Liberalizing Ukraine’s Electricity Market: Benefits and Risks

BY ANDRIAN PROKIP

In 2018 the Verkhovna Rada adopted a new Law on the Electricity Market. The aim of the law is to establish in Ukraine a retail electricity market similar to the one being obtained in the EU. Liberalizing the electricity market is among Ukraine’s obligations to the international community and is expected to have many positive benefits for the country in terms of both improving the macroeconomic situation and creating a mechanism to refresh and economize the aging electricity-producing and transmitting infrastructure. The impacts on end-users in the form of higher energy prices will be felt most in the first two years and will require deft management from the incoming administration.

In 2011, while still laboring under a pro-Russia administration in Kyiv, Ukraine joined the European Energy Community and committed to implementing the same energy regulations adhered to by most European states. However, little progress was made in the following years. According to the agreement, incentive-based tariffs for electricity transmission were to be introduced by 2014 and a full electricity market by 2015. But these changes were not realized, and Brussels did not pressure Kyiv to live up to its agreement.

Then-president Viktor Yanukovych even publicly floated the idea of leaving the European Energy Community because membership in it, he said, contradicted certain Ukrainian interests. The formal reason, according to Yanukovych, was that the EU and the European Energy Community did not support Ukraine in its relations with Russia and did not help Ukraine preserve its role in the regional gas market. The real reasons probably included an unreadiness to start energy reforms and Russia’s opposition to closer relations between the EU and Ukraine.

After the Revolution of Dignity in 2013–2014, however, and the signing of the EU-Ukraine Association Agreement by President Petro Poroshenko, Kyiv renewed its commitment to implementing European energy regulations.

The Significance of Synchronized Regulations

The impetus behind synchronized regulations is multifold: to enhance regional security, boost energy independence, improve environmental conditions, and promote investment in the energy sector, which is critically needed to rehabilitate or replace Ukraine’s aging infrastructure.

The first stage of the reforms properly launched at the start of 2019. The new electricity market rules are expected to be functional as of July 1, 2019, when Energorynok loses its effective monopoly on buying and selling electricity on the wholesale market. Recently, however, representatives of President-elect Volodymyr Zelenskiy have raised the possibility of postponing a full market launch for at least a year. One reason for doing so is the utility companies’ huge debts to the state-owned Naftogaz, which need to be resolved. But the decision is likely to be colored by political concerns as well: increasing electricity prices for households will almost certainly reflect negatively on the new president and his political party before the parliamentary elections in late October.

Ukraine’s electricity market reforms entail a number of major changes affecting everyone in Ukraine. The most important changes are the following:

• The elimination of cross-subsidization (which occurs when industrial consumers pay higher prices to compensate for the lower prices paid by households) and a shift to market pricing for electricity, with direct trading and intraday and day-ahead markets.
• Substituting the cost-plus pricing system for electricity distribution with RAB (Regulatory Asset Based) tariff regulations. The tariff design of the RAB system is primarily aimed at encouraging investment in the modernization of infrastructure.
• Adopting the EU’s Third Energy Package, a legislative package for regulating the EU’s gas and electricity market.

Critically, the electricity market reforms will simplify the integration of Ukraine’s power grid with the European one, known as ENTSO-E. This will mean a better environment for competition once Ukraine is part of the single European market and ensure a more reliable electricity supply for Ukraine.

Domestically, the reforms will help with the financing of electricity infrastructure modernization. Currently the electricity-producing and transmission assets have highly depreciated. For instance, 90 percent of electricity transmission lines are outdated. The distribution lines have depreciated by 60 percent, and thermal electrical power stations have depreciated by 80 percent. Any additional depreciation of energy assets will decrease electricity production in the country and turn it into a net importer of energy within fifteen years. Before then the quality of electricity supply will take a significant hit, and end-users can expect frequent brownouts and blackouts.

Impact of the Reforms

The Ukrainian Institute for the Future, a Kyiv-based think tank, has identified key impacts to be expected from the reforms.

With the market reforms in place, electricity-generating companies should be able to invest U.S. $29.8 billion during the period 2019–2030, which is 11.5 times more than without the reforms. This significant increase in investment capability will allow the financing of new power units and prevent a deficit in baseload capacity, which, in the absence of the reforms, would occur after 2029.

The transition to incentive-based tariffs should also allow the distribution and transmission system operators to realize €7.5 billion in investment resources, almost twice the amount that would be realized without the reforms in place. And with greater investment volumes, losses in both distribution grids and transmission grids are expected to decrease.

Internationally, synchronization with ENTSO-E is expected to increase the export of electricity by almost five times, from 5.6 billion kWh in 2017 to 25.0 billion kWh in 2030, resulting in an estimated U.S. $6.7 billion in surplus export earnings in 2019–2030. Should synchronization not be achieved, however, Ukraine will remain dependent on importing electricity from the Russian Federation and Belarus during a period of strained relations with these countries.

The macroeconomic situation in Ukraine should also benefit greatly from liberalizing the electricity market. The rollout of additional reforms in 2019–2030 is expected to add U.S. $72.1 billion to the country’s GDP. State budget revenues from taxes should increase by U.S. $12.1 billion, and the population will benefit from receiving an additional U.S. $17.7 billion in income.

Certain negative impacts of the reforms are also expected, most prominently an increase in electricity prices for industry and retail consumers. The price increases will be most dramatic in the first two years of the reforms. The Ukrainian Institute for the Future estimates that residential tariffs will increase by 28 percent in 2019 and by another 84 percent in 2020. For industrial consumers, tariffs will increase by 45 percent in 2019, followed by a slight decrease of 5 percent in 2020.

Over the long term, liberalizing the electricity market is expected to bring important and positive results to the country and its citizens. But this can happen only if the new regulations are not manipulated by, for example, parliament passing laws that alter the current legislative framework in such a way as to benefit individual actors, to the detriment of many others.

Another threat comes from active populist movements and campaign promises made in the run-up to the presidential elections about keeping electricity tariffs low. Promises of the latter sort can be partially met by providing direct subsidies to those who would not otherwise be able to afford retail electricity.

Reforming the electricity market is among Ukraine’s key international obligations. Failure to move forward with the reforms or, worse, their outright cancellation would significantly degrade the attractiveness of the country to foreign investors and reduce the trust of Ukraine’s international partners.