Turning On The Water Works Over Russian Gas

BMI View: Ukraine is keen to end its reliance on Russian gas for power generation, but will struggle to access the private financing necessary to diversify its energy mix significantly in the long term because of its woeful business environment. While moves such as modernising the hydropower sector hold promise, it is clear that the country will ultimately have to attract private capital rather than rely on development institutions if it is to stop its power sector from curbing economic growth and achieve energy independence.

Ukraine has achieved 50% of its hydropower project construction and modernisation targets with the help of funding from the World Bank (WB), according to a recent announcement by Prime Minister Mykola Azarov. Under its current energy strategy, the country aims to generate 15% of its electricity from hydropower by 2030 in order to diversify its energy mix - with the wider aim of curtailing its exposure to imported Russian gas and becoming an energy export hub.

Such moves to modernise the hydropower sector (and the broader electricity sector) are indicative of a wider trend of diversification within Ukraine's electricity generation mix. To this end, the country is in the process of revamping its electricity sector through privatisation, increased utilisation at existing facilities and the completion of two new nuclear plants. However, while this latest announcement is positive, we still believe there are a number of significant downside risks to the government's diversification plans. Without doubt, the biggest is the country's deficient business environment, which is deterring private investors and has left Ukraine with amongst the highest sovereign borrowing costs in the world.

Russia Driving Diversification

Ukraine is exposed to import volatility and price disputes with Russia as it is only able to meet 30% of its gas demand from domestic sources, according to the Energy Information Administration. This has been exacerbated by the government's power price subsidies. This is driving plans to boost nuclear and renewables capacity - of which hydropower is the only major renewable source currently being exploited. In August 2012, President Viktor Yanukovych highlighted the importance of the development of small hydropower plants to ensure the stability of the country's energy system. Ambitious non-hydro renewables targets have also been established - with plans to realise 30% of electricity generation from solar and wind by 2015.

Russia Holds Sway Over Thermal Capacity
Ukraine - Electricity Generating Capacity Mix (%), 2013f

However, while we accept steps have been made towards energy independence, we nevertheless believe there are some major downside risks which could hinder plans to liberalise the Ukrainian market, and our long-term outlook is fairly negative.

Ukraine is one of the most energy inefficient countries in Central and Eastern Europe. With ageing infrastructure meaning transmission and distribution losses are running at around 16%, the scale of investment needed to prevent inefficiency in the power sector from curbing economic growth is huge. However, aside from big development institutions - such as the WB, EBRD and IMF - it is currently difficult to see where the financing necessary to modernise the Ukraine's creaking electricity and energy infrastructure will be sourced. While the WB can plug the gaps in the short term, attracting a very significant level of private investment will be required if the country is to wean itself off reliance on Russian gas.

Attracting this private investment will be a major challenge. Many private investors are currently deterred from entering the power sector in Ukraine because of a lack of liberalisation, a lack of clarity during the tendering process, fears about corruption, and concerns about the overleveraged banking system and high levels of external debt. This will make it very difficult to finance power projects on the scale needed. Furthermore, in Transparency International's Corruption Perception Index 2012, Ukraine scores only 26 out of 100, ranking 144th out 176 countries.

Making matter worse, BMI's Country Risk team believes Ukraine is positioned exceptionally poorly to move to a more diversified and industrialised economy, which will have considerable implications for the power sector. On a scale of energy intensity of GDP at purchasing power parities - a measure of an economy's energy efficiency - Ukraine's score of 0.44 kilograms of oil equivalent /$05p made it the third most energy inefficient country in the world in 2009.

Add into the mix the fact the economy is forecast to contract by 1.4% in 2013 and the population is set to shrink to 2022 - with concomitant effects on consumption - and the outlook for the power sector is pretty bleak in the near term.

Torn Between Russia And Europe

Further complicating the picture is Ukraine's cooling relations with its neighbours. Ukraine is keen to court both Russia and the EU to achieve its economic and political aims and realise the revenues that come from being a gas transit state - at the risk of alienating both.

Russia in particular has been growing increasingly annoyed with its neighbour. It has threatened to bypass Ukrainian territory when transporting gas to Europe (it is exploring alternatives such as the offshore Nord Stream pipeline), which would deprive Ukraine of vital pipeline revenues. Fearing such an outcome, at the end of April 2013 Ukraine's government asked parliament to lift a ban on the privatisation of state energy firm Naftogaz, which includes pipelines that pump Russian gas to Europe. Such a move could allow Kiev to sell or lease them to Russia's gas export monopoly Gazprom in return for cuts to gas prices - with Yanukovych promising voters lower gas prices as recently as February 2013, according to Reuters. At the least, this development highlights that it will be extremely difficult for Ukraine to become independent of Russia in relation to its energy policies in the near term, despite its efforts to diversify.

Meanwhile, Ukraine will find it equally difficult to gravitate towards Europe. Although the EU has been keen to dilute Russian influence, the widely condemned jailing of ex-prime minister Yulia Tymoshenko for abuse of office has soured relations with US and EU governments. While the EU is still keen to see the country become an energy hub (producing its own gas, establishing storage capacity and importing from both the EU and Russia), there has been growing frustration with the country's handling of the situation. This threatens to damage the prospect of greater cooperation with the EU and the financing of projects in the power and energy sectors that such convergence would bring.

As a result of these competing dynamics, whether Ukraine orientates towards Russia or Europe will clearly have a considerable impact on the country's future energy policy and the speed at which it is pushed to diversify its energy mix - creating even greater uncertainty for already reticent investors. Due the souring of relations with Ukraine's two most significant benefactors, we expect political risks to grow over the next 12 months and this will continue to weigh heavily on investor sentiment towards the country's energy sector.

This article is tagged to:
Sector: Infrastructure, Power
Geography: Ukraine, Ukraine, Russia, Ukraine, Ukraine

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