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)

Before proceeding with the test, it is imperative to mention the potential impact of a major confounding variable, the effect of which on Ukraine’s gas consumption might approximate the impact of high gas prices suggested by the theoretical framework. This confounding variable is the global financial crisis of 2008 that, by 2009, contributed to a 15 per cent contraction in the Ukrainian economy (Svoboda 2011; Balmaceda 2009). The financial crisis catalyzed a sharp decline in demand for Ukraine’s gas-intensive steel, chemical, metallurgical, and machine exports (Balmaceda 2009; Aslund 2009), which diminished industrial gas consumption. Although the contemporaneous occurrence of the financial crisis and the 2009 gas contract makes it nearly impossible to disentangle their unique effects, the confounding impact of this variable on each hypothesis must be considered separately before proceeding with the analysis of events after 2009.

Hypothesis 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.

The potential effect of the confounding variable is potent here, since it is virtually impossible to say definitively if an absolute decline in Ukraine’s gas consumption after 2009 would reflect the effect of high gas prices, or simply a decrease in demand for Ukrainian exports abroad. Even a decrease in the relative proportion of gas in Ukraine’s overall energy mix can be attributed to the effect of the financial crisis, as it would disproportionately affect the gas-intensive industries and potentially induce fuel-switching away from gas. However, if the financial crisis were the reason for the absolute and relative declines in Ukrainian gas consumption, one would expect to see a correlation between fluctuations in the size of the Ukrainian Gross Domestic Product (GDP) and Ukrainian demand for gas. Specifically, one would expect that as the Ukrainian GDP grew and the economy recovered, the country’s gas consumption would also grow. Meanwhile, investments in improving the energy efficiency of businesses are usually made with a long-run calculus of costs and benefits in mind due to the large financial outlays involved. Since business owners are likely to consider the effects of the financial crisis more or less temporary, it is unlikely that they would seek to make long-term investments to improve energy efficiency on the basis of a recession alone. Consequently, evidence of investment in the improvement of business energy efficiency cannot be primarily attributed to the effects of the financial crisis.

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

Efforts to diversify suppliers of gas usually entail immediate and direct costs, as investment into importing arrangements from new sources necessitates the construction of nonexistent infrastructure, investment in new technology, and the establishment of new diplomatic contacts. An economic recession leaving both the government and the Ukrainian business sector cash-strapped is thus likely to discourage efforts at supply diversification. Thus, evidence of increased efforts to diversify sources cannot be attributed to the effect of the financial crisis.

Hypothesis 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. 

The same logic that applies to hypothesis 2 applies to hypothesis 3, as efforts to boost domestic gas production entail costs to the government and business for the exploration and extraction of shale gas—the only gas Ukraine has left—or for reaching out to potential foreign investors, which would be a more likely prospect at the end of a recession. Moreover, a recession that would depress gas consumption in gas-intensive export industries and thus gas demand can be expected to deter the appearance of new domestic gas suppliers. Evidence of increased efforts to find domestic sources of gas therefore cannot be attributed to the effects of the financial crisis.

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

The financial crisis, which launched Ukraine into its worst recession since the 1990s and impoverished its government, might be expected to make Ukraine particularly eager to accept any Russian discount on the price of gas. Thus, the financial crisis might temporarily increase Russian leverage over Ukraine and thereby offset any gains accruing from its decreased energy dependency on Russia. The findings for hypothesis 4 are thus particularly vulnerable to distortion by the confounding variable.

Testing Hypothesis 1

Hypothesis 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.

Since 2009, Ukraine’s gas consumption has fallen significantly in absolute terms. In 2009 it decreased by 21.8 percent compared with the previous year, from 67.3 bcm to 52.8 bcm (Pirani 2011; 2012). Although in 2010 it rose again modestly to 57.6 bcm (Pirani 2012), the following year imports fell to 40 bcm, only to diminish to 33 bcm in 2012 (Olearchyk & Buckley 2013). These figures suggest that between 2009 and 2012, Ukraine’s annual gas consumption averaged at 45.9 bcm/annum, compared with about 73.6 bcm/annum between 2003 and 2008 (Pirani 2012). Thus, in the aftermath of the 2009 gas war Ukraine was consuming on average 27.7 bcm less gas per year than previously, with its absolute consumption falling by almost 40 percent. This is a considerable and unprecedented reduction in light of the country’s previous consumption patterns. Ukraine was projected to import only 24 bcm of Russian gas in 2013 (Tuohy & Bulakh 2013), with its consumption in the first quarter amounting to a 17.4 per cent reduction compared with the same period in 2012 (National Radio Company of Ukraine 2013).

These numbers reveal consistent annual reductions in Ukraine’s consumption of Russian gas, despite the fact that by 2010 its economy had begun to recover (Matsuki et al. 2012). While Ukraine has not yet recovered its pre-2009 GDP levels and in fact entered a mild recession in 2012 (Olearchyk 2013a). Whereas its GDP fluctuated yet has risen overall, its gas consumption declined. This suggests that cuts in Ukraine’s gas consumption were not prompted by the recession primarily, but instead by the new high gas price environment—the only new factor that can account for the observed changes after 2009.

There is also evidence that savings in gas consumption arose partially because the share of gas in Ukraine’s energy mix fell. Gas-intensive industry and electricity generators have cut demand by diversifying towards other fuels like coal. This has decreased the relative significance of gas in total energy consumption (Pirani 2011; Olearchyk & Buckley 2013). In general, while in 2007 gas accounted for about 47.9 percent of Ukraine’s energy landscape, by 2013 its share had gently fallen to about 40 percent (Apergis & Payne 2010; Natural Gas Europe 2013b).

Further, sensing that the principle of higher gas prices has become an entrenched fact of Russo-Ukrainian energy relations, Ukraine has begun to seek not only short-term, but also long-term strategies for reducing its heavy reliance on gas such as enhancing its renewable energy capabilities. The Yanukovych government worked to build wind energy potential in Crimea and to accelerate the development of Ukraine’s hydro, biomass, photovoltaic, and geothermal energy sources (Kudrya & Pepelov 2011). The context of rising energy prices seems to have generated some investor enthusiasm, with DTEK, Ukraine’s largest power generator, launching construction of a large wind park in Zaporizhia in 2012 (Pirani 2011; KyivPost 2012). In addition, there seems to have been a rise in public awareness of the need to develop more renewable sources of energy, with Ukraine hosting renewable energy summits such as the Ukraine Renewable Energy Development Summit (December 2012) and the annual Ukrainian Energy Forum. The latter was launched in 2010 to invite discussion on Ukraine’s energy situation and ultimately to move forward by adopting sustainable development strategies.

 In addition to fuel source diversification, by 2012 Ukraine began to work toward improving the energy efficiency of its gas pipeline infrastructure, in part by turning to Europe for funds and expertise. In 2009, Ukraine secured EU financing to upgrade its GTS (Balmaceda 2009) and on May 3, 2013 it held roundtable talks with the EU regarding the future development of Ukraine’s gas market (The Wall Street Journal 2013). In part as a result of these measures, through efficiency investments Ukraine has succeeded in decreasing its consumption of so-called “technical gas”—gas that is lost in the pipeline system due to various inefficiencies and problems—by about 37 percent (Olearchyk & Buckley 2013; Pirani 2013).

In 2013, the energy intensity of the Ukrainian economy remained high and the country stayed among the world’s eleven most energy-inefficient economies (Tuohy & Bulakh 2013). However, high gas prices seem to have nudged Ukraine’s industrialists to invest in improving fuel efficiency in their sector (Pirani 2011). Although it is impossible to disentangle the effect of the financial crisis from that of high gas prices, in 2009 overall industrial demand for gas fell by more than 41.9 percent, while industrial output contracted by about 30 percent. This suggests that gas consumption declined more steeply than production (Aslund 2009; Pirani 2011). Pirani (2013) has indicated that at least some of this decline can be traced back to business’ investments in improving efficiency through technological upgrades.

In sum, as the framework suggests, after 2009 Ukraine decreased its consumption of Russian gas in both absolute and relative terms, and improved the efficiency of its economy. This is because it became rational to consume less of a product that had significantly risen in price.

Testing Hypothesis 2

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

The end of low Russian gas tariffs prompted efforts in Kiev to erode Russia’s status as a monopolistic supplier of gas to Ukraine. This applied alike to Russia’s role as the point of origin of imported gas, its role as an intermediary player in gas flows from the Central Asian gas exporters, and its political clout in the area (Pirani 2013). In particular, Ukraine has begun investing in infrastructure aimed at decreasing reliance on conventional natural gas, of which Russia remains the only viable major source in Ukraine’s geographical vicinity, while building partnerships with European countries to import small quantities of their fuel. In 2013, Ukraine scheduled the construction of three coal gasification plants and a liquefied natural gas (LNG) terminal, which would enable it to receive as much as 5 bcm of gas—equivalent to about 17 per cent of its annual energy needs—through non-conventional, non-pipeline means (Olearchyk & Buckley 2013). Ukraine also succeeded in arranging imports of small volumes of fuel from Slovakia and Germany, and began developing capacities to import from Hungary at prices which appear lower than those charged by Gazprom and in volumes that could potentially meet one fifth of gas requirements (Pirani 2013; The Wall Street Journal 2013). According to former Minister of Energy Eduard Stavytsky, by diversifying Ukraine’s gas suppliers and undermining the Russian export monopoly, Ukraine’s bargaining position in future gas price negotiations with Russia will be enhanced, rendering Ukraine less dependent on Russian energy (The Wall Street Journal 2013). These findings are consistent with the framework presented here, as they reveal that after 2009 Ukraine began working to diversify its energy suppliers to reduce exclusive reliance on gas flows controlled by Russia.

Testing Hypothesis 3

Hypothesis 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.

Since 2009, Ukraine has attempted to increase its domestic gas output as a means of mitigating its reliance on Russian gas (Olearchyk & Buckley 2013). Having depleted its easily accessible gas deposits, it has had to develop capabilities for reaching “hard gas” like shale (Natural Gas Europe 2013b). Before 2009, Ukraine was ignorant of the extent of its shale deposits, but has in recent years learned that these might in fact constitute the third largest in Europe (Reuters 2012). According to former Energy Minister Stavytsky, within a decade these deposits have the potential to make Ukraine self-sufficient in gas (Olearchyk & Buckley 2013). This would drastically decrease its energy dependency and possibly make it a net exporter of shale by 2025 (Olearchyk 2013c; Olearchyk & Buckley 2013; Natural Gas Europe 2013c). To explore and extract hard gas, which requires the application of cutting-edge Western technology, Ukraine awarded three production- and revenue-sharing agreements in 2012 to Royal Dutch Shell, Chevron, and Exxon Mobil (Natural Gas Europe 2013c; 2013d).12 At present it is far too early to share in Stavytsky’s enthusiasm entirely. The technical and environmental concerns pertaining to shale drilling, the uncertain impact of political upheaval in Ukraine, and Gazprom’s avowals that Ukrainian shale projects would not threaten the company’s position in the Ukrainian market, all complicate a rosy outlook (Olearchyk & Buckley 2013). However, Ukraine’s attempts to develop its shale deposits are nonetheless steps towards mitigating its energy poverty, in line with hypothesis 3.

Testing Hypothesis 4

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

The confirmation of the first three hypotheses amounts to a reduction in Ukraine’s energy dependency. We can now investigate whether this circumstance has, in turn, reduced its political and economic reliance on Russia. As noted above, the distorting impact of the major confounding variable—the financial crisis—is potentially major, as the event (from which Ukraine is still recovering) may exert additional and unique pressures on the country to yield to Moscow’s demands in exchange for financial relief. The same can be said of many other factors, including Ukraine’s domestic political structure, which in practice could render the country pliable to Russian pressure and offset gains in energy independence. However, these complications do not obviate the fact that reductions in energy dependency might still result in gains for Ukraine in terms of politico-economic independence. The following should be construed as tentative reflections on the post-2009 dynamics of this relationship.

The April 2010 agreement between President Yanukovych and President Medvedev to exchange a twenty-year extension on Russia’s lease of a Crimean naval base for a small, temporary reduction in the prices at which Russia sold its gas to Ukraine, has been sometimes interpreted as an indication that gains in energy independence did not alter Ukraine’s pliability to Russian political pressure (Charnysh 2013; Conde & Martins 2010). However, the agreement came so soon after the conclusion of the 2009 gas contract that it would be unreasonable to expect a significant reduction in Ukraine’s energy dependency on Russia by mid-2010. Further, it is not at all clear that the conclusion of the agreement was foreseeably detrimental to Ukrainian interests or was concluded against its will as a simple result of Russian energy pressure. While naval bases on its territory were in some ways an affront to Ukrainian sovereignty, and proved to be a stepping-stone in Russia’s eventual takeover of Crimea, the so-called Kharkiv Accords helped Ukraine through the recession by keeping its gas bills lower than they might have been.

Nonetheless, the stalemated Russo-Ukrainian discussions on Ukraine entering the Russian-led European Economic Community (Customs Union) represent a clear attempt on Russia’s part to reintegrate the FSU under its leadership by exploiting Ukraine’s dependency on Russian gas. President Putin has consistently promised much lower gas prices for Ukraine if it accedes to the Union (BBC World News 2013). However, in acceding Ukraine would have put a decisive end to the prospect of moving closer to the West which, as the recent “Maidan” protests have shown, is favoured by a broad cross-section of the population. Despite the seductive “carrots” of much cheaper gas, and the “sticks” of ultimatums that Ukraine immediately repay its purported debt to Gazprom,13 former President Yanukovych consistently refused the Russian offers. While the decisions of Ukrainian politicians have been influenced by a variety of factors—a topic on which meaningful research has yet to be done—Ukraine’s gains in energy independence were of rhetorical use in resisting Russian pressure. Politicians threatened to dispute the Russian energy debt charges through international arbitration, as Ukraine had acquired against Russia “more leverage than ever in the past” as a result of its preliminary success in diversifying its gas suppliers and reducing consumption (Olearchyk 2013c). Similarly, Ukraine’s former Prime Minister Mykola Azarov referred to these successes as the “strong new cards” that Ukraine could use to bargain in disputes with Russia (Olearchyk 2013b). At minimum, on the level of formal governmental discourse Ukrainian officials appeared confident that the country had made real progress in reducing its energy dependency. They deployed this in defense of what they saw as Ukraine’s politico-economic interest in abstaining from the Customs Union.

With the severance of the “umbilical cord” of cheap Russian gas which, since 1991, nurtured elements in Ukrainian society that kept its domestic and foreign policy largely frozen in the Soviet era, we can now expect to see changes in both spheres. By eliminating one  of the Ukrainian industrial elite’s pro-Russian sympathies, while at once increasing the importance of Ukraine as a large and very profitable market for Russian energy exports, higher Russian gas prices have improved Ukraine’s position relative to Russia in terms of their asymmetrical interdependence in energy and politico-economic matters. As a result, in theory Ukraine has become freer to pursue a pro-Western foreign policy if it so desires—a factor which may have played a role in enabling the 2013-2014 “Maidan” protests. The ties that Ukraine has been able to forge with European states for the import of their gas, financing, and expertise in gas sector reform can be used as a springboard for a more comprehensive rapprochement with the EU. On a domestic level, having to court outside investment into the non-conventional gas sector has brought to the fore a need for Ukraine to improve its business climate. This could be beneficial to the Ukrainian economy as a whole by necessitating greater transparency. Similarly, investments in improving the energy efficiency of Ukrainian industry may make the economy more resilient, dynamic, and secure in its future prospects, instead of riddled by fear of chaos during a spike in gas prices. Ukraine’s political system may also be subject to a push for meaningful democratization as a result of economic reforms and greater cooperation with the West. In fact, this outcome, while far from certain, is a necessity if Ukraine is to benefit fully from the new opportunities afforded by its altered energy relationship with Russia.

As the history of post-1991 Russo-Ukrainian energy relations makes clear, Ukraine’s domestic political configuration, and particularly the ability of successive business-administrative groups to take state institutions hostage and exploit them for private gain, have consistently prevented the country from fully reaping the benefits of its asymmetrically interdependent energy relations with Russia. As result of the 2009 gas war, Ukraine’s potential leverage in energy matters vis-à-vis Russia has increased. However, the extent to which this development will translate into practical reductions in Ukraine’s politico-economic dependency on its Eastern neighbour will greatly depend on the extent to which its political institutions will be geared towards pursuing state interests. It will also hinge on the general skilfulness and uprightness of its politicians, who in turn depend on the quality of the country’s educational and legal institutions. Also of crucial significance will be whether Ukrainians choose to consider the full (rather than the nominal) costs of cheap Russian gas for development and appreciate that Ukraine can successfully adapt to high energy costs—it has in fact already begun to do so—or whether they instead choose to focus on the inevitable short-term costs of transition to a new energy and economic model. A high gas price regime does not amount to a magic formula for fixing Ukraine’s numerous problems, but it provides an unprecedented opportunity for the country to make a decisive, positive break with its past.



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