Ukraine's Most Important Battle Is For Energy Independence
Ukraine has an energy security problem the size of the Dnipro river. This is despite boasting the third largest hydrocarbon endowment in Europe (after Russia and Norway) and a rapidly growing renewables sector. It also has an impressive, albeit aging, Soviet-era nuclear reactor fleet, and enough power generation capacity to be a net exporter of electricity in 2018. Yet the country is still unable to wrest energy-self sufficiency from Russia's iron grip. Until it does, it will not be able to enjoy true economic and political independence.
A combination of overreliance on the Russian Federation for oil, gas, coal, and uranium, as well as a domestic energy sector in dire need of reform, are behind this precarious energy security situation.
Though Ukraine no longer imports natural gas directly from its bellicose eastern neighbor, it is still reliant on energy giant Gazprom for natural gas transit fees. Ukraine is Russia’s primary transport route for Europe-bound gas and receives some $3 billion dollars in annual revenues – right around 2.5% of Ukraine’s GDP – for its role in this relationship.
Furthermore, over 64% of Ukraine’s coal and 55% of its enriched uranium– two staples of the Ukrainian energy sector – still come from Russia. Russia also charges Ukraine for disposal of its spent nuclear waste.
Beyond foreign dependencies, Ukraine has significant energy sector issues at home. Aging infrastructure is in dire need of maintenance and renewal. Energy markets are monopolistic, inefficient, and corruption-ridden. Over-regulation and complicated licensing procedures are preventing extraction of the plentiful oil and gas buried beneath the country’s soil, creating a less than attractive environment for up-stream investment. Renewables are making strides partially thanks to green-minded oligarchs, but alternative energy is still far from replacing Ukraine’s 55 gigawatts (GW) of legacy thermal and nuclear capacity. Together, these problems pose an existential challenge to Ukraine.
The elephant in the room: Nord Stream II
Large-scale transit of Russian gas via Ukraine to Europe is coming to an end with the launch of Gazprom’s $11 billion Nord Stream II project, which links Russia to Europe’s most voracious gas consumer – Germany.
The 1,230 km pipeline circumvents Ukraine via the Baltic Sea, and once completed will double the existing 55 billion cubic meter (bcm) capacity of Nord Stream to 110 bcm. When viewed in conjunction with Gazprom’s 32 bcm TurkStreampipeline under the Black Sea to the south, the Kremlin’s strategy to by-pass Ukraine becomes obvious.
Once operational, these two projects would be sufficient to make up ~90 bcm of gas that passes through Ukraine each year, thereby depriving Kyiv of its badly-needed transit fees. It also means that the Kremlin will no longer have an economic reason to hold back its aggression in future conflicts. In sum: Ukraine's economic and physical security benefits tremendously from Russia shipments.
Russia is in the process of circumventing Ukraine entirely when it comes to natural gas exports
On December 31, 2019, the contract upholding those critical gas shipments is set to expire -- Gazprom will no longer be obligated to pump gas through Ukraine. But this doesn’t mean that gas will stop flowing through Ukraine immediately.
James Grant, a colleague and fellow energy security expert, had this to say at the 7th annual Ukraine Working Group Summit in Washington, DC earlier this month:
Luckily for Ukraine, the chances of a 2020 shutoff scenario are slim. Russia will not have the capacity available to divert all 90 bcm of gas that transits through Ukraine by the end of the year – and most likely not until 2022. Nord Stream II is nearing completion but is expected to miss its winter 2019 launch deadline.
Moreover, both strings of TurkStream, the 31.5 bcm/yr pipeline from Russia to Turkey under the Black Sea, will not be running at full capacity until after 2021. Until these networks come online, Russia will be unable to meet European gas demand without its neighbor, which actually gives Ukraine some negotiating leverage in the near-term. If Kyiv is clever, they will use this leverage to establish a favorable long-term contract with Gazprom under threat of locking-in most of Russia’s Europe-bound gas sales for the next few years.
Two years ago, the Ukrainian parliament adopted the law that stipulated a new electricity market model similar to the one used by EU member states. This will finally enable the integration of Ukraine’s power grid to the ENTSO-E (the European Network of Transmission System Operators) – a boon for Ukraine’s energy security.
Electricity market reform will help boost investment in the sector. According to an assessment by the Ukrainian Institute for the Future (UIF), electricity-generating companies will be able to attract 11.5 times more investment compared to a no-reform scenario.
Conducting energy reforms and investments will boost Ukrainian energy exports to the EU. They could also bring electricity exports to 25 billion kWh in 2030, compared to today’s 5 billion kWh of cross border sales. This would increase the revenues from electricity exports up to US 1.5 billion.
Synchronization with ENTSO-E will intensify competition in the domestic electricity market as well, forcing monopolists to compete for domestic consumers by offering better prices and service quality. Most importantly, it will create the foundation necessary to reduce consumer dependence on just a handful of suppliers.
Reforms will also address the unbundling of Ukraine’s Gas Transportation System (GTS). In line with the EU´s Third Energy Package, Ukraine began the process unbundling its state oil and gas giant Naftogaz, with the goal of separating transmission from production and supply. The first wave of reforms targeting Naftogaz management, which took place in 2016, resulted in Naftogaz posting a $1 billion profit for the first time in company history. Unbundling and gas market liberalization should bring much-needed trust and transparency to the Ukrainian energy sector.
Bolstering Ukraine’s Energy Security
Ukraine is facing yet another existential challenge. This is not the battlefields of Donbas or the fight for their native language. Achieving energy security is another step to sever the umbilical cord from its former imperial master.
Kyiv is moving forward with deep energy sector reforms that will make it more investor-friendly, competitive, and resilient. The specter of Nord Stream 2 and $3billion in lost transit fees will be defeated by better sources of cheaper and cleaner energy. In the meantime, Kyiv can and should use its transit leverage to play hardball at the negotiating table with Russia. Ukraine’s quest for full freedom, sovereignty, and nationhood only comes from true energy independence.