the energy sector. In 2019, NEURC carried out 500 verifications of compliance, of which, 342 were planned and 258 were unscheduled (NEURC, 2019[17]).
Cabinet of Ministers of Ukraine: The ultimate decision-making body in Ukraine. It is responsible for policy co-ordination and oversight of state energy companies. It also sets the prices in the regulated markets of the energy sector. Energy policy is high on its political agenda, with the parliament and the president also involved in decision-making.
Ministry of Energy: Responsible for generating and implementing policies on the electricity, nuclear, coal, oil, and gas industries, as well as energy efficiency and renewable energy sources. The Ministry also exercises ownership rights in a number of energy SOEs, including, most recently, those of the transmission system operators – both electricity and gas.
Ministry of Environmental Protection and Natural Resources: Ensures the protection of natural resources, including the rational use of subsoil and the compliance with international commitments to preserve the environment.
Ministry of Finance: Responsible for taxation relevant to the energy sector and the ownership of certain SOE companies in the energy sector.
Ministry of Regional Development, Construction, Housing and Utilities Housing: Develops local-level policies and programmes on heating and is responsible for reporting estimated energy efficiency indicator (EEI) values to the SAEE.
Ministry of Economy: Creates programs and plans to achieve economic development, public-private partnerships, trade and investment that impact the energy sector.
State Agency on Energy Efficiency and Energy Saving: Under ME, is the central government body responsible for advancing energy efficiency and renewable energy developments, as well as promoting the deployment of energy-efficient and renewable energy technologies.
Anti-Monopoly Committee: Is a central body of executive power with special status responsible for protecting and promoting fair competition in the country’s business activities and public procurement, which also cover the energy sector.
State Nuclear Regulatory Inspectorate: Has regulatory responsibility for the operation of nuclear facilities, including uranium mining, radioactive waste storage and decommissioning at Chernobyl.
State Property Fund: Implements state policy regarding the privatisation of state property. Also exercises ownership rights in SOEs slated for privatisation.
State Service of Geology and Subsoil: Responsible for issuing special permits, such as subsoil licences, monitoring their compliance with legislation and imposing sanctions for infringement of subsoil use terms.
Source: Authors’ elaboration based on the OECD Snapshot on Energy Report (OECD, 2019[22])
Energy Pricing
Crude Oil and Gas Condensate
In accordance with Article 4 of the Law on Oil and Gas, companies extracting oil and gas condensate must sell crude oil and gas at exchange auctions, and selling prices should reflect global oil price trends.
Natural gas
In compliance with the Third Energy Package, NEURC introduced the Methodology for Determining and Calculating Tariffs for Natural Gas Transport Services for Entry and Exit points for the regulatory period 2020-2024 applicable to the GTSO of Ukraine. This enabled the GTSO to sign new interconnection agreements with all neighbouring transmission system operators, thus increasing interoperability and enabling the smooth flow of gas along all routes (Energy Community, 2020[25]). The calculation of tariffs for services of pumping, storage and extraction of natural gas is carried out in accordance with the Methodology for Determining and Calculating Tariffs for Services of Storage (or pumping or extraction) of natural gas. This pertains to gas storage facilities and the regulated access regime is applied for these calculations (European Commission, 2019[28]).
Regarding the pricing of natural gas in the wholesale market, Ukraine divides it into two segments: the regulated segment of the wholesale market, which encompasses actors under the regime of Public Service Obligations (PSO), and the unregulated segment of the wholesale market, which operates with free pricing and covers the needs of industry and trade sectors, and the energy sector’s own needs. The regulated wholesale price, in 2019, was UAH 207 per thousand cubic meters, or 4%, lower than the price in the unregulated segment of the wholesale natural gas market. Comparatively, in 2018, it was lower by UAH 3 353 per thousand cubic meters, or 39%. Thus, in 2019, the wholesale price in the regulated market segment began to approach the wholesale price in the free market, and at the end of the year the prices were almost at the same level (NEURC, 2019[17]).
Public Service Obligations limited the liberalisation of the wholesale and retail gas market because they required Naftogaz to buy volumes from local producers and sell them to household and district heating companies (DH) at regulated tariffs. It also prevented the state-owned gas company, Naftogaz, from selling gas directly to end users and forced it to provide gas to intermediaries (Atlantic Council, 2020[29]).
Naftogaz and private retail companies of gas had disagreements concerning retail market prices because certain retailers were making unauthorised offtakes of cheaper gas to producers. Ultimately, this involved paying a lower price due to a PSO but with the intention of selling the gas to non-regulated consumers at higher prices, including private manufacturing and steel companies. This practice has been blamed for distorting the daily balancing market, which is operated by GTSO (ICIS, 2020[30]).
Ukraine made headway in deregulating the gas sector, by unbundling its transmission systems and stimulating the establishment of a wholesale market. May 2020 was supposed to be the date when the natural gas market would take another step towards full liberalisation, as over 8 billion cubic meters of natural gas, representing 60% of the traded volume, would enter the free market. The government was expected to remove the PSO for protected consumers, such as households, religious establishments and district heating. Nevertheless, the CMU determined that the PSO for households would be extended until 1 August 2020 and for district heating until May 2021 (Ministry of Energy of Ukraine, 2020[31]).
In the energy sector, regulators and policy makers strive to achieve three major energy goals: i) competitiveness of energy markets; ii) security of supply; and iii) environmental sustainability. The European Union acquis has recognised that Public Sector Obligations are sector-specific tools that shall be used, as an exemption not as a rule, to provide services of general economic interest. Moreover, the EU acquis determined that countries have wide discretion to define PSOs in line with the needs of end users. It is therefore the responsibility of the state to define public services or services of general economic interest provided that the rules of Article 3(2) of Directive 2009/72/EC12 are observed (Energy Community, 2020[25]).
Consequently, the State’s discretion to define PSOs in line with national circumstances may be exercised only in full compliance with the acquis. Accordingly, while relatively free to define them, countries can use the public service obligations’ provision only in exceptional and clearly defined circumstances, provided that they satisfy the criteria indicated in the European rules and case law (Energy Community Secretariat, 2018[32]). Therefore, PSOs that are prone to constituting an obstacle to the realisation of an operational internal market in energy, shall be an exception and not the rule, and they shall not be invoked to cover purposeful deviations from mandatory internal energy market rules.
According to the EU acquis on electricity1 and gas2, the national legislation of Contracting Parties may impose PSOs on energy undertakings if such obligations relate to security of supply, regularity and quality, price of supplies, customer protection, and environmental protection, including energy efficiency, energy from RES and climate protection. The case law has determined criteria for assessing PSOs, as they should pursue a general economic interest, comply with the principle of proportionality, i.e., impose PSO only in so far as is suitable and necessary to achieve their objectives in the general economic interest and, consequently, for a period that is necessarily limited in time, and are clearly defined, transparent, non-discriminatory, verifiable and guarantee equal access for energy undertakings of the Energy Community to national consumers.
In Ukraine’s energy sector, PSOs are determined by the Ministry of Energy, according to the proposals of NEURC as the regulator, and submitted to the Cabinet of Ministers of Ukraine for approval.
← 1. Electricity Directive 2009/72/EC, article 3 (2).
← 2. Gas Directive 2009/72/EC, article 3 (2).
Source: Energy Community Secretariat, Ukraine – electricity Public Service Obligations Act 2020, May 2020 at ECS_CN032020; Energy Community Secretariat, Public Service Obligations: a black box case, August 2019 at SS2019_D4_secretariat_public_service_obligations_a_black_box_case.
The termination of the PSO in August 2020 for households and religious organisations entails the deregulation of gas supply prices. It is expected that this reform will encourage more retailers to enter the market. So far, the retail gas sector had been dominated by the Firtash group, which controls 70% of the market (Atlantic Council, 2020[29]). Another benefit of the PSO termination is the clampdown on unauthorised off-take of natural gas. To further transition into a fully liberalised retail market, on July 2020, the competition committee of the Ministry of Energy selected Naftogaz as the supplier of last resort for the retail market.
Although the government removed the PSO for households in August 2020, it reversed this advancement by approving gas price caps for households in January 2021, arguing that it was a necessary temporary measure valid until April 2021, with the intentions of counterbalancing the effects of COVID-19 (Government of Ukraine, 2021[33]). This change means a return to subsidies and an intervention in the retail prices, in contradiction with the conditions imposed by the International Monetary Fund (IMF) for the disbursement of financial credits to Ukraine.
Ukraine recently lifted the gas PSO for district heating companies, however, this is still pending (and represents 25% of the annual consumption). The gas for district heating remains under regulated prices and are not offered on the wholesale gas market but the PSO ceased to be in force as of May 20213, and the Public Service Obligations were withdrawn from Naftogaz (Energy Community, 2020[25]). Summing up this challenge, on April 2020, the Rada adopted Law 553-IX on Modifications to the State Budget of Ukraine according to which heat producers, regardless of ownership, were exempted from fines and penalties by gas suppliers of electricity and natural gas for the period of quarantine or restrictive measures related to the COVID-19 pandemic.
Electricity
The price at which generation companies sell their electricity varies depending on the source of production and is formed according to the Law on Electricity Market. In Ukraine, the price of electricity generated from Thermal Power Plants (TPP) includes the cost of fuels, fixed costs, profits and a surcharge. The price of electricity generated by Nuclear Power Plants (NPP) includes labour costs, fuel, repair costs, depreciation deductions, profits, administrative costs, operations and financial costs. The price of electricity generated at Combined Heat and Power Plants includes labour costs, fuel, production services, and depreciation charges (NEURC, 2019[17]).
Although noticeable advancements towards an efficient electricity market have been made, the Ukrainian wholesale power market is still limited by excessive Public Service Obligations and price regulations. For instance, price caps in all segments of trading, including IDM and DAM have been considered as generating price distortions (Energy Community, 2020[25]). Concerning the PSOs, as discussed earlier, two PSO mechanisms were introduced: (i) Household PSO to protect household consumers by keeping electricity tariffs below full cost recovery, and (ii) RES PSO to cover RES obligations under FITs which are significantly above the market price (see Box 2.2 and Box 2.3).
Feed-in tariffs (FIT) are a policy mechanism used to encourage the deployment of renewable electricity technologies. A FIT program typically guarantees that producers who own a FIT-eligible renewable electricity generation facility will receive a set price for all the electricity they generate and provide to the grid. Typically, FIT will specify eligible technologies, rate and contract terms, system size and sector restrictions and program size limitations.
Historically, FITs have been associated with models in which the government mandates that power utilities enter into long-term contracts with generators at specified rates, typically well above the retail price of electricity. The premium level may depend on the underlying programme motivation and goals. For instance, in 2012, Japan implemented a new FIT with particularly high PV tariff rates as part of its post-Fukushima policy. However, without additional controls, generous FIT levels can lead to more investment than intended. One example is the experience of Spain, in which the government significantly reduced the tariff a year after its start, and suspended the FIT altogether in 2012, to contain costs that the government could not afford.
In 2008, the Government of Ukraine set a regulatory framework to promote investments for the generation of power through non-conventional sources of fuel, according to which, a model of differentiated feed-in tariffs would be paid to entities that generated electricity using non-fossil technologies. Ukraine agreed to grant the green FIT to investors until December 31, 2029. The regulations set green FITs in euros, passing the exchange risks to the government, at one of the highest levels in the world, with an annual decrease until 2030.
However, after a first period of fixed FITs for power plants commissioned until 2013, the green FITs in Ukraine started to be reduced gradually until 2017. Between 2017 and 2020 the FITs underwent a more significant reductions due to the increasingly burdensome payment obligations.
Notwithstanding the challenges that FIT generated in 2020, green feed-in tariffs substantially increased the installed capacity of RES from 2010 to 2019 in Ukraine. Since 2010, the share of RES (hydro, biofuels, waste, wind and solar) in the total primary energy has increased from 2.1% to 4.6% in 2018. In particular, solar capacities have been increasing significantly, reaching 4.9 GW in 2019. The wind capacities reached 1.1 GW in 2019. The general installed capacity of RES reached over 6 GW in 2019.
Source: (US Energy Information Administration, 2013[34])
The Household PSO imposed on SOEs requires 90% of the electricity produced by Energoatom and 35% of the electricity generated by Ukrhydroenergo to be sold in bilateral auctions to the SOE Guaranteed Buyer through 1 July 2022, as a mechanism to subsidise cheap electricity for households. Distortive PSOs imposed on SOEs should be eliminated gradually as the wholesale electricity market evolves. The electricity market should be effectively regulated and competition concerns addressed through effective enforcement of competition law. To mitigate any potential concerns about the price of electricity and vulnerable households, preference should be given to direct subsidy schemes that benefit these households.
Derived from the RES PSO, the biggest challenge that Ukraine currently faces in electricity pricing is related to the renewable energy segment. Since 2009, Ukraine has used green Feed-In Tariffs (FIT) when contracting with investors in solar power facilities, wind power plants, small hydro-power plants and biomass power plants. NEURC calculated the FIT based on the variety of alternative renewable energy sources (RES) used, with an additional premium for using equipment produced in Ukraine (European Commission, 2020[35]). Green FITs were applied to over 300 renewable projects and were expected to remain valid until 2030. The FIT scheme provided tariffs in the range of 4.35 to 24.56 US cents/kWh. for utility-scale solar and 10 to 11.4 US cents/kWh for wind, which is much higher than the average tariffs awarded in other countries. The FITs were regulated through a mandatory RES offtake by the SOE Guaranteed Buyer (GB).
From 2009 to 2016, when the single buyer model was operational, the SOE Energorynok used to control the wholesale electricity market. With the entry into force of the 2017 Electricity Market Law, the Guaranteed Buyer (an SOE constituted to increase the share of electricity generation from RES) absorbed the obligation to pay the FIT and to subsequently sell the RES electricity on the wholesale market. The Guaranteed Buyer receives the funds needed to cover the difference between the FIT levels paid out to generators and the usually lower electricity market prices from the TSO Ukrenergo, which finances these payments through its transmission tariff surcharges (European Commission, 2020[35]). The difference was supposed to cover the fees for the renewable producers. However, since the household tariffs have remained capped, due to PSOs, the Guaranteed Buyer could not recover the full amount to pay the renewable producers (OECD, 2020[36])
Since 2019, the Guaranteed Buyer has been unable to meet its payment obligations not only to RES producers but also to SOEs due to a lack of funds, mainly as a consequence of low electricity market prices and the inflexible design of the aforementioned levy system. The financial stability of state-owned companies, Ukrenergo and Energoatom, absorbed the largest burden of the PSO imposed by the government, primarily to cover expenses for below-cost electricity for household consumers and the cost of renewables. This situation has generated two major risks that affect the overall electricity market: a) lack of payment to the Guaranteed Buyer stalled compensation for green energy producers, including foreign investors, and b) a risk of corruption as a significant portion of domestic renewable electricity producers are affiliated to well-known businesspersons (OECD, 2020[37]). This situation also poses an overall disruption risk to the energy market in Ukraine. Under these circumstances, more predictable and transparent RES PSOs and accountable compensation schemes should be defined. In particular, PSOs for Ukrenergo should be determined in a transparent way and accounted for separately according to good practices.
The arrears to RES producers prompted the Rada to approve, in May 2019, the Law on Renewable Energy Auctions which amends the Laws of Ukraine on Alternative Energy Law on Electricity Market and the Law on the Regulation of Urban Development Activities. The Law on Auctions contains key provisions, such as terms of participation in auctions, size and allocation of support quotas for RES producers, availability of feed-in tariffs, a decreasing schedule of FITs, bank guarantee requirements, responsibility for imbalances and technical conditions for grid connection (Sayenko Kharenko, 2019[38]). Despite the Law on Auctions, the SOE Guaranteed Buyer was not able to fully pay its financial obligations to RES producers and the problem reached its peak in mid-2020 when the arrears reached EUR 500 million (European Commission, 2020[35]).
To reach a solution with RES companies, in January 2020, the Energy Community Dispute Resolution and Negotiation Centre hosted the first mediation sessions between representatives of the Ministry of Enmergy and two investor organisations, the European-Ukrainian Energy Agency (EUEA) and the Ukrainian Wind Energy Association (UWEA). The mediation activities aimed at agreeing on a stabilisation package, finding an amicable solution for the liquidity crisis threatening the SOE Guaranteed Buyer – offtaker of RES in Ukraine and proposing an adequate electricity market design (Energy Charter Secretariat, 2021[39]). On 10 June 2020, the parties signed a Memorandum of Understanding (MoU) “Settlement of Problematic Issues in the Field of Renewable Energy”, by way of which producers of RES energy accepted the terms of voluntary restructuring of green FIT (Energy Community, 2020[40]). According to the Ministry of Energy, the MoU would reduce the financial burden on electricity market participants and the state would be able to save roughly EUR 2 billion by 2030, which is when the preferential green FIT would be applicable (Ministry of Energy of Ukraine, 2020[41]). RES producers agreed to reduce green feed-in-tariffs in exchange for a commitment by state authorities to repay the Guaranteed Buyer’s outstanding receivables on renewables by the end of 2021, and resume regular payments for power production.
To maintain the reached consensus, the Memorandum was tranformed into binding legislation through Law 810-IX, which was signed by the President and began being implemented in July 2020 (Ministry of Energy of Ukraine, 2020[41]). Law 810-IX introduces a reduction of coefficient calculations for feed-in tariffs from RES, pertaining to wind and solar power plants. This Law also changes the upcoming green auction procedures, tightens the timeline for full imbalance responsibility and introduces regulations for compensating the RES producers for mandatory curtailments. The changes differ based on the type of energy source and commissioning date of power plants.
Additionally, in June 2020, the Rada adopted the Law 719-IX on Measures to Repay Debts Formed in the Wholesale Electricity Market, which aims to implement a set of measures to settle accounts payable and receivables that were accumulated as a result of the wholesale electricity market. These measures came into force on July 6, 2020, as did the termination of the activities of Energorynok. While the Law addresses old debts in the electricity market, a mechanism to stop the accumulation of the debts in the new market has not yet been established. Other structural problems in the market design, including market concentration, below-cost prices and tariffs, are yet to be addressed.
Heat
The transition to cost reflective natural gas prices has presented significant challenges for the District Heating (DH) sector, since natural gas is by far the primary fuel and number one expenditure for DH in Ukraine. Because of the gas tariff reform, District Heating Companies have been required to pass through much higher gas costs in their own tariffs. The required increase in heat tariffs has revealed the inefficiencies in DH operations and made consumers more sensitive to the demanding level of energy bills. Higher gas prices have also revealed the real economic cost of low energy efficiency in DH operations, in particular, regarding thermal losses in DH networks and with regards to boiler efficiency (NEURC, 2019[17]).
Energy sector reforms almost always take place in the context of a wider national transformation process, and Ukraine prompted the reforms in the energy sector as part of a socioeconomic and political transition that followed the 2014 Euromaidan protests (World Bank, 2020[42]). Following the change in government in 2014, the country signed an Association Agreement with the European Union. The Agreement is a concrete path to enhancing EU-Ukraine relations, with a specific focus on supporting policy reforms in areas such as environment protection, taxation, mining and others intertwined within the energy sector. Additionally, it contemplates financial co-operation for sustainable development, which includes energy and environmental protection (European Union, 2016[43]).
Gas and coal-rich economies like Ukraine must go beyond simply replicating the standard model of energy reform and should adapt an integrated reform model to their unique context. An integrated model shall include policies that liberalise end user and wholesale prices, improve energy efficiency, adequately integrate renewables and eradicate the discriminatory treatment of private and public investors (International Energy Agency, 2019[44]). To this end, in August 2017, the government adopted the Energy Strategy of Ukraine (ESU) until 2035, which sought to promote a systematic and holistic approach to energy sector reform. It replaced a previous Energy Strategy that was initially supposed to be enacted until 2030, and was already outdated. The current 2035 Strategy envisions a sectoral transformation that will improve the country’s energy efficiency, security, competitiveness and integration with the EU energy space. It outlines six headline objectives: a conscious and energy efficient society, energy independence, reliability and sustainable, market development, investment attractiveness, network integration and modern management system (Government of Ukraine, 2017[45]). Of the six objectives that the ESU foresees, market development, investment attractiveness, network integration and a modern management system play a key role in establishing a business environment that is attractive for local and foreign investors.
Source: ESU 2035, (The Government of Ukraine, 2017[46])
The Market Development objective is relevant to private investors as it aims to create competitive gas, electricity, heat, coal, and oil markets. A crucial component in achieving this goal is securing access to the grid for all energy producers. Market Development also aims to ensure the independence of NEURC and the Anti-Monopoly Committee of Ukraine.
The Investment Attractiveness objective mandates the implementation of the EU acquis in Ukrainian legislation, and supports a competitive environment that guarantees uninterrupted access to markets and to existing infrastructure. It aims for a stable and predictable investment attraction policy and to promote the entrance of international developers and investors in the domestic energy market.
The Network Integration objective aims to create fully functional natural gas and electricity markets that can enable Ukraine’s integration into ENTSO-G, the European Network of Transmission System Operators for Gas, and ENTSO-E, the European Network of Transmission System Operators for Electricity (Government of Ukraine, 2018[47]). The objective envisions that European companies should be able to buy gas at the Eastern border of Ukraine. The Modern Management System objective foresees the introduction of public-private partnerships to advance the energy industry, develop resource management system in mining, and to enhance the flexibility of the energy infrastructure.
In order to support the implementation of ESU 2035 Phase 1, the 2020 Action Plan was approved by the CMU. It identified 186 actions to be completed by the end of 2020 and listed the plurality of stakeholders involved in their implementation (OECD, 2018[48]). The government published two reports on the implementation status of the Energy Strategy of Ukraine in March 2019 and May 2020 (Government of Ukraine, 2020[49]). The reports mentioned that 105 actions had been effectively implemented, 39 actions were being currently executed, and 37 actions had not been implemented. For five actions, no data were available (Razumkov Centre, 2019[50]).
Source: Energy Strategy of Ukraine until 2035, (The Government of Ukraine, 2017[46])
According to forecast analysis that was prepared by the Wilson Centre, if Ukraine implements all the reforms prescribed in the ESU 2035, for the 2019-2030 period, power generation companies will be able to invest USD 29.8 billion, which represents 11.5 times more funding than the amount that will be invested without the reforms being introduced. This could help to finance the full introduction of new power units and prevent a deficit of baseload capacity. Moreover, as an outcome of the transition to market tariffs and the end of cross-subsidisation, the distribution and transmission system operators that operate in Ukraine will be able to invest EUR 7.5 billion in the grid, which, compared to the amount without the reform, is nearly twice as much. With the increase in investment volumes, losses in distribution grids are expected to decrease – from 8.6% in 2017 to 7.2% in 2030, in transmission grids – from 2.6% to 2.1%. Finally, the introduction of reforms to synchronise Ukraine’s power system with the ENTSO-E could increase the export of electricity by almost 5 times – from 5.6 billion kWh in 2017 to 25 billion kWh in 2030. Consequently, the surplus export earnings in 2019-2030 could reach USD 6.7 billion. However, in case of failure to carry out synchronisation, Ukraine would remain dependent on imports of electricity from the Russian Federation and Belarus (Wilson Center, 2019[51]). It is worth noting that in May 2021, NEURC decided to limit the imports of electric energy to the Integrated Power System of Ukraine from Belarus and the Russian Federation as of 1 October 2021.
The ESU 2035 suffers from a number of structural weaknesses, which affect the quality of implementation, such as the lack of alignment between the ESU 2035 and 2020 Action Plan, the lack of methodological clarity regarding the lower-and-higher-level components of energy sector reform, and the lack of mechanisms for effective risk assessment. In addition, despite the broad consistency of ESU 2035 with the energy commitments outlined in Ukraine’s Sustainable Development Goals, the strategy is only partially consistent with the EU-Ukraine Association Agreement because it is lacking a set of legal acts to reform energy markets and align energy efficiency standards according to EU rules. Other policy and information gaps may also affect the achievement of objectives, such as the lack of measures to promote the phase out of coal-fired power stations and shortage of information relative to budgeting and costing processes by the Government. Overall as of 2020, progress towards ESU 2035 objectives has been mixed. Progress towards the Market Development and Modern Management System objectives is at an intermediate stage, while progress towards the Energy Efficiency, and Energy Independence, Sustainability and Reliability, Investment Attractiveness and Network Integration objectives is at an initial stage. At the sub-sectoral level however, implementation progress has varied much more significantly (OECD, 2020[52]).
Ukraine has been a bold reformer in the energy sector and, between 2000 and 2015, the country announced ambitious reforms, delivered substantially on them, and sustained them over time (World Bank, 2020[42]). For example, Ukraine reformed its gas sector and increased the participation of private corporations in the wholesale and retail markets. As a result, over the past five years, Naftogaz ceased to be the near-monopoly supplier of the domestic market. Its share of imports was nearly cut in half, it imported 7 bcm (billion cubic metres) of the total 10.6 bcm imported in 2018, while 7.2 bcm of 14.3 bcm imported in 2019. The remainder was imported by a range of wholesale traders (65 companies in 2018 and 76 in 2019). The share of gas produced in Ukraine by companies other than Naftogaz has also grown to 4.7 bcm, in 2019.
Despite the advances in Ukraine’s reform programme, to finance the much-needed modernisation of ageing energy infrastructure while maintaining fiscal discipline the government should increase the availability of mechanisms to leverage public-private financing instruments. Furthermore, Ukraine should bear in mind that investments in mid-stream and downstream infrastructure, which are badly-needed in the country, are contingent on regulatory frameworks that enable companies to recover their fixed investment cost.
Direct private participation in Ukraine´s energy sector
For Ukraine to achieve the objectives and goals set out in the ESU 2035, the country requires long-term investments, the majority of which can come from the private sector. Successful private investments in upstream, mid-stream and downstream projects in all energy sub-sectors rely on having adequate legal schemes that allow the participation of private companies (Fitch Solutions Country Risk and Industry Research, 2021[53]). There are six main forms of direct private participation in the energy sector that have been used in Ukraine (Figure 2.6): concessions, permits and licences, production sharing agreements (PSA), service contracts, public-private partnerships and joint ventures (see Chapter 5 for an analysis on joint ventures, public-private partnerships and service contracts).
Source: (Fitch Solutions Country Risk and Industry Research, 2021[53])
Concessions are regulated by the Law on Concessions, which was approved in September of 2019. The Law introduces clear and non-controversial procedures for initiating concessions, with both contracting authorities and concessionaires having the right to initiate the transfer of infrastructure objects into the concession, conducting concession tenders and choosing concessionaires. This takes place through a competition or competitive dialogue as envisaged by the UNCITRAL’s Model Legislative Provisions on Privately Financed Infrastructure Projects. In addition, the 2019 Concession Law allows investors leasing state property to obtain concession rights for the property by negotiating directly with the contracting authorities. The Law also includes new rules, providing investors with more options when resolving disputes. Parties to concession contracts may, by mutual consent, choose which law will apply. They may also choose to resolve disputes via mediation, non-binding expert assessment, international commercial arbitration or investment arbitration - including arbitration sitting abroad, if the concessionaire is a subsidiary of a multinational enterprise (Government of Ukraine, 2019[54]).
For permits and licensing, the State Service for Geology and Subsoil of Ukraine, in accordance to the Subsoil Code, issues licences to private investors granting the right to explore and produce hydrocarbons. In return, companies are required to pay royalties, taxes and fees to the government (Fitch Solutions Country Risk and Industry Research, 2021[53]). A special permit must be obtained for each stage of development: for the geological survey, up to 5 years onshore and 10 years offshore, for the production permit it is up to 20 years onshore and 30 years offshore and for a special permit associated with a Production Sharing Agreement (PSA) up to 50 years (Government of Ukraine, 1994[55]).
Regarding PSAs, private companies have similar rights, but only containing “cost oil” and a share of any “profit oil” produced, with the state recouping the remainder in lieu of, or sometimes in addition to, collecting royalties (Government of Ukraine, 1994[55]). The investor also pays taxes and fees. Under a service contract, the private corporation explores for and produces hydrocarbons on behalf of the government and is paid a fee for its services, with the possibility to buy a portion of the production. Association or joint venture agreements involve private investors partnering with host governments or state-owned enterprises, as in a PSA, sharing hydrocarbon production. In practice, these forms and labels tend to be much less important than the specific content of a contract.
As part of its efforts to implement a more enabling investment framework in the sector, the Government of Ukraine has modernised its Law on Production Sharing Agreements (PSA) and adopted the 2018 Law on Deregulation of the Oil and Gas Industry (Fitch Solutions Country Risk and Industry Research, 2021[53]). The Law on Deregulating Oil and Gas Industry simplifies regulatory procedures relating to exploration and commercial development of oil and gas fields. Such deregulation involves cancelling procedures for construction approvals from local authorities, state approvals for pilot production of hydrocarbons, state approvals for transfer of the company’s geological information to third parties, approval for transfer of the company’s geological information to third parties and environmental impact assessments (EIA). These shall be required only for production activities, but special permits for exploration works may be obtained without the EIA. Regarding the simplification of land allocation procedures, a specific type of servitude is introduced for construction of oil and gas extraction facilities and pipeline infrastructure without the need for changing their designated purpose (Government of Ukraine, 2018[10]).
Ukraine eased the granting of subsoil licences and permits through the 2019 Law on Extraction of Amber and other Minerals (Government of Ukraine, 2020[56]). Despite its name and main focus, the Amber Law also contains provisions that will have an impact on the production of other mineral resources in Ukraine, including oil and gas, such as lifting the requirement for a regional council’s approval as a necessary step in the process of granting the right for subsoil geological survey and extraction of hydrocarbons. Additionally, the requirement of an Environmental Impact Assessment for PSAs was amended, from prior to signing the agreement to after the contract was signed but before the start of activities (CMS, 2020[27]). In line with the Amber Law, in February 2020, the CMU restated the procedure of issuance of special permits for subsoil use and made it possible to submit applications electronically, in order to obtain and extend special permits. This all became possible through the usage of subsoil users’ online accounts on the State Geological Service website (Government of Ukraine, 2020[57]).
Public procurement, auctions and privatisation in the energy sector
Public procurement reform is considered as one the most successful reforms over the last years in Ukraine. It has contributed to fighting corruption and to increasing participation of private companies in the procurement market (World Bank, 2019[58]). In 2016, a new Law on Public Procurement was approved in Ukraine, introducing mandatory eProcurement through the ProZorro platform, an electronic system that ensures open access to public procurement wherein public procurement contracts are disclosed on open data standards so citizens can search them (ProZorro, 2021[59]). Starting from August 2016, all public procurements performed by all government agencies, including local ones, were made through the ProZorro centralised electronic procurement system. Since the amendment of the Law on Public Procurement in 2019, ProZorro has remained Ukraine’s electronic procurement system and more functions have been enabled, such as identifying abnormally low prices, correcting errors in tender proposals, establishing the grounds for automatic cancellation of tenders and allowing simplified procurement procedures for goods, works or services of low value.
In 2017, an additional platform, ProZorro.Sales, was launched to serve as an electronic system for auction sales of non-specialised state-owned assets (Ukrenergo, 2017[60]). Through this second platform the government also sells leasing rights to land plots managed by the State of Ukraine for Geodesy, Cartography and Cadastre (State Geocadastre), as well as the sale of special permits for the use of subsoil in Ukraine, managed by the State Service of Geology and Subsoil. More recently, in September 2021, the state enterprise ProZorro.Sale was designated the administrator of land tenders for the sale of land plots (including state and communal property) and the acquisition of rights to use them such as lease, superficies, emphyteusis, as well as being responsible for approving the requirements for the preparation and conduct of land tenders through the electronic system.4
In January 2018, the government enacted the new Law on Privatisation to simplify both large-scale and small-scale privatisation transactions at state and municipal levels (Government of Ukraine, 2018[61]). The law aims to enhance transparency, integrity of individual transactions and provides a guarantee for private investors. The IMF, IFC and EBRD considered the approval of the new privatisation law an essential step for facilitating an influx of private capital into Ukraine, especially in the energy sector (International Monetary Fund, 2020[62]). Per the regulation, the State Property Fund (SPFU) is the primary institution leading the privatisation of SOEs that have been pre-identified by the CMU. The privatisation process is split into so-called small-scale assets with a value of up to UAH 250 million, and large-scale assets. Privatisation auctions are held through the Prozorro.Sales online platform, a system that intends to ensure bidding transparency and open access to participation. The SPFU ensures full disclosure of asset information. All documents become available to investors after signing a non-disclosure agreement.
As of December 2020, the SPFU was responsible for 11 entities in the energy sector that were in the process of being privatised as part of the large-scale privatisation efforts. When SOEs are selected to be privatised, their assets are transferred to the SPFU which is responsible for their restructuring, with the purpose of maximising assets’ value before putting them on sale. Therefore, the SPFU conducts the appointment of company management and representatives to the board of directors, reviews and approves company financial plans, business strategies and is responsible for evaluating the performance of SOEs. The State Property Fund of Ukraine announced its plans to sell shares of six power distribution companies: 78.3% of the stakes of Centrenergo, the largest electricity generating company in the country, 50.9% of Ternopiloblenergo, 60.3% of Zaporizhiaoblenergo, 65% of Kharkivoblenergo, 70% of Mykolaivoblenergo and 70% of Khmelnytskyioblenergo (BakerMckenzie, 2020[63]). However, in 2020 due to COVID-19, the government required the SPFU to suspend all large-scale privatisation efforts until the markets had been stabilised. To unblock large-scale privatisations, in March 2021, the Ukrainian parliament approved the second reading of Law N. 4543 on Privatisation of State and Communal Property, which was signed by the President in April 2021. The SPFU forecasts that around USD 430 million of budget revenues will come from privatisation. Of this amount, USD 320 million is expected to come via large-scale privatisation and another USD 110 million will include revenues from the sale of smaller privatisation objects. If Ukraine seeks to attract quality investors that take responsible business conduct considerations into account as well as economic profitability, it must focus on creating transparent conditions for the upcoming auctions and expanding the participant list as much as possible.
On 2 October 2019, Ukraine’s parliament abolished the Law “On List of State-Owned Property Prohibited for Privatisation” that included a number of state-owned infrastructure objects. The law prohibits the full privatisation of industries such as energy, railway, space, and communications. In the Energy sector, full privatisation is not permitted for Naftogaz, Magistralni Gazoprovody Ukrainy, Ukrtransgaz, Ukrnafta, Ukrgasvydobuvannya, Ukrtransnafta, Centrenergo, Energoatom, Ukrenergo and Ukrhydroenergo.
Increased public-private synergies in oil and gas exploration and production
In 2019, the Ukrainian hydrocarbons sector advanced private participation and, for the first time in several years, licensing rounds and PSA tenders for new oil and gas blocks were offered. Of the nine PSA tender rounds for onshore blocks offered in May 2019, six were solely awarded to Ukrainian SOEs, one to an American company and two to a venture between the SOE Ukrgasvydobuvannya and Vermilion Energy, a Canadian company. The four concession rounds held in 2019 by the State Service of Geology and Subsoil of Ukraine (SSGS) resulted in awarding 19 blocks with exploration and production (E&P) licences for 20 years, out of the 29 proposed blocks. Fourteen blocks were awarded to Ukrgasvydobuvannya (UGV), and the remaining five were sold to five different private companies (State Service of Geology and Subsoil of Ukraine, 2019[64]). Ukraine offered concessions for 12 new onshore oil and gas fields, which were available for private investors under PSAs. In terms of subsoil auctions, the SSGS held new licensing rounds, offering 20-year exploration and production licences of 34 onshore petroleum blocks. Out of 19 blocks, 14 were awarded to the SOE Ukrgasvydobuvannya. State participation in oil and gas exploration and production activities are carried out by Nadra Ukrayny, which entered into joint-venture agreements with private investors.
In 2019, Naftogaz was awarded four PSAs after open bidding competitions and two of them were given in conjunction with Canadian company, Vermilion Energy. The partnership of Naftogaz and Vermilion Energy did not materialise. In mid-2020, Vermilion Energy decided not to proceed with these projects due to changes in their strategy and significant decline in prices for natural gas and oil compared to 2019. Furthermore, the pandemic and global economic recession affected the Company’s plans regarding participation in projects in new regions (Naftogaz, 2020[65]).
On July 2020, at the request of private investors that were awarded PSAs to exploit gas fields with Ukrgazvydobuvannya (UGV), a wholly owned subsidiary of Naftogaz, the CMU extended the term to conclude agreements by six months. The order to prolong the signing of the production-sharing agreements was adopted because the awarded companies applied to the Interdepartmental Commission requesting an extension. The investors referenced the complexity of the negotiation process and the highly technical terms contained in the contracts, which require deep analysis prior to the final signing (Cabinet of Ministers of Ukraine, 2020[66]). On December 2020, UGV signed PSAs with local players DTEK Oil & Gas for the Zinkivska blocks, Geo Alliance for Sofiyivska, and Zakhidnadraservis for Uhnivksa (S&P Global Platts, 2021[67]).
Despite Ukraine’s efforts to increase public-private synergies in oil and gas exploration and production as described above, new forms of synergies between SOEs and private investors would be welcome to attract foreign investments in Ukraine’s energy sector, particularly for projects that involve depleted hydrocarbon resources. An example of an innovative association is the Production Enhancement Contract (PEC) that Naftogaz and Expert Petroleum signed in March 2020. It is the first ever full-scale PEC in the history of Ukraine’s oil and gas industry and will generate an additional 300 million cubic meters of gas within five years, from small fields in Western Ukraine (Naftogaz, 2019[3]).
Fragmented land reforms to advance energy projects
In Ukraine’s agenda of reforms to advance private investments in the energy sector, one crucial adjustment has been the approval of regulations that help to ease the acquisition of permits and licences related to subsoil usage, which enables the use of land to install energy infrastructure.
According to the Constitution of Ukraine, mineral resources belong to the Ukrainian people and governmental authorities dispose of the subsoil rights on their behalf. Therefore, an investor in the extractive industry must obtain a land use permit as well as a subsoil licence. The State Service of Geology and Subsoil (SSGS) is responsible for issuing contracts, permits and licences related to extracting hydrocarbons or minerals from the subsoil, which are awarded through auction. The regulation determines that a subsoil user becomes an owner of the mineral resources once the minerals reach the surface (CMS Cameron McKenna LLC, 2019[68]).
The SSGS plays a relevant role with regards to land subsurface management, as it administers the use and transfer of geological information. The subsurface users must notify the SSGS of the creation, acquisition or transfer of ownership. Alongside the rights to use the geological information shall be recorded in the catalogue of data on geological information maintained by the state-owned company GeoInform of Ukraine (GeoInform of Ukraine, 2021[69]). On November 2018, to streamline the procedure for acquisition of state geological information and to enhance transparency in the sector, the CMU adopted a resolution on new procedures for the disposal of geological data, mandating that all the information should be accessible online. In 2019, the SSGS started publishing online licensing agreements and special permits granted to private investors. It also presented an online investment atlas containing basic information about subsoil areas nominated for the upcoming auctions (BakerMckenzie, 2020[63]).
In addition to these reforms, in February 2020, the CMU approved Resolution 124 with the new version of the Procedure for Granting Special Permits for Subsoil Use (Hillmont Partners, 2020[70]). The key point was to eliminate the need to agree with regional councils on a procedural basis, for the provision of subsoil use and the extraction of minerals of national importance. The changes have helped reduce the administrative burden and political influence on investors, minimise corruption risks and stimulate the development of subsoil exploitation.
In 2011, Ukraine introduced the Law on Energy Lands and the legal regime of Special Zones for Energy Facilities, which defines the principles for granting use of land plots for energy facilities. To ease land permits for RES investments, in 2018, the Law was reformed so that solar and wind companies could develop energy projects not only on land designated as “land for energy” but also on land designated within the generic category of “land for industry, transport, telecommunications, defence and other designation” with no need to change the designated use of land (Government of Ukraine, 2021[71]).
Investing in the energy sector and the COVID-19 crisis
COVID-19 has dealt a devastating blow to the global economy, disrupting supply chains while stifling demand. In Ukraine, all parts of the energy value chain were affected - upstream, midstream, downstream and service companies. The challenge from the COVID-19 crisis for oil and gas companies was compounded by the oil price crisis that started before the pandemic. Ukraine's oil and gas industry has remained affected due to the ongoing impact of the COVID-19 pandemic on consumption, in particular of refined fuels, notably due to lingering restrictions on travel. Transport and industrial decrease in demand for refined fuels has led to an estimated 10% contraction in consumption in total (Fitch Solutions Country Risk and Industry Research, 2021[53]).
In addition to implementing COVID-19 safety measures, energy companies need to pull all the traditional downturn levers, such as reductions in capital expenditures and cash conservation. The implications of current hedging positions and future hedging positions need to be carefully evaluated, and procurement and risk mitigation strategies will need to be based on effective scenario and demand curve data analysis (PWC, 2020[72]). High-cost producers, such as oil and gas extraction, may need to go further and consider ways of partnering to reduce their cost base, including Production Enhancement Contracts.
As the crisis evolves, power utility companies need to build strategic forecast tools that examine various possible scenarios under different timeframes, so that the organisation is ready for fast decision-making. Business continuity and preparedness plans will need continual review to ensure that operations and infrastructure are properly supported. More than ever, it will be important to work closely with governments and regulators to consider the implications for energy affordability, sustainability and security of supply.
COVID-19 has further deepened the existing crisis in the energy sector of Ukraine. The full range of consequences for the energy sector are yet to be revealed and are difficult to predict, however it is already clear that demand for energy resources has dropped, prices have plummeted and non-payment of utility bills by end-consumers has had a detrimental effect along the supply chain, from DSOs, TSOs, to suppliers and producers (EnergyWorld Magazine, 2020[73]).
In Ukraine, the fall in electricity demand has also been driven by a decrease in the volume of industrial production, caused mainly by COVID-19, given that the largest consumers of electricity are industrial enterprises. The drop in electricity consumption amounts to approximately 5% in 2020 compared to the same period of the last year (Diahovchenko and Morva, 2020[74]).
Lockdowns pose challenges for the implementation of RES projects as there is a significant risk that companies with concluded pre-PPAs will not be able to complete the construction of RES projects on time. Prohibition of entry to the territory of Ukraine for foreigners came into effect during March of 2020 and many RES projects involve participation of foreign companies, from Engineering to Procurement and Construction (EPC) specialists (IMEPOWER, 2020[75]). Consequently, due to the force-majeure situation and restrictions on entry into Ukraine, many companies could be forced to temporarily suspend their activities in Ukraine.
The sharp drop in power demand in 2020, due to the COVID-19 pandemic and the decline in business activities, contributed to a deep financial crisis in the power sector. But the financial indebtedness of the SOE Guaranteed Buyer was just a reflection of several problems in the market, such as the imbalances of power produced by RES. According to Ukraine’s National Action Plan for Renewables, the country set the objective to produce 2 300 MW of solar energy, 2 280 of wind and 950 of biomass by the end of 2020 (Government of Ukraine, 2020[76]). However, as of the end of June 2020, 4 593 MW of solar, 1 064 MW of wind and 171 MW of biomass capacities were installed. This huge injection of power capacities to the grid prevented remedial action needing to be taken, and solar power, the most expensive in terms of the feed-in tariff, has not only exceeded other renewables, but also the planned benchmark for itself.
The abovementioned factors coupled with the simultaneous overregulation of electricity market design and attempts to maintain artificially low prices for households were significant contributors to the debts shadowing the RES market.
Renewable energy potential and opportunities in Ukraine
With a population of around 42 million and CO2 equivalent emissions per capita of 5.02mt, Ukraine is one of the most energy-intensive economies in Europe. The largest greenhouse gas (GHG) emitter in the country is the energy sector, with around 66% of emissions. As part of the country’s commitments derived from the Paris Climate Agreement, the government approved the Renewed Nationally Determined Contribution (NDC), which sets a new GHG emission target not to exceed 65% of 1990 GHG emission levels in 2030 (UNFCCC, 2021[77]). The 2030 target will be achieved through aligning climate policy and legislation with the European Green Deal, particularly in the areas of renewables, hydrogen and the transformation of the coal sector. The government aims to phase out coal-fired power generation and increase the share of renewables in the energy mix.
At the national level, Ukraine has set a goal of sourcing 25% of its total energy mix from renewables by 2035. In 2035, bioenergy is expected to have the largest contribution with 11 Mtoe – having a share of 11.5% of total primary energy supply, followed by wind and solar energy with 10 Mtoe together – a combined share of 10.4% (Government of Ukraine, 2017[45]).
Ukraine has huge potential for generating energy from biomass, wind and solar (International Renewable Energy Agency, 2015[78]). The country's wind energy potential is estimated at 30,000GW, with about half of the country suitable for establishing wind farms. Ukraine has most notably been making progress in deploying solar equipment and developing solar power facilities, exhibiting substantial growth in the sub-segment. There are five main regions in southern Ukraine where approximately 66% of all renewable generation is located, namely Odesa, Zaporizhzhia, Mykolaiv, Kherson and Dnipro regions. Those regions have the best wind resources and highest solar radiation (US Department of Commerce, 2021[79]). While Ukraine's hydropower sector makes up only a minor share of the energy mix, it is the most developed renewable source in Ukraine, through the use of large-scale hydro power plants. As such, the sector is attracting some investment, primarily focused on the modernisation of existing large plants (US Department of Commerce, 2021[79]).
The government incentivised private sector investments in RES by granting generous FITs for variable renewable projects with no capacity caps, which resulted in the rapid installation of over 8GW of RES capacity at the end of 2020, with the bulk of these additions occurring in 2019. Ukraine's RES sector boomed over 2019, as a number of developers rushed to capitalise on the country's high green FITs for wind and solar capacity before they were cut in 2020. The renewables expansion in Ukraine was aimed at decreasing GHG emissions and diversifying the market’s power mix, in the face of ageing nuclear capacity and the rapid drop in coal production. This follows the separatists taking control of significant swathes of the Donbass region, where much of the country's coal production capacity is located (Fitch Solutions Country Risk and Industry Research, 2021[80]).
As a result of the FITs, Ukraine quickly emerged as one of the fastest expanding renewables markets in Europe. Tariffs, which awarded USD150.2/MWh and USD100.2/ MWh for solar and wind power projects respectively were very attractive relative to other European renewables markets and led activity in the Ukrainian renewables sector to surge over the previous two years. Hence, at the beginning of 2020, the share of renewables in energy reached 11% and by the end of the year reached 12.4% (US Department of Commerce, 2021[79]).
With the surge of renewable generation from solar and wind resources, the grid is increasingly in need of balancing capacities. In this regard, the electricity market has provided opportunities for the evolution of a completely new segment of balancing services and auxiliary services. Hence, there are prospects for private companies to invest in: a) grid-scale energy storage systems b) distribution equipment c) energy infrastructure d) storage technologies and batteries f) smart grid technology and metering and e) technical consultancy (US Department of Commerce, 2021[79]). However, some investment projects like storage technologies and batteries, in order to be implemented in Ukraine at large scale, are dependent on the adoption of new regulations, which define important legal conditions for such projects.
Amendments to the regulatory framework for renewable energy
Although Ukraine has made significant progress in planning out the future of its energy system and developing its renewable energy generation (International Renewale Energy Agency, 2015[81]), the RES market has faced limitations for structural reasons, including budgetary deficits, price interventions and cross-subsidisation, insufficient capacity of the grid, lack of a legal framework that adequately regulates imbalances and flexibility in the grid, as well as non-payment of the Guaranteed Buyer.
The rapid increase of RES project has changed the structure of generation in the power system of Ukraine. In 2020, compared to 2019, the generation from RES was projected to almost double to 10.284 TWh. During 2019, the installed capacity of SPPs and WPPs in Ukraine increased 2.7 times and reached 4.7 GW, which is the largest amount that the state power system can accept without serious operational deviations and imbalances (Diahovchenko and Morva, 2020[74]). As of the end of 2020, the installed capacity of RES had already reached 8GW, thereby posing a major challenge to the grid balance.
The rapid increase in the capacity of renewables has created financial and operational challenges for Ukrenergo, the TSO and the Guaranteed Buyer, the latter of which ultimately has accumulated large debts, approximately USD 1.2 billion by the end of 2020, to renewable energy companies (World Bank, 2020[8]). Moreover, there is a lack of flexibility when balancing this 8GW of renewable energy generation, which is produced by private investors. Often times, wind and solar generation is curtailed, and the compensation comes from the take or pay of PPAs.
When RES electricity is curtailed, part-loaded thermal power plants have to intervene and provide the required reserves. The large SOEs that supply 60% of electricity are not allowed to participate in the WEM and are obliged to provide power at low regulated prices, which increases their financial stress, particularly, as higher priced RES power puts a squeeze on their volumes. These practices result in market distortions and price manipulations in the bulk power prices (World Bank, 2020[8]). Adding to the abovementioned challenges, since the launch of the new wholesale electricity market in mid-2019, tariff-setting mechanisms for electricity transmission and dispatching have been characterised by its constant changes and the contesting of prices by industrial consumers who are reluctant to cross-subsidise electricity (Box 2.3).
On July 2019, the wholesale electricity market started its operations in a phased manner to enable a smoother transition to the new structure by imposing various restrictions, including constrained bidding in the DAM and bidding caps in the BM and ASM. Additionally, two Public Service Obligation (PSO) mechanisms were introduced: (i) a Household PSO to protect household consumers by keeping electricity tariffs below full cost recovery; and (ii) a Renewable Energy PSO to cover RES obligations under the FIT mechanism, since FITs are significantly above wholesale electricity market prices.
Under the household PSO, nuclear and hydro producers – Energoatom and Ukrhydroenergo – are obliged to sell a bulk of their production at low regulated rates to meet residential consumption needs. On the other hand, the Renewable Energy PSO is funded through Ukrenergo’s revenues from its transmission tariff, which must be approved by NEURC. Since NEURC does not consider the Renewable Energy PSO to be part of Ukrenergo’s mandate, this PSO is not fully funded in the transmission tariff calculation. This leads to a large and growing unfunded mandate of Ukrenergo towards RES.
Since end-consumer tariffs – both for households and for industrials, that include transmission tariff – are regulated by NEURC, there is a disconnect between the legislated household, renewable PSO requirements and the approved end-user tariffs, leaving a large and growing unfunded gap that is at the heart of the sector’s financial stress
Source: (OECD, 2020[24])
As of end of 2020, the accumulated arrears of Ukrenergo to guaranteed buyer and power suppliers exceeded UAH 26 billion or USD 0.9 billion. Per preliminary estimate, nearly UAH 50 billion or USD 1.8 billion will be necessary for RES purchases under FIT in 2021. This is expected to grow to about UAH 55 billion or USD 2 billion in 2029.5 The current financial stress on Ukrenergo has made it difficult for the TSO to perform its core functions, including attracting investments to modernise the grid resilience capabilities, such as rapid response frequency technology, which is needed for timely UkrES grid synchronisation with the EU. According to Ukrenergo’s calculations, the Ukrainian energy system, among others measures, will need around 2GW of manoeuvrable capacities with quick start for the next 10 years, and 2GW energy storage capacities (UkraineInvest, 2020[82]). Thus, as more renewables are connected to the grid, more efficient balancing capacities will be needed to enable proper balancing, to limit curtailment of renewables and to continue attracting private investors of RES projects. The implementation of Law 810-IX and Law 2712-VII will be essential for restoring the trust of RES investors. Law 810-IX changes the terms of the agreement that were signed by investors, in several ways (PV Magazine, 2020[83]) : it reduces green FITs, increases local content bonuses, limits new SPP and WPP capacity addition under green FITs, sets partial payment to RES producers using state budget funds, accelerates the balancing responsibility for RES power plants, introduces a compensation mechanism for curtailment due to TSO instructions, updates the stabilisation clause for PPA of RES producers and extends the list of potential sources of financing for the off-taker’s costs, related to payments for the FIT to RES producers. Meanwhile, Law 2712-VII on Promotion of Competitive Conditions for Producing Electric Power from Alternative Energy Sources sets the framework for the implementation of RES auctions.
It is worth mentioning that, in Europe, investments in the renewable energy sector have been largely driven by regulatory policies such as quotas, obligations and pricing instruments. Past experiences in Spain and France show that Feed-In Tariffs and Premiums need to evolve continuously, and regular tariff-level adjustment is one example of measures that are needed to reflect the falling cost of technology. As such, auctions are being increasingly adopted, given their ability for real-price discovery. In addition, corporate PPAs for renewable energy are increasingly relevant for achieving the energy transition. Notably, the success of auction and corporate PPAs relies on the design and deployment of policies that are adequate to the country conditions. Ukraine must develop policies that are adequate to its energy market, technology and economics. Hence, the government should consider implementing a policy agenda that advances transparent auctions and corporate PPA from RES.
The Law on RES auctions prescribes the procedure that companies producing variable renewable energy should follow to be part of the electricity market. Originally, auctions were foreseen to take place two times a year, but Law 810-IX abolished these provisions and gave the CMU full discretion regarding the auction schedule and dates. The annual quotas are set for wind, solar and other RES technologies separately. In addition, when setting the annual quotas, the CMU can decide to conduct multi-technology or site-specific auctions, for example, the Chernobyl Exclusion Zone. To have control over the RES introduced to the electricity mix, the quotas are based on proposals of the TSO and the State Agency on Energy Efficiency and Energy Savings of Ukraine.
Bidders are required to submit their sealed bids through the ProZorro system. The bid shall include the technical proposal or power capacity of the power plant (kW) and the price offer (EUR/kWh). The winners are determined by opening the bids simultaneously, with the price offers being the sole selection criteria.
The SOE Guaranteed Buyer is mandated to buy the electricity from the producer at the awarded auction price, under the Power Purchase Agreement, which needs to be signed within 15 working days after the auction results are published in the electronic trade system. Until the end of 2029, RES producers are exempted from balancing costs in hours during which their imbalance rate is below 10% for wind operators, 5% for solar and 5% for all other RES operators.
To avoid imbalances, and as stated in Law 810-IX, from January 2021, RES operators with projects over 1 MW will have to bear 50% of the cost for imbalances created by their RES projects, while starting from 2022, they will have to bear the full cost. Also, to level the participation between large and small RES projects, wind power plants with more than 5 MW (Law 810-IX deleted the exception of projects with up to 3 turbines) and solar plants with more than 1 MW are obliged to take part in the auctions. All other RES types can take part on a voluntary basis regardless of their power capacity in the auctions or use of the FIT-scheme, with support until the end of 2029.
Companies that want to participate in the bidding process have to comply with pre-qualification requirements, including: a) Material pre-qualifications, such as confirmation of a right for land use/ownership, concluded grid connection agreement for the project, and disclosure of beneficial owners and b) Financial pre-qualifications in the form of a bid bond of 5 EUR/Kw. The bond is refunded to an unsuccessful bidder after signing the PPA. Additionally, successful bidders must submit a performance bond of 15 EUR/kW, after signing the PPA with the GB. Winning companies will guarantee the purchase of electricity for 20 years after the project is commissioned.
To foster the participation of investors, the content rule of the FIT schemes stays in place. Projects with more than 30% local equipment get a 5% increase in the awarded bid price. If more than 50% are of local origin the support increases by 10%. Law 810-IX introduced a 20% increase in support if more than 70% of the equipment is from a local origin.
Although the auction scheme itself seems to be suitable to ensure an efficient and effective RES expansion, the greatest challenge will be to win back investor confidence after the recent FIT cuts, as well as the delayed auction implementation.
Source: (AURES, 2020[84])
International co-operation to advance energy projects
Support to advance energy reforms and the integration of Ukraine into the EU energy system
Ukraine has established strong cooperation ties with actors of the international community to reform and develop its energy industry. Ukraine-EU co-operation is based on a comprehensive partnership in line with the Energy Charter Treaty, the Ukraine-EU Memorandum of Understanding on Energy Cooperation, the Ukraine-EU Association Agreement and the Energy Community Treaty. Currently, Ukraine is implementing measures to further reform its energy sector in accordance with the EU's Third Energy Package, as well as, provisions of the updated Memorandum of Understanding on the Strategic Energy Partnership between Ukraine and the European Union (Government of Ukraine, 2021[85]).
Ukraine is a key transit country for Russian gas exports to Europe. Nevertheless, there was a dispute from 2014 to 2019 between Gazprom and Naftogaz over the price of gas and its transit through Ukrainian territory. This put in peril the flow of Russian gas and the revenue collected by the Ukrainian government from transit tariffs. In December 2019, Gazprom and Naftogaz reached an agreement to continue the transit of Russian gas through Ukraine for the period 2020-2024.
The European Commission facilitated trilateral talks between the parties. This effort led to a new gas transit agreement with Russia based on EU rules. It outlines that 65 bcm are to be transited in 2010 and 40 bcm per year from 2021 to 2024, for a total of 225 bcm, with provisions for additional volumes to be shipped if required. The agreement expressed the two sides’ intention to co-operate further on transit in 2025-2034. It was the first major trading agreement between Russia and Ukraine since the outbreak of military conflict in eastern Ukraine in early 2014. The arbitration clauses in the agreement state that disputes are to be settled at the International Chamber of Commerce in Zurich. This differentiates the agreement from the previous practice, where Gazprom-Naftogaz contracts were subject to arbitration in Stockholm. Gazprom will pay USD 7.2 billion to Naftogaz as part of the transit contract and 2.9 billion USD in compensation under the Stockholm arbitration award.
Source: (Pirani and Sharples, 2020[86])
The European Union and Ukraine entered into the Deep and Comprehensive Free Trade Agreement (DCFTA) on 1 January 2016. Although the Association Agreement and the DCFTA are separate from the Energy Community agreements, the provisions of the DCFTA includes references to the provisions and actions being implemented as part of the Energy Community. The DCFTA is primarily focused on issues concerning trade in energy and raw energy materials, including setting prices, customs duties, infrastructural co-operation, transport of energy resources and the flow of investments (European External Action Service, 2019[87]).
As part of the international co-operation that Ukraine receives from the European Union, the EU4Energy Initiative helps the country to improve the quality of energy data and statistics, shape regional policy-making discussions, strengthen legislative and regulatory frameworks and improve access to information. The initiative’s main objective is to support its partners on their way towards a low-carbon economy. The program is implemented by the International Energy Agency, Energy Community Secretariat and Energy Charter Secretariat. The project has five key components: data project, policy project, governance project, web portal and communications project. Among the six partners of the project (International Energy Agency, 2016[88]), Ukraine is the country which is closest to achieving the objectives set by the EU4Energy initiative.
Multilateral Development Banks (MDBs) have afforded substantive support to the Government of Ukraine and SOEs in order to spur indirect positive effects to private sector participants. For instance, Ukrenergo’s co-operation with MDBs has enabled an increase in the flow of foreign investments into the country. In July 2019, the European Bank for Reconstruction and Development (EBRD) agreed to provide EUR 149 million to Ukrenergo, to support the upgrading of the country’s power transmission network (EBRD, 2019[89]). Ukrenergo committed to using the EBRD funding to upgrade its key transmission and infrastructure, which is necessary in order to enable synchronisation with European electricity networks. The funding is accompanied with technical assistance, which will support the country’s efforts to align its legal framework and operational practices with the EU Third Energy Package, a legislative package for gas and electricity markets within Europe. The EBRD financing is also promoting the commercialisation and institutional development of Ukrenergo through the implementation of a comprehensive Corporate Governance Action Plan and robust procurement standards.
The International Bank for Reconstruction and Development (IBRD) leads the second power transmission project (PTP-2), with a total cost of USD 378 million. The main objective of the PTP-2 project is to increase the level of security, reliability and efficiency of electricity transmission. Additionally, the PTP-2 will improve compensation of reactive power in the grids, thus creating technical conditions to advance the integration of the IPS of Ukraine into the European Network of Transmission System Operators (ENTSO-E), ultimately, thereby enabling it to become a competitive member of the European electricity markets. This project includes investments in the smart grid and advancements to the institutional development of the power company (Ukrenergo, 2021[90]).
Not only has the electricity sector received assistance from MDBs. On May 2018, the CMU formalised the Action Plan created by the EBRD and WB for the Implementation of the State Policy in the Area of Heat Supply. This will help to create a transparent, stable and predictable regulatory and business environment, under which District Heat Companies (DHCs) will be able to attract private investments for modernisation (See Figure 2.7).
Source: (EBRD, EIB, WB, 2019[91])
In Ukraine, the European Investment Bank (EIB) has invested in large-scale infrastructure projects focused on increasing the utilisation of NPPs, reducing pollution and enhancing stability of the electricity supply to consumers. The EIB supports Ukraine in implementing an ambitious energy efficiency programme. A EUR 300 million loan will allow Ukraine to improve the energy efficiency of some 1,000 public-owned buildings, including schools, cultural centres, kindergartens and hospitals (European Investment Bank, 2021[92]).
In August 2019, Ukraine and Germany signed a ‘Memorandum of Understanding on Establishing an Energy Partnership”. The energy partnership consolidates the activities of the German government, which has been working on bilateral energy projects with Ukraine for several years. Its main priorities include: increasing energy efficiency in buildings and industry, modernising the electricity sector, expanding and integrating renewable energy and reducing carbon emissions. With financial and technical aid from Germany, the government established a Coordination Centre for the Transformation of Coal Regions of Ukraine (Ministry for Communities and Territories Development of Ukraine, 2018[93]).
Support to advance private investments in the energy sector
To reach the next stage of development and close the gap with its more advanced neighbours, such as Poland and Hungary, Ukraine needs to support innovation and consolidate a dynamic, competitive, and robust private sector. This is where international development institutions, such as development aid agencies, multilateral development banks (MDBs), can provide key support (Emerging Europe, 2018[94]). Regarding the energy sector, Ukraine has strengthened its relationship with MDBs in specific areas, including: (i) overcoming persistent investment gaps, which persist despite policy reforms (ii) focusing on infrastructure needed over the long term, including the important dimension of innovation and scaling up of low-carbon technologies (iii) supporting new market-based investment in the energy sector, in particular, for relatively new types of infrastructure, such as auctions, demand response and storage technology and (iv) advancing regulatory and policy reforms.
Ukraine is a partner of the Eastern Europe Energy Efficiency and Environment Partnership (E5P). The E5P fund provides Ukraine with access to financial support for the implementation of 25 energy efficiency projects valued at over EUR 962 million. The projects approved for implementation in Ukraine have shown that the E5P grants can leverage, on average, investment volumes that are five times the size of the committed grants. Moreover, E5P projects in Ukraine have reduced 790,466 tonnes of CO2e emissions. The grant allocations are flexible and recognise the priorities of each recipient country. The overall aim is to reduce energy use, pollution and greenhouse gas emissions. The fund also supports policy dialogue and regulatory reform (Eastern Europe Energy Efficiency and Environment Partnership (E5P), 2021[95]). The grants from E5P are used as an incentive for clients to take loans provided by those participating as Implementing Agencies:
Due to the relevance of the co-operation between Ukraine and the E5P, the Ministry of Energy signed an agreement of contribution to continue participation in July 2019. The agreement provides a 10 million EUR contribution to the fund, which will provide access to financial support and technical assistance for energy efficiency. This will result in significant reductions in electricity consumption, carbon dioxide emissions and other greenhouse gases (Ministry of Energy of Ukraine, 2020).
The EBRD has been the most important provider of financing with regards to advancing RES projects in Ukraine. In order to encourage businesses to pursue sustainable energy projects, the EBRD launched Ukraine’s Sustainable Energy Lending Facility (USELF), a loan program that goes beyond providing tailor-made financing, and also affords assistance by providing technical consultants for businesses and local authorities. USELF supports the fulfilment of the goals of the Ukrainian government on its path to higher shares of RES and brings more competition into Ukraine’s electricity sector, which is currently dominated by state-owned enterprises. Loans within USELF are available to local and international project developers in the renewable energy business. Programs like USELF have led to a total investment of EUR 1 billion by the EBRD in Ukraine’s power sector (Ukraine Sustainable Energy Lending Facility (USELF), 2021[96]). Despite the RES crisis in 2020, the EBRD aims to continue its engagement in Ukraine for the duration of the transitional period, from the FIT to the auction scheme. Similar to the FIT scheme, investments from international financing institutions will play a crucial role in de-risking auctions in Ukraine (European Commission, 2020[35]).
The financing for private solar and wind projects in Ukraine have also been made possible due to the participation of development banks and export credit agencies from different countries, including: the Dutch development bank (FMO), the Norwegian Export Credit Guarantee Agency (GEIK), the German development bank (KfW), Proparco as a subsidiary of the French development agency (ADF), the Nordic Environment Finance Corporation (NEFCO), the Nordic Investment Bank (NIB), the US EXIM bank, etc.
Ukraine has successfully implemented regulatory reforms in the energy industry that have led to the participation of private companies in the power, oil & gas, coal and heating markets. The country has shifted the energy sector from an industry with absolute control by the government to one that encourages free market principles.
In terms of ownership and management, Ukraine has developed policies and regulations that have enabled private sector participation and privatisation of energy assets. Major reforms have been implemented to modernise SOEs and enhance their governance, while opening the sector to private companies.
An important advancement has also been the enactment of laws that have allowed the introduction of renewable energy into the energy mix and the deployment of energy efficiency programmes. However, renewable energy generators have faced severe challenges derived from the imbalances of the power sector and the regulatory changes that Ukraine approved in 2020. The crisis caused major arrears to key actors in Ukraine’s power market and affected the trust of private investors in the rule of law.
Despite these challenges, Ukraine has the opportunity to continue encouraging investments in the energy sector, particularly in projects that will help to achieve the country’s National Determined Contributions, by offering legal certainty to private investors. Such an approach could lead to positive outcomes, including reducing the country’s dependence on energy imports, securing a just energy transition and creating sustainable returns for investors.
Progressively move from feed-in tariffs to more competitive support mechanisms. In addition to the feed-in tariffs, Ukraine’s renewable energy market offers the possibility of auctions and the introduction of corporate power purchase agreements that will play an important role in energy transition efforts. Ukraine may wish to consider putting in place awareness campaigns that highlight the benefits of renewable energy.
Advance the implementation of regulations on the development of bioenergy potential of Ukraine related to the development of solid biofuels market, development of liquid biofuels market, development of bio methane market, development of energy crops on marginal lands, reduction of the tax burden on bioenergy facilities running on biofuels by setting a zero rate of C02 emissions tax for them.
Move forward with the implementation of regulations that promote competition in the electricity sector, while placing a special emphasis on the Auctions Law.
Assess electricity and gas tariff schemes for consumer households, abolish cross-subsidies and provide targeted subsidies to benefit the poorest households. In this regard, ensure that tariff and pricing policies reflect the costs of production, transmission, and distribution and allow for a profit for investors. In addition, gradually reduce public service obligations and ensure that those applicable in the country are in line with the EU acquis.
Develop a regulatory framework and action programmes that expedite the economic switch from hydrocarbons to renewable energy sources at a faster rate by strengthening national and regional efforts to phase out coal power plants and eradicating policy support mechanisms for the consumption of fossil fuels.
Continue implementing policies and programmes that pursue the integration of Ukraine’s power and gas system with the EU through synchronisation with the ENTSO-E and the ENTSO-G, including integration measures such as reinforcements of the transmission network, realisation of frequency regulation reserves, establishment of a telecommunication network, and studies on future grid stability.
Establish a mandatory condition for power quotas for entities generating electricity from renewable energy investors, according to which they must simultaneously provide highly manoeuvrable generation, efficient balancing capacities, or Energy Storage-type systems. Incite policy investments that allow RES producers to use the grid to store surplus generated power for a long time and to consume it later.
Adopt a progressive regulatory framework to attract players with new technologies, such as battery energy storage systems, demand response technologies, and green hydrogen to energy markets. This step will encourage the implementation of many more investment projects with these technologies.
Ensure that public procurement and privatisation processes in the whole energy sector are transparent, open to quality private investors, free of corruption and continue using public procurement e-platforms such ProZorro and ProZorro.Sales, Continue providing training for public officials, both at the central and local levels of governments, on the use of ProZorro and ProZorro.Sales.
Take additional actions to ensure that state-owned enterprises active in the energy sector observe high standards of transparency and are subject to the same high quality accounting, disclosure, compliance and auditing standards as listed companies, as was recommended in the OECD 2021 Review of the Corporate Governance of State-Owned Enterprises: Ukraine
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Notes
← 1. See https://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD?locations=UA, https://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS?locations=UA.
← 2. See https://www.flandersinvestmentandtrade.com/export/sites/trade/files/market_studies/Ukrainian%20Energy%20Market.pdf.
← 3. In accordance with the amendments (made by the Resolutions of the Cabinet of Ministers of Ukraine of 24 April 2020 No 303 and of 30 April 2021 No 444) to the Resolution of the Cabinet of Ministers of Ukraine dated 19 October 2018 No 867 "On Approval of the Regulations on the imposition of special duties on the subjects of the natural gas market to ensure public interests in the functioning of the natural gas market" the Resolution ceased to be in force as of 20 May 2021, and the Public Service Obligations were withdrawn from Naftogaz.
← 4. See https://land.gov.ua/proekt-postanovy-kabinetu-ministriv-ukrainy-deiaki-pytannia-pidhotovky-ta-provedennia-zemelnykh-torhiv-dlia-prodazhu-zemelnykh-dilianok-ta-nabuttia-prav-korystuvannia-nymy-orendy-superfitsiiu-emfit/, https://www.kyivpost.com/business/cabinet-authorizes-prozorro-sale-to-conduct-electronic-land-auctions.html?fr=operanews.
← 5. According to the Law of Ukraine “On Amendments to Certain Laws of Ukraine on Improving Conditions for Supporting Electricity Production from Alternative Energy Sources” of 21 June 2020 № 810-IX, new generating capacities on biogas / biomass put into operation after 2023 will not receive FIT. New solar power facilities will receive 40% of the FIT, which is almost equal to the current electricity prices at day-ahead market. According to the latest estimates, it is expected that in 2029 the volume of payments under FIT (including industrial stations and solar power plants installed on the roof of the property) will not exceed UAH 55 billion excluding VAT (in prices and at the rate of EUR / UAH 2021).