Should Ukraine have market prices for gas? (Press release)

Historically in Ukraine gas prices for the population[1] have been strictly regulated by the state and are artificially understated compared with market gas prices (on the level of import parity). This causes a number of problems for the economy and the welfare of the population:

• Low prices do not cover the expenses of “Naftogaz” for buying gas for households, and the state company’s deficit is covered by the state (5.7% of GDP in 2014).
• Differences in prices for households and industry (more than 5x difference at the end of 2014, even at full price for the population) is fertile ground for corruption.
• Low prices can lead to a drop of domestic production (around 1 billion cubic metres per year according to data from “Ukrgasvydobuvannia”) and thus increase Ukraine’s dependence on imports.
• Low prices do not encourage reasonable consumption, thus the energy efficiency of public utilities and direct households’ consumption remains very low.
• Subsidsed prices promote social injustice – gas consumption by the rich as well as the poor is subsidised, but the rich consume more.

In the research on “Should Ukraine have market prices for gas?” experts of the Centre for Economic Strategy examined two alternative approaches to pricing in terms of their influence on key economic and social problems, and looked at important compensatory mechanisms necessary for efficient implementation of reforms.

Regulated low prices on natural gas of market prices?

On the one hand, regulated low prices can exist if a country has its own gas production, the costs of which differ from world prices of gas as commodity. Tariffs based on the cost of local production do not burden consumers financially, but at the same time cause a number of problems for the economy. On the other hand, gas is a market commodity and it cannot be ignored when an open economy is being built and Ukraine is forced to buy half of its required gas abroad.

The analysis of two alternative approaches to pricing shows the following:

Influence on public finances. Low gas prices put pressure on public finances and render macro-financial stability impossible. Adoption of market prices should eliminate the huge “Naftogaz” deficit and, consequently, help the state budget, even with subsidizing consumption and energy efficiency investment. The final effect will be positive – the pressure from indirect subsidies for rich households and from losses linked to corruption will be removed, expenses on debt servicing will be decreased, and rising domestic production will allow for higher rents, taxes, dividends. A side effect – decreasing imports – will have a positive impact on the balance of payments and remove pressure on hryvna rate of exchange.

Influence on corruption. In terms of corruption, any understatement of gas prices for the population encourages abuse, because it is profitable to use this gas for other purposes. An efficient means of eliminating this problem is market prices for all categories of consumers. This reform will eliminate the possibility to profit from arbitrage.

Influence on own production. Low, regulated prices mean domestic production will most probably continue falling, while dependence on imports will stay high. Market prices after payment of rent for “Ukrgasvydobuvannia” would boost production volumes.

Influence on energy efficiency. So far because of artificially low prices, unnecessary consumption is subsidized while the costs of efficiency assessment and heating modernization pay back over 10-15 years, thus there is no motivation for energy saving. An increase of gas prices to the market level will provide such motivation. The potential for gas consumption efficiencies in the household sector in Ukraine is from 20% to 60%. Price increases must be combined with such operating levers as:

• a system of payment for actually consumed energy (measurement and regulation);
• accessibility of modernization tools (state credit and grant programs);
• improvement of payment discipline (limitation of access to resources for defaulters).

Social effect and administration of social risk. Low, regulated household gas prices create negative consequences in terms of state finances and debt, driving inflation and currency devaluation.

“Adoption of market prices for gas will cause an increase in public utility costs for the population. For rich families this will be an incentive for energy modernization and will not significantly influence their cost structures”, Maria Repko, CES deputy director, comments. “For households with average incomes the increase will be significant and programs encouraging energy saving must be rolled out. For low-income households, price increases will be compensated through a mechanism of direct monetary subsidies. At the same time, a functioning subsidies system does not decrease incentives for energy savings, because it allows households to reduce the size of future payments by consuming less in the current period.”

Conclusions

Having examined the influences of market and low, regulated gas prices from different aspects, we can summarise: market prices for gas for all categories of consumers will result in gains to supply companies, the state, and in longer perspective – households. The losers will be beneficiaries of corruption and rich households with high consumption. In general the influence of market prices on the economy will be more positive than negative.

Based on the above, we consider the best option for Ukraine being to introduce prices at the market level. Compensatory mechanisms are also vitally important. Only by proper application of all these elements of gas market reform will the process be successful. In particular, these are:

• assignment of direct subsidies for the population to pay for public utilities;
• programs stimulating energy efficiency;
• formation of conditions for free market competition;
• an effective independent regulator.

For more detailed information about CES research on “Should Ukraine have market prices for gas?” please visit our web-site https://ces.org.ua/en/gas-price/ or contact Maria Repko, CES deputy director (tel.: +380 44 492-7970, office@ces.org.ua).

[1] In terms of direct consumption by households and consumption by Teplokommunenergos (municipal heating companies) for households, including hot water and heating.

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