In a recent Memorandum of Understanding between the Prime Ministers of Ukraine and the Russian Federation, both side accepted adjustments of gas import prices towards the level of "European gas prices" within a transition period of three years, in exchange for "European fees" for gas transit through Ukraine. Against this background, this paper argues that "European gas prices" in Ukraine should be determined by the replacement value of gas shipments in Europe minus the transit costs from Ukraine to EU markets. Based on this concept and using current prices for Russian gas imports in Germany as well as transit costs that include full "European fees" the paper estimates current "European gas prices" in Ukraine at a level of 554 USD/tcm. Since "European gas prices" typically follow the development of crude oil prices with a time-lag of about five months, this price is likely to increase even further until the end of 2008 before the fall in oil prices that started in August 2008 will also bring down gas prices. With this in mind, we project alternative levels of "European gas prices" based on alternative oil price developments. Our estimations yield projected gas prices between 450 USD/tcm and 750 USD/tcm by 2012, the year in which Ukraine has to reach the "European gas price" level.
The second part of the paper addresses the current system of domestic gas pricing and assesses its capability to cope with further price increases. Although the system has succeeded in keeping gas prices for residential consumers at rather low levels, there are major drawbacks. Firstly, it induces significant additional taxes on industry prices in order to cross-subsidise privileged consumers. In particular, supplying expensive imported gas to district heating generators causes significant financial losses which will increase even further with rising import prices. Furthermore, the use of domestically produced gas for supplying residential consumers at regulated prices distorts incentives in domestic gas production and distracts investments which are urgently needed to utilize Ukraine"s potential. Finally, forcing Naftogaz to supply to privileged consumers endangers the economic viability of the entire holding and thereby risks the functioning of the system as a whole.
Against this background we recommend that the three years transition period which the agreement between the Ukrainian and Russian Prime Minister stipulate must be used for ensuring that necessary price adjustments take place as soon and as smoothly as possible. To this end, we argue that the current pricing scheme can generally be maintained, but that the magnitude of expected adjustments requires fundamental institutional improvements. Overall, four key objectives must be met:
- To keep price increases for residential consumers at responsible levels
- To secure the economic viability of Naftogaz as a key player in the gas sector
- To reduce the cross-subsidization of residential consumers by industry
- To ensure a long-term sustainable development of Ukraine"s gas sector
The main steps that need to be taken to meet those objectives are:
- To assess the fundamental energy needs of residential gas consumers and improve tariffsetting methodologies accordingly.
- To free Naftogaz from the obligation to supply gas to privileged consumers and to transfer this obligation to a legally independent entity that will get its losses compensated from the budget.
- To improve tariff setting for domestic gas production so as to provide sufficient investment incentives.
- To implement a gradual phasing out of additional taxes on industry tariffs in response to lower energy demand of privileged consumers.
- To continue with general structural reforms which aim at strengthening competition and investment incentives in Ukraine"s gas sector.
