Forced to be Free? The Consequences of the Transition to European Netback Gas Prices for Ukraine’s Energy Dependency

April 2015

From: JUPS #1, 2015 (pp. 58-78).

Photograph: Andrey Skakodub / UNIAN (2011)

Although profits from the deft exploitation of Ukraine’s energy dependency were mostly pocketed by select individuals with connections to top-level Russian and Ukrainian politicians, its costs were foisted upon the Ukrainian public in a variety of more or less covert, and more or less monetized, schemes. These included “state guarantees, high inflation, a devalued currency, and growing budget deficits and foreign debt”, as well as a besmirched international reputation as an unreliable trade partner, an increasingly non-transparent economy, state corruption, and a growing number of political concessions to Moscow as Ukraine slowly recovered its economic and geopolitical clout following the dramatic rise in post-1998 oil and oil-linked gas-prices (Balmaceda 2013, p. 104; Goldman 2008; Pirani 2012). In the 1990s, Russia’s weakness and the the dominance of pro-Russian voices in the Ukrainian Rada under President Kuchma rendered Russo-Ukrainian energy relations underpinned by low prices acceptable to both parties.

By offering energy discounts for naval infrastructure in Crimea, Russia was already exploiting Ukraine’s energy dependency to extract political concessions (Balmaceda 2013). The dawn of the new millennium, however, brought the exogenous shock of steeply rising oil and oil-linked gas prices in Europe, and Ukraine’s endogenous political transformation that culminated in the Orange Revolution. While the former rendered Russia more assertive as it sought to re-impose its control over the members of the former Soviet Union (FSU), the latter made Ukraine increasingly unwilling to participate in Russian-led reintegration schemes in the post-Soviet geopolitical space.

Because a major increase in energy costs would have immediately destabilized the fragile gas-intensive Ukrainian economy, so long as the generally pro-Russian Kuchma regime was in power (1994-2005) Russian gas prices for Ukraine, while rising, remained low (Nygren 2008). Meanwhile, both Gazprom and the Russian government, through foregone profits and tax revenue, effectively subordinated Russia’s immediate financial interests to its long-term political aspirations, as well as to the personal interests of select politically powerful individuals in the Russian government and Gazprom—individuals who sometimes colluded with Ukrainian politicians and oligarchs to extract rents from Ukraine’s energy dependency (Balmaceda 2013). However, as the prices for gas in the European market rose steadily throughout 1998-2006, and as Ukrainian politicians began deploying anti-Russian rhetoric in the lead-up to the Orange Revolution, the particular configuration of state, corporate, and personal interests in the Kremlin and Gazprom that had until that time fostered relatively stable low gas prices for Ukraine, was unsettled. A process of disorderly reshuffling ensued, culminating in the 2006 and 2009 gas wars.

The causes of the 2006 gas war can be traced to contemporaneous and mutually reinforcing transformations in both Russia’s and Ukraine’s official energy policies, the shifting dynamics of the complex bidirectional relationship between the Russian state and Gazprom, the upsetting of existing cross-border rent-seeking schemes in the energy sector by the newly elected regime of President Yushchenko, and possible attempts by actors in both countries to foster artificial energy scarcities and insert new actors (Balmaceda 2013). Among Ukraine’s new team of “Orange” politicians—notably Yushchenko and Prime Minister Tymoshenko—there was a sudden outpouring of anti-Russian and pro-NATO rhetoric. This prompted the Kremlin to doubt that its policy of subsidizing Ukrainian energy imports since 1991 was paying off. Members of the new Ukrainian government quickly moved to redistribute energy-related rents among themselves, quarrelling and disturbing status quo rent-sharing schemes that included Russian partners (Balmaceda 2013). In the process, Yushchenko came to demand the raising of tariffs on Russian gas transit through Ukraine, which, due to the linkage of the price of gas imports to transit tariffs in the Russo-Ukrainian energy agreement, escalated into a broader conflict. Through Gazprom, Russia retaliated with a firm insistence that Ukraine begin paying almost four times as much for its gas imports. Meeting resistance, it responded with a three-day gas cut-off.7

Both prior to and after this conflict, Gazprom was not a passive foreign policy tool of the Russian government. Instead it was steered by close Putin ally Alexei Miller, and the state had more than half the company’s stock in its hands. These realities, coupled with the fact that Gazprom’s corporate interests demand not only charging its foreign energy customers high gas prices, but also appeasing the Russian state,8 suggest that Gazprom cannot be considered an independent active generator of Russia’s new energy stance towards Ukraine, though it certainly helped foster it. The Russian state effectively permitted Gazprom to insist on its corporate interests—and Russia’s financial interest—of raising the export prices to Ukraine as, with recalcitrant ‘Orange’ elites in Kiev, there was no longer good reason to forego this revenue. This was especially the case as, by 2006, Russia had grown strong enough that it no longer had to subsidize the Ukrainian economy in order to extract key concessions.

The 2006 gas war concluded with a weakening of Ukraine’s leverage over Russia. It also prompted public indignation over Yushchenko’s apparent weakness in the face of Russian pressure and rumours that he used the deal to pursue his own and his allies’ interests at the expense of the state. The new contract committed Ukraine to charging Russia low gas transit and storage fees, and to pay increasingly more for Russian gas; between 2006 and 2008 the price of Russian gas imports doubled, though it remained significantly lower than the level of European netback. Meanwhile, no clear mechanism for negotiating the terms of future price increases was established, paving the way for further altercations, which would culminate in the gas war of 2009 (Balmaceda 2013). RosUkrEnergo (RUE), a new intermediary with ties to both Gazprom and Yushchenko, acquired a monopoly on all gas imports flowing into Ukraine from both Central Asian and Russian sources, arrogating to itself tremendous profits for unnecessary services. As a result, any gains in Ukraine’s energy independence due to the ostensible geographical diversification of energy supply were offset by needlessly high prices and further obfuscation of the country’s energy dealings (Balmaceda 2013).

The result of these measures was that the Ukrainian economy did not, as expected, take a hit, but in fact continued growing due to record-high world prices for its exports. However, the terms of the conflict’s resolution largely discredited ‘Orange’ politicians (those who believed in the necessity of maintaining low Russian gas prices as well as those committed to breaking the cycle of dependency) in the eyes of the Ukrainian public and Western observers. Because during the crisis to counter the Russian gas cut-off Ukraine diverted quantities of Europe-bound gas for its own consumption, it exposed itself to charges of corruption and criminal activity from Russia and Europe alike. The resultant perception that Ukraine was engaging in illicit activities at Europe’s expense raised yet another barrier on its already perilous path to strengthening relations with the EU, and effectively doomed the new government’s pro-Western foreign policy to failure. All of these developments benefited Russia, as they helped to isolate Ukraine from the West and fundamentally undermined the credibility of pro-Western factions within the Ukrainian political system. In essence, the course and outcome of the 2006 gas war illustrates how Ukraine’s energy dependency on Russia made it possible for this external actor to significantly affect the course of Ukraine’s domestic and foreign policy, while setting the stage for the gas war of 2009.

Conceptualizing Ukraine’s Energy Dependency: Theoretical Framework

On the eve of the 2009 gas war, Russia still supplied over 70 percent of Ukraine’s gas and was its only major supplier of energy through the intermediary RUE.9 Meanwhile, Ukraine’s energy intensity remained twice that of neighboring Poland and, in 2008, when (at its peak) the Ukrainian GDP ranked 45th largest in the world, Ukraine was the world’s sixth largest consumer of gas. It devoured more of the precious resource than the Czech Republic, Hungary, Poland, and Slovakia combined (Chow & Elkind 2009). With the main Ukrainian economic sectors still relying on supplies of cheap Russian gas, it became impossible not to question the meaning of the country’s nominal independence (Balmaceda 2008). However, while detrimental to its claim to sovereignty, Ukraine’s dependence on Russian gas was rendered rational by fiscal concerns, and given Ukraine’s domestic political environment. The following paragraphs illustrate how, prior to 2009, Ukraine’s energy dependency on Russia can be seen as resting on three pillars: the high gas intensity of the Ukrainian economy, Russia’s status as a monopolistic supplier of gas to Ukraine, and Ukraine’s energy poverty. Each pillar contributed to Ukraine’s fumbling approach to foreign policy and economic development.  

After 1991, Ukraine’s gas-intensive economy was a luxury that it could afford only because cheap Russian gas remained available and insulated it from financial pressure to diversify its energy mix. Cheap gas also enabled Ukraine’s exports to remain competitive without significant structural economic reform or innovation. In effect, the continued availability of cheap natural gas enabled the Ukrainian economy to remain “frozen in seemingly permanent transition” (Chow & Elkind 2009, p. 79), as it offered no material incentive for businesses to incur the costs of improving energy efficiency, or for residential customers to conserve energy. It also sent confused and distorted price signals to economic actors, making it rational to continue investment into the already-developed, gas-intensive industries instead of incurring the costs of entry into other sectors that would have been truly competitive in global markets without Russian subsidies.

 As cheap gas could only enter Ukraine through Russia, that country could not but remain Ukraine's only major external supplier. Artificially low Russian gas prices discouraged attempts to look for other suppliers and other sources of energy in general, many of which had become available due to technological breakthroughs in the 2000s. While some European countries began to take advantage of deliveries of liquefied natural gas (LNG) from North Africa, the Middle East, and Canada as a substitute for Russian supplies, for Ukraine investment in the construction of a LNG terminal would have seemed an unnecessary cost in light of the availability of cheap Russian gas. This abundance also helped keep Ukraine energy-poor by discouraging investment into exploration of the country’s own shale gas deposits. To assess and extract shale gas which, by the 2000s, remained its only domestically available gas source, Ukraine would have had to make sizable investments into the necessary technology or to improve its domestic business environment to attract foreign direct investment (FDI). As with building an LNG terminal, these were seen as superfluous costs as long as Ukraine could import Russian gas cheaply.

In short, by 2009 it had become clear that Russian energy had only been nominally cheap; Russian gas in fact carried with it many invisible “costs”. Low prices not only helped keep Ukraine’s economy energy-inefficient, undiversified, and vulnerable to sudden shocks in energy prices, but also fuelled corruption in the Ukrainian political system and rendered Ukraine extremely vulnerable to Russian pressure politically. This was true both on the visible level of interstate relations, and beneath the surface. Circumstances visibly came to a head in the aftermath of the Orange Revolution, when Russia exchanged energy discounts for assets in Crimea (possibly influencing the peninsula’s ultimate secession from Ukraine in 2014). Beneath the surface lay Russian actors’ impact on powerful Ukrainian business-administrative groups. 

On the basis of these observations a theoretical framework for understanding the interaction between the price of Russian gas for Ukraine and its energy and politico-economic dependencies on Russia can be formulated. The historical record to 2009 suggests that, given Ukraine’s domestic political configuration, including the political prepotency of industrial interests, low Russian gas prices structurally underpinned Ukraine’s exposure to arbitrary interference from Russia in its economic and political affairs. In particular, the availability of cheap Russian gas rendered reasonable Ukraine’s over-consumption of Russian gas imports, as well as Russia’s continued status as the monopolist exporter of gas to its energy-poor neighbour. These consequences in turn enabled Ukraine’s energy dependency to translate into economic and political dependency on Moscow. The development of the Russo-Ukrainian energy relationship prior to 2009 in effect suggests that the price of Russian gas and Ukraine’s energy dependency were negatively correlated, with declining prices corresponding to an increase in energy dependency. It also indicates that there was a positive correlation between Ukraine’s energy dependency and its political and economic dependence on Russia, as the more Ukraine relied on Russian energy for maintaining its economy, the more its economic and political stability became vulnerable to Russian interference.

With the signing of the January 19 deal that committed Ukraine to paying European netback gas prices starting in 2010 (after an initial doubling in tariffs in 2009), the 2009 gas war effectively ended the low gas price environment and ushered in its opposite—a high gas price environment in Ukraine, as in the rest of Europe.10 By acquiescing to European netback, Ukraine committed itself to paying the oil-linked price of gas at which it is sold at the border with the EU (the EU base price) minus the transportation costs between Ukraine and this border (Pirani 2013).11 This shift enables a test of whether or not Russian gas prices negatively correlate with Ukraine’s energy dependency in general, and whether or not Ukraine’s energy dependency positively correlates with its economic and political dependence on Russia—that is, if the opposite of what held in a climate of low gas prices continues to hold when gas prices are high. I propose to investigate this with the help of four hypotheses:

1. High Russian gas prices would make it rational for Ukraine to reduce its consumption of gas in absolute terms, diminish its relative proportion in the country’s overall energy mix, and lower the energy intensity of its economy through investments in energy efficiency.

2. High Russian gas prices would make it rational for Ukraine to diversify its sources of energy supply in order to bypass Russian or Russian-controlled suppliers.

3. High Russian gas prices would make it rational for Ukraine to seek to boost its domestic gas output and thus become less energy-poor. 

If any of the first three hypotheses hold—which would amount to a reduction in Ukraine’s energy dependency on Russia—then it is also possible to formulate the fourth hypothesis:

4. By diminishing Ukraine’s energy dependency on Russia, high gas prices would decrease Russia’s political and economic leverage over Ukraine.



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