Electricity reform in Ukraine : the impact of weak goverance and budget crises

Privatesector P U B L I C P O L I C Y F O R T H E Note No. 168 December 1998 Laszlo Lovei Electricity Reform in Ukraine The impact of weak governance and budget crises Many countries are Although reform of Ukraine’s electricity sector is far from complete, the experience so far shows struggling to liberalize their energy markets that ingrained attitudes are harder to change than written rules of the game. Moreover, the and to replace rigid state controls with reemergence of old behavioral patterns during political, macroeconomic, or sectoral crises can private initiative and ownership. Ukraine quickly undermine early gains from reform. Thus the long time needed to achieve deep and illustrates the extreme difficulties irreversible changes places a high premium on stamina and patience for reformers. By contrast, of this transformation when a country’s and contrary to some predictions, in Ukraine it was relatively easy to put in place the basic macroeconomy is severely imbalanced, systems for a functioning competitive electricity market. Dispatch center, generation, and enterprise governance is poor, and political distribution company employees quickly learned to work with the new procedures and leadership is ineffective —shortcomings that demonstrated a remarkable ability to adapt imported solutions to local conditions. also exist in several other countries of the former Soviet Union. This Note is the first FIGURE 1 THE ENERGY SECTOR REFORM CHALLENGE—HIGH CONSUMPTION, of three on Ukraine’s energy reforms; the HEAVY DEPENDENCE ON IMPORTED FUEL, VULNERABILITY TO TERMS other two are on the OF TRADE SHOCKS gas and coal industries. Per capita energy consumption relative Energy consumption, 1990 to GDP, 1990 Energy consumption per capita (thousands of kilograms of oil equivalent) Nuclear Other 7 6 Russia Coal 5 Ukraine 4 Bulgaria 3 Hungary Poland Natural 2 gas 1 Trend line for market economies 0 0 1 2 3 4 5 6 7 8 9 10 GDP per capita (thousands of US$) Crude oil Note: The trend line in the chart is the result of a least-squares regression of the logarithm of energy consumption per capita in nineteen market economies with climates similar to those of the five transition economies shown, using the logarithm of their GDP per capita as the explanatory variable. Source: World Bank 1992. Source: Ukraine Ministry of Economy. The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 Electricity Reform in Ukraine FIGURE 2 DECLINING SUPPLY AND DEMAND In early 1992 the Russian government an- nounced that the price of fuels exported to the Electricity generation, 1990–97 “near abroad” would be raised to world mar- ket levels (within a year for oil, and within Terawatt-hours two years for gas), giving Ukraine little time to 300 Hydro and other prepare for the coming terms of trade shock. Nuclear 250 Following intense lobbying by domestic Thermal energy producers, the Ukrainian government 200 decided that the best defense was to substi- tute for imported oil and gas through a com- 150 bination of domestic fuels (mostly coal) and energy-saving measures. The government also 100 decided that higher prices for imported fuels would be reflected in domestic energy prices, 50 with a lag so that industrial and residential consumers could adjust. The budget was left 0 as the only source of funding for the neces- 1990 1991 1992 1993 1994 1995 1996 1997 sary investments in domestic coal production and energy conservation. Electricity consumption, 1990–97 Net exports Over the next three years the budget deficit Terawatt-hours 300 reached 10 percent of GDP, the energy inten- Losses sity of the economy increased 10 percent, coal Households production dropped 30 percent, and the value 250 of unpaid energy imports surpassed US$5 billion. Other sectors Energy utilities—electricity, gas, and district heat- Industry ing networks—could not cover their operating 200 costs, and service quality rapidly deteriorated. The leadership of the electricity industry was 150 the first to respond to the wake-up call. The electricity industry in 1991–94 100 Ukraine inherited a very developed electricity 50 industry and high levels of energy consump- tion from the Soviet Union. With a generation capacity of 52,000 megawatts (65 percent ther- 0 1990 1991 1992 1993 1994 1995 1996 1997 mal, 25 percent nuclear, and 10 percent hydro), 18,000 kilometers of high-voltage lines (220 Source: Ukraine Ministry of Power and Electrification (Minenergo). kilovolts and higher), and 50,000 kilometers of low-voltage lines, the power industry provided Ukraine became independent in late 1991. In 296 terawatt-hours of electricity in 1991, includ- that year the new state consumed 229 million ing 28 terawatt-hours for customers outside the tons of oil equivalent of primary energy, more former Soviet Union (figure 2). The nonnuclear than most countries in Europe on a per capita part of the power industry was organized into basis (figure 1). Half of Ukraine’s energy de- seven vertically integrated regional monopo- mand was supplied from Russia at prices that lies under the Ministry of Power and Electrifi- were quite low relative to world market prices. cation (Minenergo). The five nuclear power  The World Bank Group 3 plants were overseen by a separate state com- The new industry structure mittee (Goskomatom). In May 1994 the president of Ukraine issued a Despite a growing surplus of (nameplate) gen- decree requiring the unbundling of the power eration capacity due to decreasing domestic sector and the development of a competitive demand, a sizable backlog of investments national wholesale market for electricity. started to accumulate in the early years of inde- Restructuring took place in 1995–96, supported pendence. Ukraine’s Western partners began by extensive technical assistance from multi- demanding safety upgrades for nuclear plants. lateral and bilateral donors. Today Ukraine’s Aging thermal and hydropower plants desper- power sector is organized as follows: ately needed rehabilitation. And automatic con- ▪ The fourteen largest thermal power plants trols and flexible peaking capacity had to be are owned and operated by four joint stock installed to improve the quality of the electric- generation companies (figure 3). Two joint ity supply (stability and security). stock companies own and operate the eleven hydropower stations. A nuclear gen- The origin of reform eration company—Energoatom—owns and operates the five nuclear plants. (Gosko- The leadership of Minenergo actively studied matom was merged with Minenergo in electricity reforms in other parts of the world. 1997.) The state, represented by Minenergo, They were particularly impressed by the re- owns the majority of the shares of the ther- form that took place in the United Kingdom in mal power companies, and 100 percent of 1989–90. First, they noted the similar size and the shares of the hydropower and nuclear generation mix of the two countries’ power companies. systems. Second, they liked the comprehen- ▪ T wenty-seven joint stock companies siveness of the U.K. reform, which established ( oblenergos ) own and operate the low- specialized generation companies to sell elec- voltage networks and some generation ca- tricity through a competitive pooling arrange- pacity (mostly combined heat and power ment, introduced a license-based regulatory plants) in the twenty-five oblasts and two system, and privatized the sector. Third, they city administrations (Kiev and Sevastopol). wanted to restore Ukraine’s place as a leading The state owns the majority of the shares of force in Eastern Europe’s power industry. (The most of the oblenergos. As regulated tariff Soviet Union’s first large hydropower plant as suppliers, oblenergos have an obligation to well as the largest nuclear power plant had serve all customers wishing to buy electric- been built in Ukraine. In addition, the trans- ity at the regulated retail price. mission lines exporting the Soviet Union’s elec- ▪ Several licensed, nonregulated tariff suppli- tricity to Central Europe had been controlled ers purchase electricity from the wholesale from Kiev.) market and resell it to large consumers. By late 1997 these privately owned suppliers ac- Minenergo also concluded that the structure counted for 20 percent of electricity sales. and governance of the power industry impeded ▪ Ukrenergo, a state company, owns and modernization. Electricity prices needed to be operates the high-voltage network and the depoliticized, but this was unlikely without an National Dispatch Center. The dispatch cen- autonomous, transparent, rule-based regulatory ter performs a number of functions. It con- system and extensive competition among gen- trols and finances the high-voltage grid. It erators and suppliers. The industry needed purchases all electricity from generators (ex- know-how and investment that the current cept industrial self-generators) and resells it owner (the state) could not provide, but the to regulated and nonregulated tariff suppliers. privatization of regional monopolies seemed It dispatches power generators. And it pur- politically unacceptable in a fragile new state. chases ancillary system services. 4 Electricity Reform in Ukraine FIGURE 3 STRUCTURE OF THE POWER MARKET Thermal generation companies Oblenergos Energomarket (4) (27) Generation division Hydro generation companies (2) High-voltage network Low-voltage network Nuclear generation company Independent suppliers Electricity supply division Electricity Large industrial Retail customers customers Payments Source: Ukraine Ministry of Power and Electrification (Minenergo). Technical and financial market operations are governance structure and a demonstrated ca- governed by market rules laid out in the pacity to evaluate hourly bids, implement dis- Energomarket Members Agreement signed by patch accordingly, determine financial claims generators, suppliers, and Ukrenergo. The price and obligations, and implement the financial of electricity purchased from thermal power transactions needed to settle those claims plants and their dispatch are determined on the among market members. Access to the high- basis of hourly bids. A National Electricity Regu- and low-voltage networks was regulated by an latory Commission, established in 1995, issues entity (the National Electricity Regulatory and monitors licenses for electricity generation, Commission) independent from power com- high-voltage transmission, low-voltage distribu- panies and government ministries. The regula- tion, wholesale market operations, and tariff and tor made a commitment to allow the full nontariff supply. The licenses stipulate the meth- pass-through of justifiable costs (including the odology for calculating high- and low-voltage market-determined wholesale price) to retail network fees, the National Dispatch Center’s tariffs. margin, and retail tariffs applied by oblenergos. Between 1994 and 1996 the average retail price The new industry structure and basic operat- of electricity tripled (in U.S. dollar terms), even- ing principles received parliamentary approval tually reaching US$39 per megawatt-hour—a in October 1997, when a new law on electric- level that was close to electricity’s economic cost. ity was passed. Despite these remarkable achievements, the main promises of reform— In mid-1997 the foundations were laid for depoliticization of electricity price setting and competition in electricity generation and sup- attraction of investment and know-how to the ply. The wholesale market had a functioning power industry—remain unfulfilled.  The World Bank Group 5 Half-hearted stabilization liveries to oblenergos and tried to address the problem by reaching agreements with central The tripling of the average electricity price in and local governments on customers that could 1994–96 coincided with macroeconomic stabi- be disconnected without political repercus- lization and the introduction of a new currency, sions. Because Minenergo represented the dis- the hryvnia. Macroeconomic stabilization mea- patch center’s owner, the state, the dispatch sures applied rigid controls over the cash defi- center had little choice but to continue deliv- cit of the state budget, eliminated directed ering electricity to delinquent oblenergos. The credit, and tightened monetary policy, leading Energomarket Board, the governing body of to high interest rates on domestic loans. These the wholesale market, did not raise objections factors, coupled with the poor status of most to the noncompliance with market rules be- industrial enterprises and an inadequate social cause its members were also under Minenergo safety net, led to rapidly growing payment ar- control. Although the regulator theoretically rears and the barterization of the economy. could have intervened as the last line of de- fense, it was still subject to strong government Energy suppliers—electricity, gas, and district influence (see below). heating companies—were particularly hard hit. Their best self-defense mechanism, reducing In a parallel development, the government be- or cutting off deliveries to delinquent custom- came concerned about the impact of electric- ers, was undermined by pressure from central ity price increases on the rest of the economy. and local government officials to protect im- In late 1996 the National Electricity Regulatory portant constituencies (such as municipal ser- Commission was (informally) instructed by the vices, fiscal budget–funded organizations, Cabinet to leave retail prices unchanged until agricultural cooperatives, coal mines, and “stra- further notice. Minenergo was ambivalent about tegic” industrial enterprises). By determining the indefinite postponement of the planned which individuals and enterprises could con- price increase. On the one hand, it recognized sume energy without paying for it, the govern- that the average retail price could not fully ment was able to selectively cushion the impact cover generation, transmission, and distribu- of tight monetary and fiscal policies on enter- tion costs. On the other hand, higher retail prises, workers, and the general population. prices would have increased the tax obliga- In essence, the government used the energy tions of the sector, while the increase in actual sector as a substitute for the social safety net revenues would have been negligible as long and as an instrument of industrial and agricul- as delinquent oblenergos continued to receive tural policy. This strategy slowed structural re- electricity. The regulatory commission knew forms in the economy, delaying the supply that it could not keep retail prices unchanged response and ultimately undermining the en- without changes in the wholesale market price. tire stabilization effort. Accordingly, it instructed the National Dispatch Center to apply (ex post) downward correc- Political interference in market tions to the daily average marginal price, con- operations trary to the market rules. (According to the market rules, the system marginal price should According to the market rules, oblenergos that be determined by the bid of the most expen- have not fully paid for the electricity purchased sive generation unit needed to meet demand.) from the wholesale market should be cut off from future electricity deliveries. The National The proliferation of barter and other noncash Dispatch Center, as operator of the wholesale payment modes (mutual cancellation of market, had to choose between following the payment obligations, promissory notes, tax market rules or obeying instructions from write-offs) further compromised application of Minenergo. Minenergo opposed curtailing de- the market rules. Because noncash payments 6 Electricity Reform in Ukraine had limited fungibility, the National Dispatch Lack of a privatization strategy Center could only collect and allocate cash pay- ments. Noncash transactions offered significant Unbundling and demonopolization of the tax advantages because cash received in the power industry were expected to be closely bank account of an enterprise was often con- followed by privatization. But privatization has fiscated by the tax service. In addition, the re- proven considerably more complicated than re- duced transparency of noncash transactions structuring. First, there was disagreement be- provided opportunities for personal gain. As a tween the government and Parliament about result generators and other market members the distribution of responsibilities in the priva- had strong incentives to maximize barter. Soon tization process. Second, key players—the State the share of noncash transactions in the power Property Fund, Minenergo, the Cabinet of Min- industry surpassed 80 percent. (The economy- isters, and various parliamentary commissions wide average was about 40 percent.) In es- —could not agree on the method of privatiza- sence, only the general population paid cash tion and on the amount of shares to be kept in for electricity. state hands. These disagreements, coupled with a lack of a sense of urgency, resulted in little The perverse incentives created by the exemp- progress in 1996–97 (apart from limited sales tion of barter from revenue allocation rules of shares to workers and managers). could have been solved by reducing the cash entitlements of market members by the reported By mid-1997 reformers in the central govern- value of the barter transactions they entered ment and in the power industry recognized that into. But generators and oblenergos were continued majority state ownership of electric- reluctant to fully disclose their noncash trans- ity companies undermined the autonomy of the actions and constantly lobbied for exceptions Energomarket Board. Moreover, major improve- to the market rules (for example, generators ments in payment collection were unlikely un- argued that they needed a minimum amount less oblenergos were privatized. Only strong, of cash to pay wages and buy spare parts). experienced, and independent operators could These demands were accommodated by the be expected to resist the political pressure Energomarket Board as well as by the National placed on regulated tariff suppliers. The priva- Electricity Regulatory Commission, and the in- tization plan adopted by the State Property centives favoring barter remained in place. Fund in 1997, however, assigned a high prior- ity to selling only minority blocks of oblenergo Not surprisingly, these “adjustments” to the mar- and generation company shares to financial ket rules—the tolerance of nonpayment by investors (after satisfying the demands of man- oblenergos, regulatory control over the whole- agers, workers, and other holders of privatiza- sale market price, and the implicit preference tion certificates). Attempts to implement this given to noncash payments in the allocation plan in early 1998 failed because of limited of revenues—strongly deterred lending insti- investor interest in minority stakes. tutions and equity investors. The European Bank for Reconstruction and Development can- Recent developments celed a US$62 million loan to the power sector, and the World Bank suspended disbursement To reduce the share of barter, in May 1998 the of a US$314 million loan. Both institutions also National Electricity Regulatory Commission or- slowed down the preparation of new loans for dered the National Dispatch Center to take into additional nuclear and hydro capacity. Simi- account all barter transactions when allocating larly, strategic investors became much less will- cash revenues among market participants. In ing to purchase stakes in the thermal power addition, as part of a comprehensive financial companies that the government planned to recovery plan for the electricity industry, the privatize. regulatory commission raised the average re-  The World Bank Group 7 tail price of electricity by 22 percent in May elevating decisions about the disconnection of 1998 and by 3.5 percent in June 1998. The tar- nonpaying customers to the political level, keep- iff increases, combined with decreasing oil and ing under state ownership the majority of the gas import prices and reduced electricity de- shares of electricity enterprises—have seriously mand, made it possible to liberalize the whole- undermined both domestic and foreign confi- sale market price by the fall of 1998. But these dence in the reform. While some recent steps achievements remain fragile. A recent law have sent positive signals, restoring the confi- passed by Parliament, for example, prohibits dence of investors will require major and sus- increases in utility tariffs for residential con- tained changes in government policy. sumers until the budget’s wage and pension arrears are eliminated. Formal rules are necessary but insufficient for ensuring the independence of the regulatory In mid-1998 new oblenergo privatization ten- body. The lack of a tradition of independent ders offered the right to manage remaining regulation and the high importance attached state-owned shares for five years to investors to short-term political benefits make the temp- that win the tenders for minority stakes and tation to intervene in professional decisions too fulfill other tender conditions (such as inject- large to resist. Even under the best circum- ing working capital to settle overdue payables). stances (legal guarantees, financial autonomy, Because of deficiencies in the preparation pro- high-quality staff, substantial technical assis- cess and in the assurances offered to bidders, tance) the ability and willingness of regulators the tenders again failed to attract strategic in- to balance short- and long-term interests and vestors. Local financial investors, however, ac- the interests of producers and consumers will quired majority stakes in seven oblenergos by increase only gradually. purchasing shares from workers, at the stock exchange, and through these tenders. There Wholesale market has been no change in the treatment of delin- quent consumers and the acceptance of non- Contrary to some predictions, it was relatively cash payments by these oblenergos. It remains easy (with adequate technical assistance) to put to be seen whether Ukraine recognizes the need in place the basic systems for a functioning to adopt a privatization approach that has competitive electricity market. Dispatch cen- worked well in other countries (such as Hun- ter, generation, and distribution company em- gary) that sold distribution and generation com- ployees quickly learned to work with the new panies to strategic investors. procedures and demonstrated a remarkable ability to adapt imported solutions to local Lessons conditions. Electricity reform in Ukraine is only now en- A centrally managed “gross” pool for electric- tering its second stage, privatization. Still, events ity generation and distribution is a key feature since 1994 have generated several important of the power industry model selected by the lessons. Ukrainian government in 1994. The Ukrainian gross pool determines the dispatch of all elec- Governance tricity generators according to their bids (sub- ject to certain constraints). The alternative The Ukrainian government and Parliament have option, a “net,” or residual, pool, accepts bilat- been reluctant to give up day-to-day control over eral contracts as a basis for generator dispatch, the electricity industry. Numerous manifestations and the bidding process is applied only to the of this desire to maintain control—exercising generation of electricity needed to satisfy de- de facto and de jure limits on the regulatory mand not covered by these contracts. Further- commission’s authority to set electricity prices, more, payments for all electricity delivered to 8 Electricity Reform in Ukraine consumers flow through a gross pool, while a net pool handles payments only for the part of electricity deliveries not covered by bilateral contracts between generators and distributors or large consumers. In a country being pulled in all directions by culturally and politically distinct regions, the government placed a high premium on the co- hesive force that a technically and commer- cially unified power system was expected to provide. A gross pool was expected to increase this cohesion. This feature, however, made the treatment of delinquent customers more sus- ceptible to political intervention because it made it easier to spread the cost of nonpay- ment across all generators. Under a net, or re- sidual, pool with an obligation to cover planned energy purchases through direct contracts with generators, oblenergos that continued to pro- Viewpoint is an open vide electricity to nonpaying customers might forum intended to have had more difficulty obtaining power, since encourage dissemina- individual generators would have been reluc- tion of and debate on ideas, innovations, and tant to enter into bilateral contracts with them. best practices for ex- Although establishing a flexible net pool that panding the private could accommodate a wide range of direct sector. The views pub- lished are those of the contracts would have been technically more authors and should not demanding, this extra effort might have cre- be attributed to the ated a more resilient market structure. World Bank or any of its affiliated organiza- tions. Nor do any of the Reference conclusions represent official policy of the World Bank. 1992. World Development Report 1992: Development and World Bank or of its the Environment. New York: Oxford University Press. Executive Directors or the countries they represent. Laszlo Lovei (llovei@worldbank.org), Lead Specialist, Energy Markets and To order additional Reform Thematic Group copies please call 202-458-1111 or contact Suzanne Smith, editor, Room F11K-208, The World Bank, 1818 H Street, NW, Washington, D.C. 20433, or Internet address ssmith7@worldbank.org. The series is also available on-line (www.worldbank.org/ html/fpd/notes/). Printed on recycled paper.