The performance of Ukraine’s energy sector is critical for its security. Yet systemic and pervasive corruption in this key sector during the country’s 25 years of independence is a sadly familiar story. Officials at the highest level of various Ukrainian governments and their confederates have siphoned off billions of dollars annually to spread political largesse and stock partisan war chests. Successive governments have proclaimed plans for energy reform over the years even while political insiders have continued to fight over Ukraine’s various energy franchises.
As long as reform is stalled, the energy sector will continue to corrupt Ukrainian politics and to make the country more vulnerable to external threats (precisely the outcome certain actors desire). One could say that energy corruption is the Original Sin of Ukrainian independence. Redemption from this sin, in the form of energy reform, is key to national survival. And failure would damage not just Ukraine’s security, but that of its European neighbors as well.
Ukraine once had more energy transiting its territory than any other country in the world. More than 80 percent of Russian gas exported to Europe passed through Ukrainian pipelines, as well as more than a million barrels per day of crude oil. Since the collapse of the Soviet Union, Russia has built new oil and gas pipelines to bypass Ukraine, and has used transit deals to compromise Ukrainian leaders and to demonstrate to European customers that Ukraine is an unreliable transit partner. Ukraine’s oil export pipelines and ports are now practically dry, but the country still transports nearly half of Russia’s gas exports to Europe—at least until new bypass pipelines, Nord Stream 2 and Turkish Stream, can be built.
Thus the state of energy reform is a key indicator for progress on overall economic reform for Ukraine’s public and international supporters. Much more is at stake than improving energy efficiency in a moribund economy or reducing the drain on the national treasury. More than two and half years after Euromaidan, Ukraine’s energy economy is still plagued by a lack of market competition and transparent regulation.
In their eagerness to support a beleaguered country, sympathetic observers have prematurely praised “reformist” governments since 2014 for the baby steps that they took in energy reform—a condition for receiving support from international financial institutions and Western governments. The government of new Prime Minister Volodymyr Groysman should be applauded for the courageous step of equalizing gas pricing, one of its first actions in the spring of 2016; the two cabinets of former Prime Minister Arseniy Yatsenyuk hesitated to do this.
However, gas subsidies are by no means the only way energy corruption thrives. Installing new management, including Western-trained Ukrainians or even Westerners, in state energy companies is only effective if there is real improvement in corporate governance and transparency in areas like procurement and transfer pricing. The ultimate goal should be to break up state-owned energy monopolies in order to promote competition and market efficiency, release the value of state assets, and remove the temptation for special interest groups to control energy franchises. It is not just the management, but the business model of Ukraine’s energy sector that must change.
The worst canard propounded by Ukrainian leaders and their international cheerleaders is that reverse flows of Russian gas from European countries is some sort of permanent remedy for import dependence. Certainly it helps in the face of Russian aggression in eastern Ukraine and recalcitrance in gas negotiations in the short term, when European companies are awash with gas in an oversupplied market. However, this would mean nothing in a time of shortage, should Russia actually cut gas flows to and through Ukraine and European countries have no gas to spare.
Furthermore, the value of Ukraine’s gas transit system depends on the normalization of relations with Gazprom, the only conceivable shipper. Taking Gazprom to international arbitration over the 2009 gas contracts, which Gazprom’s lawyers wrote and Ukrainian leaders willingly signed and reconfirmed multiple times, and then threatening capriciously to increase pipeline tariffs were perilous decisions, unless Ukrainian officials wanted to help Gazprom justify building new bypass pipelines. Such actions belie the professionalism of Ukraine’s energy officials and their international advisors.
Of course, the long-term answer is that Ukraine must improve energy efficiency and investment conditions for increasing domestic production. Ukraine actually exported gas to Russia through the 1970s and could again contribute to regional supply once its domestic energy production is no longer captured by corrupt interests. The problem is not geology, but the absence of a stable and attractive business climate for non-politically connected and honest investors.
The Groysman government has a limited window to pursue energy reform earnestly, after which its political legitimacy will go the way of its predecessors. The anecdotal evidence is not encouraging, as seen in this past September’s internal conflict over the unbundling of the gas pipeline company Ukrtransgaz from its parent, state monopoly Naftogaz, and the repeated failure to establish a truly independent energy regulatory commission. These episodes are reminiscent of the fight over the oil pipeline company Ukrtransnafta in 2015, which merely transferred control of a state-owned enterprise from one oligarchic group to another, and of the failed privatization of the Odessa Portside Chemical Plant. The Ukrainian public recognizes the signs of a return to business-as-usual and political infighting over energy assets. It is time that Ukraine’s Western supporters acknowledge them, too.
Realistically, even if the Ukrainian government musters up the political will to reform energy, it has neither the financial resources nor the capacity to implement reforms in an orderly and effective manner deserving of public trust. If a stable and prospering Ukraine is in the interest of the West, then Western governments and the international financial institutions they support must offer much bigger carrots and wield bigger sticks than they have been willing to thus far.
The current level of economic assistance is meager for a nation of 45 million people in a state of war, and the conditions attached to it have not been strictly enforced. Western policy often appears to be informed by wishful thinking. The result is a process in which “they pretend to reform and we pretend to support them.” Too often Western agencies see their Ukrainian interlocutors as clients who spend Western taxpayers’ money and fail to guard against corrupt business practices in spending those funds. This feeds into the natural inclination of Ukraine’s political class to muddle through and to trust that Ukraine is so important that the West will allow them to get away with business-as-usual.
There is significant risk that energy reforms will stall and then go into reverse, as they did under Presidents Viktor Yushchenko and Viktor Yanukovych, in whose administrations current President Petro Poroshenko served. The good news is that, unlike other reforms in notoriously corrupt sectors such as education and health care, energy reform in Ukraine can more than pay for itself. Success would improve the country’s economic competitiveness and contribute resources and momentum to reform in other areas.
At present there is no real energy reform action plan, as opposed to yet another broad-based strategy gathering dust on some minister’s bookshelf. A competent and committed Ukrainian team, with the help of international experts, will have to design such a plan, including a timetable of actions and target dates for completion. Not everything can be done at once, so there must be an order of play that is not driven by special interests. Most importantly, such a plan must be communicated to the Ukrainian public and accepted by their elected parliamentary representatives in the Verkhovna Rada. Too often, Ukrainian governments see the public and parliament as obstacles to executive action rather than as allies in reform, whose trust has to be earned.
It is impossible to enact sustained reforms if there is no unity of purpose and no unified team in the Ukrainian government. When such conditions appear, the West will have to help with significant funding and capacity-building in a coordinated way. Remarkably, there has never been a donor conference on Ukraine, even though there were calls for one in 2014. Such coordinated assistance will require leadership. Otherwise, Ukrainian officials play one donor off another to settle their internal disputes, which are based on interest group-politics and not economic merit.
So far, the United States has essentially outsourced economic assistance to Ukraine to the European Union and international financial institutions. Given the strategic challenge that Ukraine presents to the Western alliance, the United States must take a leading role. It must also exhibit a greater willingness to enforce penalties if Ukrainian authorities fail to meet commitments they have made to the donor community and indeed to their own public. Enabling bad behavior will only lead to a more urgent crisis down the road, as has happened all too often in the past. The next U.S. administration should re-examine the efficacy of the current Ukraine policy and formulate new policies where clearly needed, especially on energy reform.