5 November 2014

Russia-Ukraine Gas Deal – Another Last-Minute Special

OCT 31, 2014

For the fifth time in eight and a half years, Russia and Ukraine signed another gas deal, literally at the eleventh hour, late evening on October 30 in Brussels. This time negotiations were conducted under the mediation of the European Union (EU) with six months of back and forth discussions, during which Russia ceased supplying gas to Ukraine while gas transit to Europe continued. With winter approaching and Ukraine’s gas storage only half full, this five-month deal for supply of Russian gas to Ukraine through March 2015 is an achievement for the two sides, in the midst of the most difficult security and political conditions in eastern Ukraine instigated by Russia, as well as of the outgoing European Commission (EC) a day before its final day in office, with the active participation of President Barroso and Energy Commissioner Oettinger. 

A potential gas supply crisis for Ukraine and Europe was forestalled for this winter. Time has been bought to findurgently needed longer-term solutions so that the same precarious energy conditions do not persist in Ukraine, as they had for the past two decades, at the risk of endangering itself and its European neighbors.

This interim deal has largely gone Russia’s way. The agreed price was set by an addendum to the January 2009 ten-year gas agreement signed by then-prime ministers Putin and Tymoshenko in Moscow. The 2009 deal was fundamentally flawed from Ukraine’s perspective by setting too high a base gas price at a time when oil prices were at a cyclical trough during the global financial crisis. (When oil prices recovered in 2010, the oil-indexed adjustment formula in the 2009 gas agreement drove the price Ukraine was to pay Russia to an astronomical level.) A $100 price “discount” is offered by Russia in the form of an export duty exemption to be formally approved by its government, just as it was in the April 2010 gas agreement signed in Kharkiv by then-Ukrainian president Yanukovych’s government. Ukraine’s demand for a new pricing basis is set aside, subject to arbitration in Stockholm that will likely be a long drawn-out process.

Accumulated Ukrainian gas debt to Russia of $3.1 billion will be repaid in two tranches by the end of this year. Ukraine will have to pre-pay for gas supplies from November to March. This amounts to another $1.5 billion for November and December, which will put a dent in Ukraine’s already stretched budget and foreign currency reserves. Given its active mediation, both Russia and Ukraine tried to draw the EU into providing guarantees or funds as part of the deal, which the EC avoided at the risk of non-performance by either Russia or Ukraine. The January 2009 ten-year gas transit agreement, which obliged Ukraine to provide pipeline capacity without an accompanying commitment by Russia to ship a minimum gas volume, remains in place.

The best that can be said about this deal is it was signed in autumn and not in the dead of winter. Given all its economic difficulties caused mainly by its own military and political actions, Russia chose not to use its leverage to trigger a gas supply crisis so as to cast Ukraine as an unreliable transit country and to force Europe into accepting its South Stream Gas Pipeline project to bypass Ukraine. However, the game is not over, only a time-out has been called.

Nevertheless, this is a critical reprieve for Ukraine and an opportunity for its new government, which will soon come into office as a result of the October 26th parliamentary elections. For more than twenty years, Ukraine has delayed the transition of its Soviet-era economy. Instead state assets have been hijacked for private use and corruption is rampant. Nowhere are the abuses worse than in the energy sector. President Poroshenko, who came into office in June, has said “Delay with reforms is fatal for us.” He should know as a close observer and indeed participant in the infighting and avarice that doomed Ukraine’s leaders after the 2004 Orange Revolution, the last time hopes for reform had risen so high. 

Energy is a key vulnerability for Ukraine. According to the IMF, its energy intensity (amount of energy used to generate a unit of GDP) is twice as high as Russia and energy subsidies are equivalent to 7.6 percent of GDP. Price controls encourage waste and corruption while discouraging conservation and investment in domestic energy production. A country that has the geologic potential to be self-sufficient in gas instead imported 60 percent of its gas needs from Russia. Various Ukrainian leaders have used Ukraine’s transit leverage, which was once as high as 80 percent of Russia’s gas exports to Europe to today’s 50 percent, to obtain cheap gas to fuel the corrupt system and line the pockets of their cronies.

All these practices have been well documented and reported. Under President Yanukovych, such abuses rose to new heights and were a direct cause of the Euromaidan movement. Yet even Yanukovych gave lip service to economic reform, including in energy, as did President Yushchenko before him. Europe and the United States greet every new Ukrainian government as if its leaders mean what they say. The Ukrainian people are no longer willing to show such patience. The West should listen to them.

Ultimately the only effective deterrence against Russian aggression is an economically prosperous and politically unified Ukrainian state that is supported strongly by society, not oligarchs. If the new government under a clear electoral mandate (which the acting government did not have, while understandably overwhelmed by war and insurrection in eastern Ukraine) commits to and embarks on a serious reform path, then it needs and deserves substantial support from the West in both financial resources and capacity building. Such assistance must be strictly conditional on performance in reform that is monitored regularly. Donor countries and institutions must closely align and coordinate their efforts to be successful.

Given the severe problems energy causes for Ukraine’s economy and politics and the vulnerability they create for Europe’s gas supply (15 percent of which still transit Ukraine from Russia), the sector should be high on the priority list for systematic reform. Areas to focus on are numerous: pricing reform, creation of a truly independent energy regulatory body, restructuring the state-owned oil and gas monopoly, improving investment conditions for domestic energy production, stabilizing the gas supply and transit relationship with Russia according to international business standards by professionals and not politicians, etc. With the prospect for stable gas relations after Ukraine cleans up its energy sector, Russia will have to find other reasons to justify the building of South Stream, costing tens of billion dollars, at the expense of Russian gas producers and European gas consumers.

An order of battle is required to tackle energy reform in a bold, swift and systematic way. Ukraine possesses neither the technical expertise nor the professional experience to do this on its own without substantial assistance from the West. Yet the potential payoff is tremendous. Given the cynicism about past abuses by government leaders in energy, a public campaign will be required to engage Ukrainian society in a conversation on the benefits of energy reform and to elicit societal input and support.

Reform in energy (and elsewhere) will require a sustained effort over five to ten years, beyond the attention span of most Western politicians. Consequently Western governments must first ask themselves how important an independent Ukraine, moving toward integration with Europe, is to their own national interests. Beyond rhetorical support and economic sanctions against Russia, which do not address Ukrainian weaknesses, assistance from the West, so far, has not been at the scale required, nor has it been well coordinated. U.S. assistance has been particularly meager. Mention of a donor conference at the end of January 2015 in Kyiv belies the urgency of the situation.

The interim Russian gas deal and diminished fighting in eastern Ukraine during winter months provide an opening to the new Ukrainian government that will be formed in the next week of so. It is time for them and the West to get to work. To do otherwise is fatal.

Edward Chow is a senior fellow at the energy and national security program of the Center for Strategic and International Studies in Washington, DC.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s). 

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