The transformation of Naftogaz since 2014 has been about more than just weeding out poor managerial practices or corrupt schemes, or even reducing dependence on Russia. Each element, though important, should serve to build a modern, competitive gas market in line with best European standards.

Prior to 2015 gas market structure would play second fiddle to Russian-Ukrainian negotiations. Dependence on imports meant that although "formally the monopoly in Ukraine was Naftogaz, the market was actually controlled by Gazprom who set the price and got the economic benefits from the absence of real competition," according to Naftogaz Executive Director Yuriy Vitrenko.

Now that Russian imports have been eliminated getting market design right has huge implications for the country's future. Proper structure and regulation can ensure a competitive environment that efficiently delivers gas to households and industrial clients at attractive prices. Getting things wrong, however, could drive up costs and hurt the economy.

Gas markets and vertical integration

Natural gas markets tend to be on the complex end of the spectrum. Multiple pieces need to work together to ensure technically sophisticated production or imports with fluctuating prices translate into stable and reliable heating for households.

The number of players and power dynamic at each step – extraction, transmission, storage and distribution, to name but a few – are different, which makes the system unwieldy and expensive if broken down among individual organizations. This is particularly true for Europe, with smaller, fragmented markets (unlike, for example, the United States) that require strong vertical integration to get the scale and efficiency to remain competitive.

Typically, strong vertical integration lowers capital costs (borrowing is easier and cheaper for large firms) and helps build expertise. Further, an integrated model reduces transaction costs, improves economies of scale and limits supply disruptions, according to Vladyslav Medvedev, a senior manager at global advisory PwC.

"Collaboration is a particularly effective way to lower costs. Combining skills, equipment and technology can unlock significant value for the company," he argued.

But going too far – creating a monopoly – creates risks to prices and quality of services. Seeking to strike a balance, European regulators have issued directives dating all the way back to 1986, when they adopted the Single European Energy Act.

Unbundling gas transmission has been a particularly contentious issue. Regulation is governed by the Third Energy Package, which outlines three models for companies to split out transmission activities: Ownership Unbundling (integrated energy companies sell off their networks), Independent System Operator (energy companies can formally own part or all of their networks, but operations, maintenance and investment is left to an independent player), and Independent Transmission System Operator (energy companies own and operate networks, but through a subsidiary that makes decisions independently of the parent company).

Different approaches to unbundling

European practice shows a range of models have been adopted. France's Engie, for example, has financial interests in its subsidiary GRTgaz – a transmission system operator covering most of the market except southwestern France (covered by Terega, an international joint venture) – but is not directly involved in running the network and is significantly integrated. Norway's oil and gas giant Equinor, which supplies much of Europe, is quite similar in its set up to deliver scale and efficiencies.

Conversely, Poland's PGNiG chose the path of full unbundling of gas transmission operator Gaz System (100 percent state-owned), but bet on integration across the rest of the value chain. This notably true for power and heat generation, which PGNiG set as priority segments in its latest 2017-2022 group strategy, so the company controls every step from storage to individual sales.

It is worth noting that Third Energy Package implementation is spotty according to some experts. Italy's Eni and the Austrian arm of OMV are joint owners of Trans Austria Gas Pipeline, which provides Russian gas to Italy and Austria. In theory, this is acceptable due to regulation that ensures third parties can access the pipeline, although the EU has brought anti-trust cases against the company in the past.

Comparing Naftogaz to European peers shows gas transmission and storage is indeed a key area where the Ukrainian player stands out – a challenge regularly highlighted by international experts as a top priority. "I would still argue for strong ownership unbundling and divestment of Naftogaz to create viable competition to ensure the best service at fair prices for Ukrainian consumers," summed it up Georg Zachmann, an energy analyst from the Bruegel think tank in Brussels.

The question of the right model has been stuck, however, due to a deadlock over energy policy between Naftogaz and the former government of Prime Minister Volodymyr Groysman. The government favored a "full ownership unbundling" model (with an option to revoke the status of the operator), while Naftogaz pushed for the "independent system operator" model, whereby an independent operator worked as part of an international consortium, a common practice that offers greater protection to foreign partners. Importantly, the former option could damage a claim by Naftogaz against Gazprom in the Stockholm international arbitration court – resulting in gridlock.

According to Edward Chow, an expert at the Washington DC-based Center for Strategic and International Studies, the underlying problem was a lack of united vision inside the Ukrainian government on what energy policy to set or "how energy reform should proceed."

The right model for Ukraine?

Persistent threats to supply from Russia's Gazprom – which is trying to circumvent Ukraine via building the Nord Stream 2 pipeline under the Baltic – as well as large groups of price sensitive consumers have defined the priorities for building a Ukrainian model.

Ability to attract international expertise and investment is particularly relevant given Ukraine's sizable gas deposits, which could see the country become a potential energy exporter. "We are building the Ukrainian Statoil [now renamed Equinor]," the CEO Andriy Kobolev said of the company's ambitions.

However, vertical integration and unbundling are not contradictory – quite the opposite argues Alex Vedeneyev, head of market research and analytics at Naftogaz. The has set the strategy to strengthen integration irrespective of what unbundling model is picked (and the potential benefits that might arise from it. "The issues of unbundling and improving vertical integration are linked, but should be considered independently," Vendeneyev argued.

That is fine and well as long as it doesn't come through excluding third parties from different segments of the market. Indeed, Naftogaz has faced challenges from the Anti-Monopoly Committee of Ukraine about the ability of new players to enter the gas market.

In response, the company points to the growing number of private players in such areas as gas imports. Indeed, the number of importers has increased from 18 in 2015 to 65 in 2018, while Naftogaz's share of the liberalised market (the non-regulated part on which competition is focused) has fallen below the 35 percent share defined as dominance in Ukrainian and European legislation. This is even further underscored when considering neighbouring countries, with whose markets Ukraine is closely integrated, that present additional sources of competition.

"Naftogaz has in effect ceded most of the market for industrial players," stated Simon Pirani in a report for think tank Oxford Energy.

Although initially designed to protect households from market fluctuations and rising prices, the legislation has come under criticism. According to Volodymyr Omelchenko, head of the energy programs at Razumkov think tank, this approach is fundamentally flawed and does little to prevent populism. "It is far from market principles, Omelchenko argued. "There is a law on the natural gas market and commission which should keep an eye on these issues. The government wants to play political games and to show good intentions."

On the other hand, the regulated formula tends to be one-sided in delivering benefits. Indeed, consumers who benefit from special prices don't see prices drop whenever the market trends downward. Earlier this year, Naftogaz CEO Andriy Kobolev pointed to this feature while arguing to lift restrictions and completely liberalize the gas market in discussions with the Cabinet of Ministers.

New forms of moral hazard

Excessive subsidies and the ensuing deficits were not the only problem with the previous regime. Indeed, one of the key challenges regularly brought up was that the subsidies ended up benefitting big buyers of gas (effectively making them the main beneficiaries).