Ukraine has been suffering from Russia’s aggression for over six years now, with the Crimea occupied and annexed by Moscow and the Donbas region in the country’s east ruled by pro-Moscow secessionists. In the documentary “Russia. Kremlin. Putin.” which aired on June 21, Russian President Vladimir Putin stated that some of the former Soviet republics took “Russia’s historic territories” when the Soviet Union broke up in 1991, stressing that “when the Soviet Union was created, the right to quit the Union was written in the agreement, but the procedure was not outlined.” Many fear this could portend a renewed territorial grab by the Kremlin against neighbors like Ukraine, as well as Kazakhstan, Belarus, and possibly the Baltic States.
Putin is facing record low approval ratings just one week before the July 1 constitutional referendum that could allow him to remain in power through 2036. The last time approval levels were this low, Putin annexed Crimea. The president’s popularity catapulted as a result. The fear in Moscow and Kyiv is that a new territorial adventure or geopolitical aggression may be in the works.
Traditionally, such pressures have involved the supply of Russian natural gas to Ukraine, but gas sales to Kyiv ceased in 2o15. The country still relies on Russian gas transits for 3% of GDP, but eliminating gas imports from its Eastern neighbor was a positive step for Ukraine’s energy security. But as Ukraine works to reduce its gas dependence on Russia the specter of “electricity dependence” is now emerging. Due to aging energy infrastructure and rising demand, the Zelensky Administration actually resorted to importing cheap electricity from Russia back in October 2019. In May 2020, the Ukrainian Government appears to have realized the political and economic consequences of this decision. Ukraine’s closest allies in Europe – Poland and the Baltics – also firmly oppose Ukraine’s imports of Russian and Belarus electricity. As a result, the electricity import policy was abandoned– much like its imports of Russian natural gas was halted five years ago.
One of the major milestones of Ukraine’s European integration is the coming unplugging of Ukraine’s energy system from the Russian power grid by 2022, and its integration into that of Europe by 2025. That is, Ukraine will take another step towards independence from the Russian Federation. The next significant hurdle to overcome is the obsolescence of Ukraine’s aging Soviet-era grid.
At least $17.5 billion in investment is required to bring just the distribution grid to a modern standard according to Ukrainian experts. The technical challenge of ensuring the provision of households and businesses with reliable power supply and introduction of smart electric meters will likely be addressed by international cooperation and borrowing.
Networks are a natural monopoly, therefore, tariffs for their services are regulated by the state. In our newly released report, Securing Capital Investment in Ukraine’s Grid: The Road to the Future published by the International Tax and Investment Center (ITIC), Dr. Vladislav Inozemtsev of the Center for Strategic and International Studies and I argue that in order to properly address these challenges, the government of Ukraine needs to undertake decisive reform aimed at introducing new tariff methodology that would encourage potential investors to commit capital to undertake critical maintenance and development (you can watch us discuss Ukraine’s grid reform in two upcoming virtual events on Monday, June 29 (register here) and Thursday, July 2 (register here)).
A customary methodology used for this purpose is called RAB (Regulatory Asset Base) tariff, an approach which has been widely discussed in Ukraine for several years with limited success. The essence of the methodology is that owners of grid infrastructure annually receives a certain income, which is calculated as a percentage of the value of the asset. Part of the money is invested back into grid modernization.
However, the obstacle to the introduction of this methodology, as well as many other reforms in Ukraine’s energy sector, is that electricity in Ukraine is still treated not as a commodity produced under free market conditions but rather as a ‘basic public good’ – a misguided legacy of the USSR. The RAB approach to tariff entails a secure payback and return on investment that is sufficient to service loans and generate profits for power generating and distributing companies.
Financially stimulated by the RAB tariff, companies are then encouraged to maintain and modernize the power grid, ultimately providing private and corporate consumers with reliable, reasonably priced supply of electricity. RAB tariffs were an integral part of the energy market reforms carried out in other post-Soviet countries that have successfully transitioned to a prosperous market economy – Czechia, Georgia, Hungary Poland, Romania, etc.
This tariff, as witnessed in Western and Central Europe, is the key to unlocking foreign direct investment into the domestic grid. It’s true that end users like households and industry may see modest, short term rise in electricity prices as inefficient subsidies are phased out, but a more competitive grid will ultimately push prices down in the long run, and more importantly increase grid reliability and attract foreign investment.
However, the application of the methodology will be effective only if it is applied in the same way other European countries utilize it. The return rate cannot be less than the weighted average cost of capital in a given country, and the return rate must be the same for all assets.
Threats to Ukraine’s security come from both within and without. To better defend its sovereignty from outside threats – including Russian irredentism – Ukraine must repair, modernize, and liberalize its electricity generation and distribution. Without a modern, reliable, and competitive grid, and pro-business tariff structure, Ukraine is leaving itself dangerously exposed to economic decline and the Kremlin’s energy-based coercion.
With Assistance from Bogdan Puchkov