Ukraine’s energy sector is undergoing one of the most profound crises in its history. It is no surprise therefore that solving this crisis is a priority for officials and industry. In doing so, they will have to take a fundamental decision; whether to pursue a pragmatic or a populist approach to policy and regulatory change.
Various factors have coalesced to create the current crisis in the energy sector. The extremely warm winter and the COVID-19 pandemic have both had a profound and negative impact on energy demand. These events have taken place against a backdrop of poor policy and regulatory decisions and issues. These include issues with renewable producers receiving the feed-in tariff, overregulation in the energy sector and the fact that energy price subsidies have wreaked havoc in the power sector.
However, while rarely discussed, two further issues, if left unresolved, will further undermine Ukraine’s energy sector: the future of its electricity distribution grids and the price determination mechanism for power distribution services.
At present, Ukraine’s power grid suffers from extensive wear and tear. According to the national Association of Electricity Distribution System Operators of Ukraine, the depreciation rate for the grid is 60%, This is all the more alarming when one considers that in 2019 Ukrainian consumers on average faced outages up to 683 minutes, while neighbouring countries such as Poland and Romania faced 260 and 474 respectively. This is clearly not acceptable.
Roughly $40 billion of investment is required over the next 20 years to address this issue, and the price mechanism for the distribution of services has a crucial role to play in encouraging companies’ to invest in the modernization of the grid, and the provision of higher quality services.
Ukrainian electricity distributing companies currently adhere to a “cost plus approach”, previously used across Europe, which calculates profit as a percentage of the total costs experienced by a company. The disadvantage of this method is that it encourages operators to overstate their costs, and to spend money inefficiently to increase its profit at the expense of end customers. This has now led many European states to move away from the “cost plus approach”.
Plans to usher in a new pricing mechanism, the Regulatory Assets Base (RAB) model, represent Ukraine’s best chance of tackling the inefficiencies of the “cost plus approach”.
Under the RAB system, the regulator controls both the costs accrued by the distribution operator and the price for the end consumer. However, while the system is very promising, discussions about the implementation of a RAB model have been ongoing for years.
After Ukraine joined the European Energy Community in 2011, it committed itself to replicating and adopting the EU’s energy acquis. This meant, among other things, that by 2014 the country was required to introduce an incentive-based tariff for power grids and a new liberalized electricity market design by 2015. However, while the new electricity market model was finally implemented on July 1, 2019, adapting the pricing model has failed to progress.
Discussions about the appropriate RAB design in Ukraine first began in earnest in 2012, when the energy regulator began experimenting with different models for calculating the rate of return. It did not, however, result in an approved methodology.
It was not until 2018 that an agreement was reached which priced the rate of return at 12.5% both for existing and new assets. However, as on previous occasions, its implementation remained elusive. The primary reason for this was that the issue had become highly politicised, with politicians fearing that that the new model would increase prices for end consumers. This proved to the proposal’s downfall.
Last month, however, the regulator revised the numbers; aiming to establish a rate of return of 15% for new assets and only 1% for those in existence. However, these figures disregard the costs associated with maintaining the existing grid infrastructure.
Another significant concern is that the use of different rates of return would result in a lack of capital to reinvest effectively in grid modernization and, correspondingly, disparities in the quality of service offered to final consumers. That is why the proposal should be rejected. The obvious, and most reasonable, decision would be to adopt the same rates for new and existing infrastructure and tie it to the cost of the capital.
As Ukraine looks to navigate its way out of the current crisis, and to set it on a course towards the creation of efficient and sustainable domestic energy system the fundamental challenge and choice it faces is whether it pursues a pragmatic system which upholds the quality Ukraine’s grids and power supply or populism and its false promises. For the sake of Ukraine’s consumers and economy I hope that country decides to pursue the pragmatic route.
Andrian Prokip, PhD,
Senior Associate at the Kennan Institute,
Energy Expert at the Ukrainian Institute for the Future, https://www.wilsoncenter.org/person/andrian-prokip
member of The Younger Generation Leaders Network on Euro-Atlantic Security, European Leaderdship Network