Ukraine's natural gas market is stuck in a limbo, separated into two parts. One provides gas to selected consumer segments at regulated prices – the other has been liberalized. Initially a transitory solution to gradually transform the market while protecting sensitive parts of the population, the special regime has become politically sticky. Despite some advantages, however, it is holding back further investment and competition, both of which are needed to build a truly modern economy.

Following the 2014 revolution Ukraine embarked on an ambitious program to transform its gas industry. The highly politicized sector had previously been something of a geopolitical Achilles Heel – highly subsidized prices resulted in massive budgetary shortfalls, which in turn meant that populist promises could only be fulfilled based on preferential terms from Russia, a key supplier until 2016, and these came with strings attached.

Together with international support, various reformists involved in transforming the country post-2014 set about the challenging task of addressing this weakness. They wanted Ukraine to operate according to market rules, but worried that raising prices too much on households – particularly the masses of impoverished pensioners that make up a key voting demographic – could destroy support for reforms and even set the foundation for a "counter-revolution."

Special prices for special consumers

The compromise solution of splitting the market in two was launched in 2015 (later extended by a Cabinet of Ministers resolution in force until at least December 2019). The reform effectively created a liberalized segment that operated on market prices, while sensitive consumers – including households, district heating companies, religious organizations and (during certain periods) selected state-owned enterprises would pay for gas a price below market one.

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 [...]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).

Although this particular issue has partially addressed, major structural problems remain. Naftogaz is obliged to supply district heating companies and households with gas without prepayment. As a result, not all counterparties who receive gas on preferential conditions end up settling their accounts. In August 2019 debt owed by Naftogaz's customers in regulated market amounted to more than 62 billion hryvnias ($2.5 billion). Moreover, it is logical to assume that the amount of debt will continue to grow if the conditions do not change.

At the same time, the price liberalization and early abolishment of "public service obligation" will mean that all counterparties will have to make prepayments and independently plan gas purchases. This is one of the key reasons why many stakeholders oppose the price liberalization.

Companies in the regions of Ukraine responsible for selling gas to the households will lose the "unnatural" monopoly and be forced to pay for the gas they bought, rather than accumulate further debt. Municipal enterprises that produce heat energy for households also will not be able to receive gas in case they have any debt. Reform would effectively force local government into a position of responsibility, whereby they have to control those municipal enterprises.

Holding back investment

The current split market structure has discouraged investors, depriving the industry of capital and know-how that could help modernize dated infrastructure and introduce new technologies. Wojciech Jakóbik, a Warsaw-based energy analyst at the Jagellonian Institute and chief editor of energy publication BiznesAlert, argues that this would make the market more competitive and efficient, ultimately reducing gas bills for households as well.

The experience of other countries that have liberalized their gas markets certainly seems to confirm this theory, shifting the focus from subsidies to competitiveness and energy efficiency. Indeed, this scenario has already played out in Ukraine – increased prices and efficiency measures like insulation and metering have already brought down consumption from close to 50 billion cubic meters in 2013 to around 32 billion by 2018.

Perhaps even more importantly, argues Jakobik, liberalization will make the Ukrainian market more resistant to external interference.

"Looking at the long-term perspective, in the end Ukrainians will get a healthy natural gas market which is impenetrable to Gazprom or political manoeuvres. It is a part of a general change in Europe which started with liberalization processes inside the European Union. From this point of view, Ukraine is a natural member of energy community," Jakobik argued.

Meanwhile, delays with gas reform translate into investors delaying their entry into the Ukrainian market. As Jakobik pointed out, only the strongest players, who are not afraid of political instability and have an appetite for risk end up trying their luck in Ukraine. Experts note that in such circumstances a strong national company can play the role of a key market participant able to cope with potential failures or imbalances. This solution is especially preferable for transition markets, where market failures exist.

Although the Cabinet of Ministers resolution expires at the end of this year it is difficult to predict if similar regulations will not be adopted. "It all depends on the new government and it's philosophy. As a new government is formed in September, the issue will be resolved. In my opinion, it is nonsense for the government to exercise tight control over prices. This is not its role," Omelchenko said.

The newly appointed Prime Minister Oleksiy Honcharuk already stated that he advocates for government non-interference in gas pricing. "When a politician begins to intervene in price, it leads to inefficiency, corruption and populism," Honcharuk said.