EU-Ukraine gas deal is no pipe dream

One could have been forgiven for suspecting that this month`s deal for the European Union to help reform Ukraine`s gas market was just more political window dressing. It is true that the scale of the incompetence...

One could have been forgiven for suspecting that this month`s deal for the European Union to help reform Ukraine`s gas market was just more political window dressing. It is true that the scale of the incompetence, double-dealing and corruption in the Ukrainian gas market is enormous. However, this time the EU and Ukraine may have achieved a breakthrough.

For the first time, a reform plan for the Ukrainian gas sector is backed up by a detailed, stage-by-stage program to fundamentally reform the market. If this program is implemented, it would not only drive out the corruption and opacity in the market. It would also provide a basis for increased revenues for Ukraine while enhancing EU energy security. What Europe needs to do now is work with Ukrainian politicians to implement the deal while taking parallel measures to ensure it really does work on the ground.

The core of the deal is a pledge by Ukraine to adopt EU energy legislation and to make this law binding by joining the European Energy Community. Under the agreement, the Ukrainian national gas company, Naftogaz, will turn its transmission subsidiary, Ukrtransgaz, into an independent operator. Full legal unbundling will follow, allowing Ukrtransgaz to offer access to the network to all potential gas suppliers on transparent and commercial terms. Tariffs will reflect actual costs and will be levied on a nondiscriminate basis. Equally, there will be third-party access to gas-storage facilities, again on transparent and commercial terms.

On its own, this first part of the deal would raise much skepticism with most commentators. It amounts to no more than another pledge to comply with EU rules. What distinguishes this deal from Kiev`s previous pledges is the extremely detailed master plan for renovating the Ukrainian gas pipeline network. The plan shows the Ukrainians are serious this time.

The master plan provides a network-by-network, section-by-section analysis and costing for what needs to be done to restore the network, what is technically involved, and the potential for enhancing network capacity. Under the master plan foreign investors, together with the World Bank, the European Bank for Reconstruction and Development, and the European Investment Bank, would provide capital to renovate the network.

This renovation proposal is vital. The Ukraine network delivers 80% of Russia`s European exports. Even if Nord Stream and South Stream -- two Russian projects to deliver gas straight to Western Europe, skirting Ukraine and other transit countries -- are actually completed, Ukraine will still deliver significantly more gas to Europe than these two pipelines.

The Ukrainian domestic gas incumbent cannot afford to pay for the gas it needs for the Ukrainian economy as well as maintain the pipeline network. The renovation proposal, if implemented, will ensure the continued flow of gas into the EU and provide the capacity for more gas to flow -- at least an additional 20 billion cubic meters (bcm) and perhaps as much as 60 bcm. The total cost is approximately between $2.5 billion and $3 billion.

Given the economic crisis, it is unlikely that Gazprom will be able to afford the $20 billion South Stream project, and Nord Stream is also under financial pressure. Hence both Europe and Gazprom should welcome the funding of additional capacity via the Ukrainian pipeline network at a relatively modest cost.

Taken together, the liberalization of the Ukrainian gas sector and the renovation of the network should enhance EU energy security. Liberalization will root out most of the Ukrainian sector`s opacity and corruption. Renovation and additional capacity will also ensure that the gas will flow securely and that more gas can be made available.

Furthermore, as Ukrainian President Viktor Yushchenko has pointed out, "a single, competitive gas market would help depoliticize the EU-Russia gas relationship." The EU-Ukrainian deal, together with the extension of the European Energy Community to Ukraine, will help create a single European gas market in which commercial, not political, principles will prevail. This will reduce the scope for politics in gas supply.

The EU and the international institutions need to do more, however, to ensure that the deal is implemented in practice. We already know from our experience of energy liberalization in the EU that energy companies backslide when it comes to market-opening measures. For instance, subsidiary companies that own networks have a habit of swinging preferential deals to their holding companies which supply gas. The EU and international institutions such as the EBRD and EIB could insist that Ukraine significantly upgrade the powers and resources of its antitrust agency so that it can effectively police liberalization.

A further consideration for the EU, Ukraine and the international institutions is Russia. Prime Minister Vladimir Putin has indicated he very strongly opposes the EU deal. The facts, however, plainly stand against him. Two-thirds of Gazprom`s revenues come from European sales. Given that its market capitalization has fallen by more than 70% since January 2008, that its gas revenues have collapsed, and that it has accumulated more than $35 billion of debt, Gazprom can barely afford to build Nord Stream, never mind South Stream. If there is additional Russian gas available for sale to Europe, it needs a cheap supply route. The Ukraine/EU deal can provide that route.

There is another consideration. Given Gazprom`s lack of capital, the company will need significant foreign investment into its gas fields and its own gas network infrastructure. Foreign capital is easier to raise if there is a comprehensive, legally binding regime that applies to your principal route to market. In other words, the Ukraine/EU gas deal should make it easier for Gazprom to obtain foreign investment for its gas fields and pipeline network.

The plan provides for initial funding and due diligence to be carried out in the next couple of months, and for Ukraine to take practical steps toward the liberalization agenda. So we will soon see if the promise of the Ukraine/EU deal is delivered. But of all the deals that have been done between the EU and Ukraine over the last few years, this one appears to be the most promising.

Mr. Riley is a law professor at City University in London and an associate research fellow at the Center for European Policy Studies in Brussels.

By Alan Riley, The Wall Street Journal Europe

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