Cover Story (#12 December 2019)

Clear Understanding

The Ukrainian energy sector is perhaps one of the most turbulent in light of regulatory changes and challenges ahead for its key stakeholders, population and the Ukrainian state. Tenders held recently for Production Sharing Agreements revived the interest of international energy majors seeking not only profitability but clear understanding of policy incentives, a stable competitive environment and unfailing understanding that their investment is secure at the highest level. Dr. Alexey Kot, managing partner of Antika Law Firm, outlined the opportunities present in this sector and shared his concerns on pressing issues emanating from the perspective of the energy business.

UJBL.: Many international energy corporations are beginning to look closely at Ukraine. How attractive is our energy sector for investors at the moment?

Dr. Alexey Kot: The main reason for the attention paid by the worlds energy majors to Ukraine was the adoption by the state of a high rate of feed-in tariff. At the same time, this feed-in tariff was adopted with a significant skew towards solar energy it made the construction of solar plants not only attractive to investors but extremely profitable.

In fact, the average payback period of a solar plant under the existing feed-in tariff is 5 to 7 years. With the life of a plant coming to about 20-25 years, their construction has become a profitable investment.

However, the situation remains difficult in other areas of the sector. Of course, government-led reforms have attracted investors attention as they are aimed at implementing current mechanisms for organizing the electricity and gas market. However, before the completion of reforms and the full functioning of competitive markets, it is likely that the arrival of major world players in Ukraine should not be expected.

UJBL.: In summer the government held tenders for the development of hydrocarbon sites on the basis of a production sharing agreement (PSA). How favorable is the PSA mechanism for investors? Do you foresee advantages, and perhaps disadvantages, in the implementation of PSAs for the country as a whole?

A.K.: The main purpose of concluding a production sharing agreement is to engage potential investors in prospecting, exploring and mining a particular area. Achieving this goal is possible by providing the subsoil user with more favorable conditions for subsoil use than traditional special subsoil use permits. That is why the PSA mechanism gives investors a number of benefits.

First, PSAs can be concluded for up to 50 years, with the right for extension, while the maximum validity of a special permit for hydrocarbon production is 20 years, and for extraction within the continental shelf 30 years (with the possibility of it being extended).

Second, the size of the area of oil and gas wells provided for the use of the investor on the basis of PSAs is not limited, and the maximum area of land provided for geological exploration of oil and gas wells on the basis of a special permit may not exceed 500 sq. km (for Black Sea sites it is 1,000 sq. km).

Third, the PSA Law contains a rule on the stability of legislation. This means that the investor with whom the PSA is concluded receives guarantees from the state on the application of only those rules and regulations that were in force at the time when the PSA was concluded, even if after the conclusion of the PSA, such rules were changed not in favor of the investor (for example, in the event of an increase in subsoil rent).

Although this rule contains certain exceptions (they relate to changes in national security, environmental legislation, etc.), in general, the principle of stability of legislation applicable to PSAs makes this subsoil mechanism attractive for investors.

In addition, the terms of the PSA may include consideration of disputes between the state and the investor in arbitration, as well as the waiver of the states immunity. Such PSA conditions, in conjunction with the legislative framework on the stability of the legislation, enable the investor to effectively protect his rights and to recover damages in the event that the state violates the investors rights established by the agreement.

The fourth and, probably one of the key benefits of concluding the PSA for an investor, is fiscal preference. The current tax law sets a much lower rate of rent for oil and gas production under the PSA than for the extraction of hydrocarbons on the basis of a traditional special permit for subsoil use. For example, the amount of rent for oil extraction within the PSA is currently 2% and 1.25% for gas provided for by the Tax Code of Ukraine. At the same time, the minimum rent for the extraction of hydrocarbons from new wells under the special permit is 16% for oil and 6% for gas.

Hence, the use of subsoil resources based on PSAs is much more beneficial to a potential investor than carrying out such activities on the basis of special permits for the use of subsoil, though it requires much greater financial investment from the investor in the use of subsoil activities.

In its turn the state, as a result of effective and successful implementation of PSAs, has the possibility to attract significant foreign investment to the extraction industry and national economy as a whole. Forming PSAs with large foreign-owned mining companies, which invest hundreds of billions of dollars in their own extractive activities, but for certain reasons do not produce oil and gas in Ukraine today, will also help to increase hydrocarbon production in Ukraine and attract the latest innovative technologies to the domestic oil and gas industry.

At the same time, in order to benefit from the implementation of the PSA, the state must deviate from the existing rules for the use of subsoil and provide the potential investor with special and, most importantly, attractive conditions for the use of subsoil, such as the long-term transfer of large areas of subsoil to the investor, giving the investor fiscal preferences and guarantees for the stability of legislation throughout the duration of the PSA.

UJBL.: How do you evaluate the changes in practice of auctions held by The State Service of Geology and Mineral Resources of Ukraine (State Geonadra) for licenses for subsoil use?

A.K.: The issue of the procedure for the auctioning of special permits for the use of subsoil has always been complex and provoked a negative reaction in business, first and foremost, due to the lack of a transparent mechanism for selecting the competition winners. To overcome this problem, in October 2018, the Government launched online auctions for the sale of special permits for subsoil use. As a result of this innovation, the process of selecting the winners of the auction for the sale of special permits became much more transparent and allowed the state in 10 month of 2019 alone to raise over half a billion hryvnias from the sale of special permits via the ProZorro system.

Positive changes in the procedure for conducting auctions for the sale of licenses for the use of subsoil can also be attributed to changes recently announced by the Government in the activities of State-run Geonadra. Thus, during the presentation of the new Head of Geonadra in November 2019, Prime Minister Honcharuk instructed him to digitize the entire document flow of the agency within two months.

I believe that if this process is successful, the subsoil users are given with the opportunity to submit documents for participation in auctions in electronic form, and this should greatly simplify the process of document flow. The introduction of electronic document flow at Geonadra will have a positive impact not only on the process of organizing, preparing and holding competitions for selling licenses for subsoil use, but also in general on the procedure of communication with Geonadra on all other issues related to subsoil use.

Changes in the practice of holding auctions by Geonadra for obtaining licenses for subsoil use (both those that have already taken place and those that are currently under implementation) can generally be assessed positively, although the existing procedure for the sale of licenses for subsoil use requires further improvement.

UJBL.: Foreign investors say candidly that the policy of permanent changes in regulation of the energy sector (with each new political force in power) requires urgent reconsideration, while the Government should introduce sustainable guarantees. What mechanisms are currently applied to ensure the rights of investors?

A.K.: The Ukrainian energy market currently finds itself in the process of substantial reform and transition from a state-subsidized model of operation (where energy and energy supplies are state-owned and subsidized) to a competitive market model.

In such circumstances, constant adjustment of the rules of the game is, in fact, a reaction by the Government to those processes taking place in the market, an attempt to close in time the gaps in the regulation of new laws and regulations. This is all against the backdrop of considerable political pressure (because the situation in the energy sector has a critical effect on one of the most pressing social issues that of utility tariffs).

Of course, any serious foreign investor clearly understands this, so he is not in a hurry to invest in Ukraine and will not until the new market model stabilizes. All the prerequisites for this are in place. For example, more than two years have passed since reform of the gas market. Despite the numerous statements made by industry experts and experts on numerous reform issues, the situation is gradually leveling out as market participants are getting used to the rules of the game, and the regulator is gradually eliminating gaps and regulatory defects. It should be expected that over the next two-three years Ukraine will come to a more or less stable competitive model of the gas market. In my opinion, the situation in the electricity market will develop in a similar scenario. During the first two or three years the main practical problems of a markets functioning will be revealed, which will be gradually resolved in the future.

It goes without saying that reform of the energy sector will not be completed in one to two years. Market players must get used to the new rules of the game, evaluate the advantages and disadvantages of the new model, etc. It all takes some time.

Currently, there is a generally effective system of mechanisms for protecting foreign investors in Ukraine.

The first element of the system is the internal laws that guarantee the protection of the investment, its return, impossibility of confiscation and nationalization, etc. This element is described in the Law of Ukraine On the Regime of Foreign Investment of 19 March 1996. In practice, internal measures are rarely used. There are several reasons. First, there are usually more effective mechanisms. Second, the absence of an effective mechanism for compensation of losses by the state.

However, this mechanism has been used effectively. For example, in the application of benefits on imports of goods and products. When the customs authorities refused to apply the privileges provided by the law, the investor was able to prove the correctness of their application via a court.

The second element in the protection mechanism is bilateral investment treaties. More than 70 treaties with various countries are currently in force.

Preferably, such treaties provide, in addition, for investment protection provisions, a mechanism for dispute resolution between the state and the investor. In most cases, such consideration is carried out at the International Centre for the Settlement of Investment Disputes (ICSID) or ad-hoc arbitration in accordance with the UNCITRAL Model Law on International Commercial Arbitration.

The third element specific to the energy sector is the Energy Charter Treaty (ECT). Ukraine became a member of the Energy Charter in 1991 and ratified the ECT in 1998.

Part III of the ECT is fully concerned with regulating relations arising in the field of encouraging and protecting investment in the energy sector. The provisions of this Part impose an obligation on States that are Parties to the Energy Charter to create stable, equitable, favorable and transparent conditions for investors of other Contracting Parties to make investments in the territory of another Member State. Such obligations can be described as advisory.

But when the investment is made, the contracting parties have a number of obligations to protect it: the creation of a legal regime investment like that one applicable to national companies; prompt, sufficient and effective compensation of the market value of the investment in case of damage to the host country, guaranteeing the freedom of transfer of capital and other investment-related payments, etc.

ECT in Article 26 provides for the settlement of disputes in international arbitration of choice: ICSID, ad-hoc arbitration in accordance with the UNCITRAL Model Law on International Commercial Arbitration, the Arbitration Institute of the Stockholm Chamber of Commerce without agreeing with the respondent country and/or without prior litigation in national courts.

The cases dealt with under the ECT and related to Ukraine are the Remington Worldwide Limited (UK) vs. Ukraine case, and JKX vs. Ukraine. In both cases, the claims were partially satisfied, as compensation was paid in favor of the investor, but to a lesser extent than the investors had demanded.

UJBL.: Is the protection of investors sufficiently efficient from the perspective of reducing jurisdictional risks?

A.K.: In my book, the investor protection system should, in general, be regarded as effective. At least, it is no worse than the systems that operate in other developed countries.

It should be understood that, regardless of the declared investment protection obligations, the state will never protect a foreign investor in defiance of its own interests. At the same time, foreign arbitration institutions under a bilateral agreement or ECT, as a very effective measure of protection from the point of view of the investor, are always very cautious in assessing the fact of violation and the amount of losses. Ukraines numerous investor disputes prove this: despite the satisfaction of an investors claim, the amount of compensation awarded was always much lower than the one the investor had claimed.

UJBL.: A number of investment arbitration proceedings are currently taking place in the energy sector. What are the prospects of foreign investors in their claims against the State of Ukraine?

A.K.: In fact, the number of arbitrations against Ukraine in the energy sector is insignificant. According to open sources, JKX Oil vs. Ukraine in 2015 has been among the big ones recently: an infringement of an investors rights in connection with Government actions, including raising gas rents and taking measures to limit dividend withdrawal. Right now the case is resolved. The Littop vs. Ukraine case was initiated, also in 2015: violation of investor rights in connection with state actions that complicate the economic activities of Public Joint Stock Company Ukrnafta, where the investor is a shareholder. The process continues. In 2016 Tatarstan v. Ukraine: an investor lost control of PJSC Ukrtatnafta in connection with illegal actions by the state (currently being resolved). In 2018, Gazprom v. Ukraine: the case in connection with the AMCUs decision to impose a fine on Gazproms subsidiary (currently being resolved).

According to the statistics of the United Nations ISDS platform, 983 claims by investors have been filed against Ukraine, of which 647 were, as of July 2019, resolved. 230 of them were resolved in favor of the state, violations were found in 14 though no compensation was awarded and 73 cases were terminated by the investor. At the same time, only 191 cases were resolved in favor of the investor (about 30%) and another 139 were completed via an amicable agreement (21%).

Therefore, the statistics are not clear either for the benefit of Ukraine or for the benefit of foreign investors. As always, much of the outcome depends on the details, and even more on the legal advisers.

UJBL.: During the last few years the state supported development of renewable energy. How would you comment on recent achievements? What are the trends, from your perspective, in the renewable sector?

A.K.: A positive achievement by the state in this area is that renewable energy has gained momentum and started to develop. Today, there are a large number of solar power plants in Ukraine. The feed-in tariff has been introduced and green auctions are expected to be launched.

Recent trends include a significant shift in interest from solar and wind energy to biomass, biofuels and waste. This is mainly due to the fact that solar power requires additional balancing measures when connected to the grid due to uneven generation during a day.

UJBL.: What consequences arising from the introduction of the new electricity market do you see? Could you single out important changes for the main market players?

A.K.: Despite some difficulties, from a long-term perspective, the introduction of the new electricity market is a positive event.

It should be understood that the previous model of the markets functioning not only met international standards and Ukraines obligations to the EU, but was also inefficient and destructive for the industry. Therefore, the reform of the energy market was timely.

There is no doubt that the existing model will be amended, modified and refined, which is absolutely necessary. Most importantly, the transition to a competitive market model of operation took place. And with gradual improvements in regulation, one should expect the gradual stabilization of the market and the formation of normal and stable rules of the game. And this is exactly what all participants needed.

UJBL.: Attraction of foreign investment into the Ukrainian energy sector certainly requires well-balanced state policy at the highest level. How can it be achieved?

A.K.: First of all, the state should be consistent in its steps and understandable to investors. The approval in 2017 of the Energy Strategy of Ukraine for the period up to 2035, titled Security, Energy Efficiency, Competitiveness, should set the vector for development of the energy sector. Unfortunately, the document lacks specifics, and government officials do not always find it necessary to follow the provisions set out in the strategy.

The investor is also aware of this situation and cannot predict with sufficient certainty the actions of the state in this sector.

At the same time, the reforms initiated in the energy sector give us hope that a civilized competitive market will be formed in Ukraine. And the presence of an open competitive market in Ukraine, with transparent rules of the game, always attracts foreign investors.


Key Facts ANTIKA

Year of establishment: 2010

Location: Kyiv, Ukraine

Number of partners/lawyers: 5/16

Core practice areas:

  • Antitrust
  • Corporate/M&A
  • Construction & Real Estate
  • Subsoil Use, Energy and energy savings
  • Litigation and Arbitration
  • Legal Expertise
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