Cover Story (#11 November 2018)

Sustainable Perspective

The Ukrainian energy sector has needed reforms since the country became independent. The sector is strategically important and politically sensitive as it establishes the conditions of national security. The rules of the game in the sector raise significant concerns among international energy market players.

Over this outgoing year the sector has undergone massive legislative changes, and even greater enforcement issues. What is the energy agenda of late? Does it give grounds for optimism? We talked to Olena Kuchynska, partner at the Kyiv office of Kinstellar to find out if she sees a sustainable perspective.

UJBL: How would you describe the recent changes in the Ukrainian oil and gas sector?

Olena Kuchynska: From the legal and regulatory perspective, we have witnessed quite a number of changes in the Ukrainian oil and gas sector recently. Overall, these changes appear positive, though there remains a significantly high implementation risk, which is unfortunately inherent in our reality, and which leads us to temper our optimism with caution.

Systemic changes began with the new Law On the Natural Gas Market, which liberalised Ukraines industrial consumer market. This led to a few major commodities traders launching operations in Ukraine, and subsequently the share held by state-owned Naftogaz has decreased dramatically in this segment. On the other hand, due to certain technical and regulatory issues, including complications with implementing the daily balancing of gas supplies, industrial consumers are still to some extent restricted in selecting their supplier it is not practically possible to source gas from different suppliers within a month. The situation with households is even more complicated, and this segment remains closed to competition.

In the midstream sector, the major outstanding issue is the unbundling of gas transmission activities. Work on this is currently in the active preparatory stage, but cannot be completed before the end of 2019.

The regulatory framework and fiscal regime for the upstream segment was significantly improved recently. A new Deregulation Law adopted in March 2018 reduces the number of permits required to start a new well, therefore reducing the time for preparatory administrative works. Land use rules have also been liberalised. There are now only two types of payments charged to a license holder: the signing bonus for the issuance of a license; and royalty payments, the sums of which for new oil and gas wells have been cut by more than half since January 2018 and are now fixed for five years under a stabilisation clause. This has already resulted in a significant increase in the number of new wells drilled in the private sector but has yet to translate into a significant increase in gas production, as there is a considerable time lag between starting a new well and launching the commercial production.

Finally, in mid-November a law introducing a mandatory standard for disclosure the Extractive Industries Transparency Initiative (the EITI) will come into effect. The EITI is expected to facilitate access to information about revenues generated from subsoil use and the beneficial owners of subsoil use and will also enable the identification of dormant licences.

These are some of the positive changes that show investors that Ukraine is willing to attract international business and become a self-sustainable, energy-independent country.

UJBL: In Ukraine, allocation of oil and gas production licenses has been non-transparent for years. This has allegedly resulted in the situation when the most attractive licenses were granted to a limited number of politically-connected individuals. What are the key regulatory constraints that prevent investors from entering this market?

O. K.: Historically, exploration and production (E&P) licenses for hydrocarbons in Ukraine were normally issued on a non-competitive and non-transparent basis. Unsurprisingly, under such circumstances some applicants could gain unjustified benefits. Such a set-up could not be attractive to independent foreign producers, as they need to understand the environment and evaluate risks to be able to make an informed decision on investment.

As mentioned above, the regulatory framework in the upstream sector has been improving recently, but a few important issues remain unresolved. These include access to geological data, which should be simplified by granting free-of-charge access and by providing data in an electronic format. A few steps toward this goal have already been taken a map of natural resources was made public and in July 2018 the Cabinet of Ministers of Ukraine approved amendments to the regulation governing access to geological data, but unfortunately those amendments have yet to be published.

UJBL: To what extent do the environmental impact assessment regulations affect the situation in the sector?

O. K.: The environmental impact assessment law came into effect in December 2017 and at the outset caused significant complications for producers. There have been cases when the license holders had to halt production as they were unable to renew their licenses due to the impossibility of obtaining a conclusion on the environmental impact assessment (EIA). The situation has improved since that time, as a transition period has been introduced until 1 January 2019. At present, the validity of production licenses may be conditional upon subsequently obtaining a positive conclusion in the EIA report. A successful conclusion is required in order to start production but is not needed at the exploration stage.

Generally, the EIA regulations are intended to promote a more responsible attitude of business toward the environment; if properly implemented, these would be a helpful tool in achieving this goal.

UJBL: What are the key advantages of holding auctions for oil and gas exploration and production licenses?

O. K.: Granting E&P licenses through auctions is not an entirely new practice for Ukraine, though over the past five years it has been used only rarely. Recently, following positive regulatory and fiscal changes, Ukraines State Service on Geology and Mineral Resources declared its intention to hold open auctions in 2019 on a monthly basis, as this shall become, in effect, the only way to obtain a license for production of hydrocarbons. Moreover, these auctions will become electronic in 2019, which would enable long-distance participation in the bidding process and shorter terms for the entire procedure.

From the number of different types of auctions, Ukraine has chosen to auction signature bonuses. This approach is considered to be one of the most investor-friendly, as it gives a high degree of certainty for the investor in terms of cost, which is important for future business decisions. It can be also beneficial for the state, as it will immediately receive a portion of the financial gain. At the same time, in this case it is very important to have accurate information about the resources underlying the license.

If conducted properly, auctions will become a non-discriminatory, competitive and transparent mechanism to allocate E&P licenses in Ukraine for hydrocarbons at their true market value. This is expected to attract more players to the market and contribute to the overall goal to significantly increase production.

UJBL: Do you see any increase in competition on the gas market?

O. K.: The situation is different on the various segments of the market. For instance, there is definitely more competition in the industrial consumer market, while the situation with households is quite far from that. In the upstream segment, the state sector continues to dominate, though we now see that the preconditions for increasing competition are being created and Ukraine will more actively market these achievements. Development of the upstream segment has a direct impact on the development of the servicing segment, where we see that all of the Big 4 oil & gas-field service providers are either already working in Ukraine or looking at it.

UJBL: The Electricity Market Law was adopted in 2017. What do you think about the steps taken in the course of 2018 towards establishing a liberalized market model in Ukraine?

O. K.: The deadline for introducing the liberalised market model, 1 July 2019, is fast approaching. In the time since the adoption of the Electricity Market Law, most of the related secondary legislation has been adopted, with the remaining part to be adopted by the Regulator by the end of 2018. In addition to adjusting the regulatory framework, under the new law other important steps will need to be taken, particularly the corporatisation and ownership unbundling of the transmission system operator (TSO), which has yet to be completed and now delays certification of the TSO. The new law also calls for the legal and functional unbundling of distribution system operators, which is not yet overdue but may be running late.
The guaranteed buyer for the energy generated from renewable sources has not yet been created, and this raises significant concerns for investors in renewables.
Another important set of steps to be taken is to test new software for various segments of the new market. This should start in December 2018 with tests of software for balancing and the auxiliary services markets. The introduction of the new market model is such a massive change that it requires the coordinated efforts of all stakeholders. In eight months time we should be able to better assess how successfully this has been achieved.

UJBL: Do you see any progress in terms of integration of the Ukrainian energy infrastructure into the European system?

O. K.: Speaking about integration of the electricity infrastructure into the European power system, there is some progress in this regard. One milestone was the signing of an integration agreement with ENTSO-E in June 2017, according to which Ukraine will have to carry out certain technical, organisational and other measures to achieve EU synchronisation by 2025. This will enable Ukraine to increase its power exchange with the EU from the current 885 MW to 4000 MW in 10 years. Integration will require construction and reconstruction of the grid, including high-voltage substations.

The other project in this direction is the Ukraine/EU Energy Bridge, which is intended to organise the transmission of electricity from Reactor 2 of the Khmelnytsky NPP to the European power grid, and will enable electricity exports to Poland and Hungary. Despite the fact that there is a consortium that has prepared a concept paper and feasibility study for the project, the decision to proceed with the PPP and to carry out the tender is currently delayed.

The gas transmission system is very well integrated into the European system and the local gas TSO has established relations with neighbouring TSOs. One of the key issues on the agenda with the gas transmission system is unbundling of production and supply activities and attracting an international partner. Unfortunately, the competitive selection procedure started by the Government has not yet been finalised.

UJBL: Do you expect privatisation in the energy sector to take place in the near future? Who is ready to invest in the sector? What are the crucial conditions for investors to come?

O. K.: Formally, the preparation for large-scale privatisation has already started with Centrenergo, and the auction for the sale of its shares takes place in December 2018. A few other assets (mines, cogeneration plants, Odessa Port Plant, etc.) are undergoing preparation for privatisation, and the selection of advisors for these projects is pending Government approvals. Based on the declarations made by the State Property Fund, we should also expect the start of preparation for the privatisation of regional electricity distribution companies.

Actual privatisation of these assets depends on various factors, including market conditions, readiness of the seller to properly do its homework and prepare an asset for sale, as well as set a sensible starting price. For the electricity distribution companies which are quite attractive assets per se it is important to finalise the RAB methodology (the current one has been criticised by many experts, including the Energy Community Secretariat, as not being entirely in line with the key principles of setting network tariffs and, in particular, for allowing the possibility of windfall profits for operators).

Apart from local market players, foreign energy conglomerates may be interested in larger assets, including distribution companies, as these will become an important element in the transformed energy market.

UJBL: What are your expectations for the coming year of 2019?

O. K.: We expect 2019 to be quite an interesting one. The new electricity market model will come into operation, which shall bring new players to the market. There should also be more certainty with state support schemes for renewables.

We expect to see progress with gas TSO unbundling and further development of the story with gas transit contracts andconstruction of Nord Stream 2. A few auctions for hydrocarbons licenses are expected to take place, and we may see internationals coming to Ukraine to develop the sector and boost production with their investments and technologies.

Key Facts


Kinstellar

Year of establishment: 2016

Number of lawyers/partners: 16/2

Core practice areas:

Banking, Finance & Capital Markets

Competition & Antitrust

Compliance, Risk & Sensitive Investigations

Dispute Resolution

Energy

M&A / Corporate

Real Estate & Construction

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