June 2020, Vol. 247, No. 6
Features
Ukraine’s Big Bet: Upgrading, Expanding Gas Transmission Networks
By Gordon Feller, Eurasia Correspondent
The World Bank will spend $250 million to improve the efficiency of Ukraine’s Gas Transmission System Operator (GTSO). One key goal of this ambitious project is “to strengthen its technical and institutional capacity.”
The project, officially known as “The Modernization of Gas Transmission System Project,” will cost a total of $260.63 million. Of that total, $60.63 million is provided by Ukraine’s national government, via the national Ministry of Finance.
The GTSO is Mahistralni Gazoprovody Ukrainy, also known as the Main Gas Pipelines of Ukraine (MGU), and was formed as a result of significant changes in the country’s gas industry.
Historically, the Ukraine energy sector has been characterized by three traits: inefficiency, widespread corruption fostered by nonmarket pricing, and management structures that are not conducive to accountability and transparency. As a result, Ukraine has had a very energy-intensive economy.
The inefficient energy use per unit of GDP had been about three times higher than in the EU. The reliability and quality of service declined due to deferred maintenance, minimal investment and decaying infrastructure. There was almost no progress on energy sector reform until 2013, when such reforms became critical after the political and financial crisis of 2014-2015. At that time the national economy contracted by a cumulative 16% points.
For two decades the gas sector had been dominated by Naftogaz, a state-owned vertically integrated company. Then, in 2014, Naftogaz was responsible for a massive quasi-fiscal deficit amounting to close to 6% of GDP. For geopolitical considerations, the reduction of dependency on gas imports from Russia became a Ukrainian priority.
Since 2015, the country has implemented gas sector reform on multiple fronts. These reforms were designed and implemented within the framework of the Energy Community Treaty (ECT), an international legal agreement to which Ukraine has adhered since December 2010.
Domestic reforms in Ukraine have benefitted from significant and coordinated financial support flowing from the EU, the U.S. government and other Western partners.
For the gas sector, key reform milestones were the partial opening of gas supply competition and the progressive alignment of gas prices for households to market levels, following the adoption of the 2015 Gas Market Law, which legally aligned the Ukraine gas market with the 3rd EU Energy Package. The most necessary and sensitive aspect of gas sector reform was the adjustment of gas tariffs and prices and their alignment with market prices, to achieve overall cost recovery in the gas sector and to prevent the inefficiencies and leakages associated with gas sold at below-market prices.
The adjustment of gas prices was implemented rapidly for the commercial/industrial segment in 2016, and with a phased approach for households (including district heating). In addition, the national Housing and Utility Subsidy (HUS) program was scaled up to ensure that gas and heat expenditures remain affordable for poor households. This program, though costly, was critical for creating both the political and social acceptance of energy tariff adjustments.
After the initial scale-up, reforms on multiple fronts (administration, control, targeting) allowed for considerable budgetary reductions, especially as the cost of this program declined as a share of total GDP.
Naftogaz had held a dominant position in the gas sector due to its vertically integrated structure and dominant position in all segments: gas production, transit and import of gas, storage and wholesale supply As a result of these reforms, Naftogaz’s dominance has eroded. This has been, in particular, the case for the supply to commercial and industrial users of gas and to public buildings, which in total represents close to 40% of the domestic market.
This segment is now characterized by significant supply competition. Naftogaz has remained a de facto monopoly supplier for direct supply to district heating companies (DHCs) and indirect supply to households, through regional supply companies. Regional supply companies have been established as a result of the legal unbundling of regional gas distribution companies (RGDCs), which separated supply activities from gas distribution network operators (DSO).
Naftogaz supplies these two market segments under a public service obligation (PSO) regime, characterized by price regulation and obligation to supply. The PSO regime was established as a transitional arrangement aiming to accomplish two goals: to protect consumers against excessive prices before sufficient effective competition can develop and to avoid unacceptable supply disruption for end-users even in the case of nonpayment by DHCs and regional distributors.
Thanks to the progressive alignment of PSO prices with market gas prices, Naftogaz experienced a remarkable financial recovery, transforming itself from massive recipient of government financial support to the largest contributor to the government budget. This is through its royalties on gas production, its normal business and corporate taxes and dividends paid to the national government’s treasury.
Gas tariff adjustments contributed to a significant reduction in gas consumption. In 2013, total Ukrainian gas consumption was 1.8 Tcf (50 Bcm), of which 706 Bcf (20 Bcm) was for the industrial/commercial sectors, and 953 Bcf (27 Bcm) was for the residential and public building sectors.
By 2016, the country’s total consumption had been reduced by more than one third, to 1.2 Tcf (33 Bcm), with the most significant decline being for the industrial sector [consumption halved, to 353 Bcf (10 Bcm)]. The reduction in residential and DH consumption to 20 Bcm in 2016 was less dramatic but is still significant and has continued after 2016. In 2018, total Ukrainian gas consumption was 1.1 Tcf (32 Bcm), of which 318 Bcf (9 Bcm) was for the industrial/commercial segment and 636 Bcf (18 Bcm) was for the residential, heating and public building sectors.
In addition, the consumption of the gas sector itself (transmission and distribution) is above 141 Bcf (4 Bcm) and composed primarily of technical losses and energy use. High levels of gas consumption are partly related to the transit activity, but also result from inefficient and decaying infrastructure, and significant overcapacity.
A critical step for the gas sector reform and implementation of the country’s “2015 Gas Market Law” was the unbundling of the GTSO. Naftogaz’s unbundling of gas transmission ownership, plus certification of the new GTSO, were seen as necessary to improve transparency and competition in the gas market. It focused Naftogaz on its core business: increasing domestic gas production.
Reform created conditions for the new gas transit agreement with Russia’s gas company, Gazprom, in line with the European gas market principles. On July 1, 2016, the Cabinet of Ministers of Ukraine (CMU) adopted resolution No. 496 on unbundling, which established the MGU to receive 100% of the assets and management rights for natural gas transit.
However, the transfer of ownership of the GTSO – from Naftogaz to MGU – was not implemented right away due to the legal conflicts between Naftogaz and Gazprom, which were engaged in an arbitration process (the “Stockholm Arbitration” or “SA”) over the existing contracts (signed in 2009) for gas supply and transit.
Based on this SA, Gazprom was awarded about $2 billion under the gas supply rulings (December 2017), and Naftogaz was awarded about $4.6 billion under the transit rulings (February 2018). Also, given that the SA did not accept any change in the gas transit contract, Naftogaz, through its subsidiary Ukrtransgaz (UTG), was deemed the only entity legally authorized to operate the GTS until the transit contract expired on December 31, 2019.
In this context, a new government came into office in August 2019. It adopted an action plan for the implementation of ownership unbundling of the GTSO from Naftogaz and set the date for Jan. 1, 2020. The plan includes the following:
- adopting the law on unbundling, comprising amendments to several laws required to enable the implementation of the ownership unbundling;
- canceling the 1999 agreement between the State Property Fund and Naftogaz regarding the transfer of Economic Management Rights (EMR) over GTS to Naftogaz, and transferring EMR to MGU;
- signing of sale and purchase agreement (SPA) between Naftogaz and MGU
- certifying the newly established GTSO by the Energy Regulator [National Energy and Utilities Regulatory Commission (NEURC)];
- licensing the GTSO and adopting the new tariff system for gas transport by NEURC.
All of these activities were implemented on time, and in parallel with negotiations of the new gas transit contract, with Russia’s Gazprom. As a result, the new gas transit agreement was signed on Dec. 31, 2019, and the newly independent GTSO became fully functional on Jan. 1, 2020.
The new transit agreement stipulates a minimum gas transit of 2.3 Tcf (65 Bcm) in 2020 and 1.4 Tcf (40 Bcm) per year from 2021 to 2024. Gazprom has agreed to pay about $2.9 billion to Naftogaz to settle all remaining claims under the SA. Under the new transit arrangement, Naftogaz will act as the agent of Gazprom, and it will take the regulatory risk in Ukraine.
As a result, Gazprom is expected to pay about $7.2 billion over the next five years (including VAT) to Naftogaz. Naftogaz is responsible for paying about $6.8 billion to GTSO, for transit services based on the above transit volumes and for the entry-exit tariffs established by NEURC. The expected transit revenue of GTSO will be around $2 billion (including VAT) in 2020, and $1.2 billion per year from 2021 to 2024.
The new gas transit agreement and the domestic gas transport needs [totaling about 3.5 Tcf (100 Bcm) in 2020 and declining to around 2.5 Tcf (70 Bcm) annually in the next four years] will be significantly below the capacity of GTSO, which was designed to transport a twice larger volume of gas.
Also, the overall efficiency of GTS, particularly the efficiency of gas compressor stations, is significantly below the European standards because of the aging, obsolete technology and deferred maintenance. As a result, the GTSO faces a major challenge to modernize its infrastructure, to develop a new business model appropriate for its new circumstances and to be in line with the EU practices.
The proposed project aims to support GTSO in meeting these challenges and becoming a viable and sustainable TSO able to fulfill its strategic mission to ensure the development of the competitive, transparent and nondiscriminatory gas market and to secure reliable gas flows for Ukrainian and European consumers in the most efficient way.
GTSO is challenged by the fact that progress toward full cost-recovery in the gas sector, across the supply chain, is not complete. Regulated tariffs for DH and gas distribution remain below cost recovery levels. For this reason, DSOs and DHCs have taken about 53 to 64 Bcf (1.5 to 1.8 Bcm) of gas annually belonging to the GTSO without paying for it.
Historical arrears from these unauthorized gas offtakes have remained with UTG as part of the unbundling. But, the responsibility for procuring gas, which compensates for unauthorized offtakes, fell on the GTSO from Jan. 1, 2020, onward. This represents financial risk for the GTSO and will remain as long as the process of adjusting tariff regulation for DSOs and DHCs is not complete.
Ukraine’s energy sector reform involves unbundling the gas sector and supporting Ukraine’s ambition to remain an energy transit country. GTSO’s unbundling means independence from the historically integrated dominant producer, supplier and storage operator. This shift helps to lock progress achieved with gas sector reform – in terms of transparency, opening up to competition, cost-reflectivity and good governance.
Ukraine’s Ministry of Energy and Environmental Protection (MOEEP) recently disclosed for public consultation the concept for 2050 Green Energy Transition, aka Ukraine Green Deal 2. This transition concept was developed in the context of the strategic goals adopted by the European Commission (EC).
The EC’s goals are to make the EU climate neutral by 2050, and they are outlined in “The European Green Deal.” The key strategies are to accelerate energy transition in all branches of the EU’s bloc-wide economy and cooperate with nonmember countries. Energy transition is seen by advocates as the engine for creating opportunities and constraints for Ukraine, which has an association agreement with the EU and is a member of the Energy Community. This concept would revise the “2035 Energy Strategy,” which was adopted in 2018.
The transition concept stresses energy efficiency as the pathway to decarbonize both industry and the residential sector. On the energy production side, the objective is to increase the share of renewable energy. The 2050 goal is for Ukraine to reach a 70% share of renewable energy sources in its electricity generation mix. Increasing decentralized power supply requires introducing new technologies, which, in turn, enable three different outcomes: consumption management, distributed storage and distributed generation.
The energy transition will shift the place of natural gas in the Ukrainian energy mix. The reduction of total energy consumption, combined with increased use of renewables, will reduce natural gas consumption. But natural gas would play an essential role as the “bridge fuel.”
Achieving the core goal – a complete substitution of coal-fired thermal power plants by 2050 – would be made possible by increasing renewable energy power generation, together with highly maneuverable gas-fired generation.
Project’s Components Point to Modernization, Large - Scale Spending on Pipe Replacement
I Infrastructure Modernization ($200 million) – This component finances the modernization of the physical infrastructure of GTSO by replacing aging and obsolete gas compressor stations with modern equipment to improve reliability and reduce operating costs, particularly energy costs.
The GTSO is a significant user of natural gas and electricity. It is estimated that annual gas consumption for technical needs (compression, fuel gas, technical losses) was 42 Bcf (1.2 Bcm) annually, not including purchases of gas to cover balancing needs and unauthorized offtakes.
The project finances only a limited number of priority initiatives (such as three compression stations). The final selection is to be carried out based on a new “technical economic analysis” with a comparison of different options. All of this will be done in alignment with the GTSO modernization strategy and optimization strategy.
This strategy informs the upcoming update of the Ten-Year Network Development Plan (TYNDP) to be approved by NEURC. The updated TYNDP is being prepared with the assistance of experts provided by consortium of West European gas TSOs (Gasunie, Eustream, SNAM, GRTgaz), each that have assisted the GTSO. The TYNDP reflects the needs to modernize aging equipment, as well as the internal organization and operations of the TSOs, through automation and improved metering. The GTSO will need to implement the transition toward accounting for energy instead of gas volumes, which is the international best practice.
The investment strategy aims to rationalize the transmission network and bring about capacity reduction. This will result in a significant proportion of existing compression stations being taken out of operation, perhaps up to 80%.
The new strategy envisages an evolution of the TSO, driven by a future hybrid energy system that supports decarbonization of Ukraine’s gas and electricity system – the essence of the “Green Deal” in Ukraine. The strategy is focused on hydrogen-ready technology in modernized gas compressor stations.
It is expected that these will transport decarbonized gases, ranging from biogas to “green gas” and hydrogen. To support this strategic direction, this component will help GTSO modernize gas compressor stations by introducing modern equipment. The emphasis is on the diverse technology choices needed for the operation of the decarbonized gas transport system.
Current plans are not focused on new pipeline capacity or pipeline replacement. The main transit route for Russian gas under the new agreements with Gazprom (Urengoy-Pomary-Uzhgorod) is already being rehabilitated. The project is being co-financed by the Luxembourg-based European Investment Bank (the financial arm of the European Union) and the London-based European Bank for Reconstruction and Development.
Modernization of IT Infrastructure ($40 million) – This component will finance the modernization of the IT systems of the GTSO as part of its digitalization and automation strategy.
The overall objective is to fully operationalize the independence of the unbundled TSO, which is still partially reliant on UTG’s IT systems. It aims to meet the requirement of an active and competitive gas market with regard to real-time information, transparency and data-sharing, and operating flexibility.
The major investment under this component would be a new centralized SCADA system combined with upgrading equipment with smart sensors to enable remote control of GTS infrastructure.
The U.S. government [through the US Agency for International Development (USAID)] initiated technical assistance support to the GTSO for the development of technical specifications for SCADA and for electronic data management systems.
This would be accompanied by modernization of metering equipment, particularly at the interfaces between the TSO and gas distribution networks to put in place the needed metering infrastructure for a modern competitive gas market (including real-time metering for balancing, and accounting in energy units rather than gas volumes).
In addition, digitalization would also contribute to the GTSO’s long-term modernization, by improving asset management and predictive maintenance – which, in turn, facilitates optimal investment planning.
Capacity, Project Management and Tech Assistance ($10 million) – GTSO will carry out a capacity improvement program with a particular focus on the following areas: environmental and social management, occupational safety, and procurement and fiduciary. Technical assistance will focus on supporting gas sector decarbonization (through a focus on hydrogen).
ShapeThe project’s investments will range from full reconstruction of compression stations and GDS, in some cases, to partial modernization (replacement of compressors, system of automatic controls, protection systems and cooling equipment). These would be carried out within the footprint of existing GTSO facilities (compressor and distribution stations). Some major investment will also be focused on the SCADA system.
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