Ukraine’s ‘Courageous’ Energy Reforms Meant to Erode Russia’s Leverage

Thanks to relentless prodding from the IMF, Ukraine seems poised to finally carry out the reforms of its energy sector that it has spent years chasing. Those changes, passed last week by Ukraine’s parliament, promise to do as much as anything else to help salvage Ukraine’s battered economy and help break Russia’s stranglehold over its energy and political life.

Now that Kiev has started swallowing the bitter medicine the West has spent years urging, the IMF is widely expected to greenlight on Wednesday, March 11, a four-year, $17.5 billion bailout of Ukraine. Coupled with relief from international bondholders and loan packages from Europe and the United States, Kiev’s wheezing economy is set to receive an injection of about $40 billion.

It comes none too soon. Ukraine’s currency reserves are dwindling and at current levels could pay for only about one month of imports. The currency was the world’s worst performer last year, though expectations of IMF aid have helped stanch the bleeding since late February. The country’s debt levels have jumped so high that it risks breaching borrowing agreements with Russia, which could put the screws to Kiev by demanding early repayment of $3 billion.

The IMF package will give Ukraine a way to survive the short term. More importantly, to land the international assistance, Ukrainian lawmakers have done what previous leaders tried, and failed, to do on several occasions over the last decade: reform the notoriously distorted Ukrainian energy sector.

Artificially low energy prices, especially for natural gas, have bled the state treasury for years and led to wasteful energy use. What’s worse, the pricing distortions opened the field to all sorts of corruption in Ukraine’s energy business, paving the way for shady operators with the Kremlin’s backing to inject themselves into Ukrainian politics.

“Ukraine needs to stop trading gas with Russia in order to clean up corruption,” said Anders Aslund, an expert on Eastern Europe at the Peterson Institute for International Economics and the author of the upcoming Ukraine: What Went Wrong and How to Fix It.

The sweeping reform package passed by Ukraine’s parliament last week includes measures to cut the budget deficit, curb pensions, and battle corruption. “The package of reforms already put forward by the government, and enacted by the [parliament], is impressive in its scope and political courage,” said Victoria Nuland, the U.S. assistant secretary of state for Europe and Eurasia, according to prepared remarks for her congressional testimony on Tuesday.

The centerpiece of the reforms will sharply jack up natural gas prices for businesses and households. Starting in April, the average rate for gas will jump nearly threefold. That sounds like a lot, but will still leave Ukrainian gas tariffs well short of what the fuel actually costs. Ukraine hopes to keep nudging up gas tariffs through 2017 until they reflect market prices. The reforms come after last summer’s government decree designed to reduce energy use at big, industrial concerns and among government firms.

Reforming the energy sector has been a key part of the European Union’s conditions before forging closer economic ties with Ukraine, as well as a precondition of international financial aid. Curing the economic ills of the Soviet era, especially in the energy sector, has been a crucial, if traumatic, part of economic reform in many Central and Eastern European states, such as Poland and the Czech Republic, over the last two decades.

The problem in Ukraine has always been political: Hiking cheap energy prices is unpopular and was deeply opposed by vested interests in the energy business. With their backs against the wall, though, Ukraine’s new leaders seem to have little choice but to embrace the reforms. Indeed, there was a notable lack of any public protest last week after lawmakers passed the reform package.

The practical impacts of the reforms, if they are carried to term, are threefold: They will save the government much-needed cash; they will help break the link between energy and corruption that for years poisoned Ukrainian politics; and ultimately they promise to reduce natural gas consumption and thus dependence on Russia.

While Kiev will have to help poorer families pay for pricier gas, the cost of that assistance pales in comparison with what artificially cheap local gas cost the government. The IMF estimated in 2012 that cheap gas cost Ukraine about 5 percent of its prewar GDP per year.

Equally importantly, fixing the skewed pricing system will make it harder for businessmen to buy gas at artificially low prices and resell it at a higher rate, pocketing billions of dollars. One oligarch, Dmitry Firtash, made billions of dollars in arbitrage in the Ukrainian energy market and financed pro-Russian politicians, according to a 2014 investigation by Reuters. Nuland on Tuesday cheered Ukraine for “closing the space for corrupt middlemen that buy low, sell high, and rip off the Ukrainian people.”

Bringing gas tariffs back to something resembling market prices will also curb energy consumption and provide more incentive for Ukraine to produce its own natural gas. Together, that promises to further reduce Ukraine’s reliance on imported Russian gas, potentially removing one of the sharpest arrows in Moscow’s geopolitical quiver.

Ukrainian gas consumption has fallen from 108 billion cubic meters (bcm) per year in 1993 to about 42 bcm today, thanks in part to a dismal economy in the 1990s and the phaseout of Soviet-era heavy industry. With the reform package, Ukraine could further trim the amount of gas it needs to import from Russia, which last year fell to the lowest level in 15 years.

Ultimately, Aslund said, the combination of lower consumption, greater domestic production, and alternative sources of energy in Europe could accelerate Ukraine’s escape from Russia’s energy clutches.

“That would leave zero imports from Russia within a year or two,” he said.

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