Time for 'Tough Love'in EU-Ukraine energy relations

The deal that saw Russian gas continue to flow to (and through) Ukraine during this past winter runs out at the end of March, so we are about to see another round of Russia-Ukraine-EU talks, the first since the announcement of the EU’s so-called Energy Union.

The Energy Union builds on past thinking on energy security and speaks of “reducing our dependency on particular fuels, energy suppliers and routes”. Energy security within the EU is seen as best accomplished by completing the single energy market and taking forward the liberalising reforms in the Third Energy Package for reducing energy consumption and increasing ‘solidarity and trust’ between EU member states.

But beyond the EU’s borders it is foreign policy priorities that dominate. If the EU is too forgiving in its support for Ukraine’s pro-European government, that may hinder both EU and Ukrainian energy security objectives.  There may be a pro-European government in power in Kiev, but its energy policies are not necessarily aligned with European interests.

After the two-week gas supply cut in 2009, Europe, Ukraine and western financial institutions signed a Memorandum of Understanding (MoU) on gas market reform and the modernising of Ukraine’s transit pipelines. Unfortunately, no serious steps were taken by Ukraine to fulfil its part of the bargain and as a result, Ukraine and the EU both remain in a precarious situation.

There are grounds for optimism that at least some reforms may finally be occurring as a condition for a $17.5 bn aid programme.  The International Monetary Fund has demanded some pricing reforms, including a 50% rise in 2014 and a tripling of the price as of 1 April this year, but many other reforms are still outstanding.  Key measures include breaking up Naftogaz and the regional gas monopolies and strengthening independent energy regulation.

The Energy Union package to be discussed at this week’s European Council calls for the updating and signature of a new MoU between Europe and Ukraine on energy market reforms. But what is needed isn’t more words, but actions. Europe’s leaders should also avoid giving the impression that Ukraine is ‘too big to fail’ – that well-known recipe for disaster for Europe’s taxpayers.

There is little doubt that economic and institutional reforms of Ukraine’s energy sector would be a win-win situation for all, including Russia. Our research into Ukraine’s gas market reforms, and their implications for Europe, shows that the quickest and most effective way to ensure Europe’s security of supply is for Ukraine to reform its energy pricing system. It should introduce a single wholesale gas price for all consumers and raise this price to the import price level. Raising prices would allow Ukraine to cover its gas needs from households and district heating using indigenous production. It would also enable Ukraine to meet up to four-fifths of its own energy needs within a few years – equivalent to ten months without Russian gas – using only indigenous production and reverse flow from Europe.

By increasing energy prices in Ukraine, Europe’s energy security would no longer risk becoming collateral damage in any Russo-Ukrainian gas negotiations. Increasing energy prices would give an incentive to indigenous gas producers and would possibly even help the country realise its huge shale gas potential.

The latest increases were a precondition for continued support from western financial institutions, particularly from the IMF. But further reforms and price increase could still be difficult for Ukraine. Its near-term economic prospects are bleak, which may make reforms even more politically unpalatable. It is still possible that Ukraine might reverse course, for after receiving the first tranches from the IMF under the 2008 and 2010 stand-by programmes, the Ukrainian government failed to implement the conditions stipulated in those programmes.

Europe, Ukraine and Russia will all be better off if Ukraine makes these reforms, but experience shows how difficult it is for Ukraine to commit credibly to these reforms. That raises the question of how can Europe ensure that Ukraine does not deviate this time from economic reforms?

Nobel laureate Thomas Schelling demonstrated that inflexibility or pre-commitment can often strengthen a strategic position because cutting off decisions makes the threat more credible.  Europe therefore needs to limit Ukraine’s choices to ensure Kiev makes the ‘right’ decisions. Meanwhile, a look at Ukraine’s ‘wish list’ for the next trilateral gas talks suggests old habits are re-emerging. The Ukrainian energy minister recently announced that Kiev would like to increase the transit fee by 30-100% from current levels; have Europe pay to (partly) fill up western Ukrainian storage facilities to secure supplies ‘above’ the level that Ukraine is providing; and receive Russian gas at a price as low as $250 per thousand cubic metres.

The first two of these goals have no place in the upcoming intergovernmental discussion.  Storage and transit fees should be commercial matters for Gazprom and Naftogaz to resolve. Failure to agree should lead to international arbitration, not political discussion between the European Commission, Ukraine and Russia. Moreover, the newly elected ‘pro-EU’ Ukrainian parliament recently sought a requirement that any price increase proposed by the independent regulator must be approved by Ukraine’s government, thereby turning pricing into a political matter. President Poroshenko vetoed this proposal, but it indicates how fragile any price increases may be.

Europe must clearly tell Ukraine’s government and its parliamentarians that economic and institutional reforms, of which price reforms are only a first step, are the only safeguard for Ukraine. Any extended financial assistance programme must be made contingent on progress on far-reaching reforms.

By being tough with Ukraine, Europe would actually help it to make a credible commitment to long-needed economic reforms.  The inflexibility that Europe should impose on Ukraine would have the value of improving Ukraine’s position vis-à-vis Russia. By altering Moscow’s perception of the difficult economic reforms Kiev is able to undertake, Ukraine and Europe will improve their own energy security and change Russia’s calculations as to the outcome of the conflict.