Power play

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On Jan. 1, 2006, when Russia's gas monopoly Gazprom cut off supplies to Ukraine over a price dispute, the predictions on the impact to Ukraine's economy and the security of European supplies ranged from perilous to catastrophic. Displeased by the deal with Moscow, which forced Ukraine to pay twice the amount for imported gas, the Ukrainian parliament booted out Prime Minister Yury Yekhanurov. The EU energy commissioner speculated that European customers may be held as "hostages" in Gazprom's power play. In the United States, Vice President Dick Cheney accused Russia of "energy blackmail," while Republican Sen. John McCain recommended that Russia be banned from the G-8.

What a difference a year has made. Instead of harming Ukraine, the rise in energy prices has actually acted as a catalyst in reforming Ukraine's economy. Thus, what clearly seemed a curse, has turned out -- in some respect -- to be a blessing.

Kiev, which had grown accustomed to paying $50 per 1,000 cubic meters (mcm) of gas, initially would not budge to Moscow's demand that the price increase to $230/mcm -- roughly equivalent to what Russia charges Germany and other EU states. With Ukraine acting as a transit route for 67 percent of all oil and 78 percent of all natural gas traveling from Russia to Europe, the issue was of major concern not only in the halls of Moscow and Kiev, but in Brussels and Berlin as well.

In the end, an agreement was reached -- the price of gas increased to $95/mcm, while RosUkrEnergo, an opaque energy company, took over Gazprom's role as the middle man.

The damage, however, had been done: Russia was seen as the bullying "energy superpower" and Ukraine the helpless, but more democratic, victim.

No matter the shock, even Ukraine's disgruntled politicians realized the impending reality of facing the market. Mr. Yushchenko, who initially referred to Gazprom's move as a "provocation" from Russia, has conceded that Ukraine should be "ready to pay market prices."

As all concerned braced for impact, the doomsday scenario feared by Ukrainian and European officials did not materialize.

Feeling the cringe of a rising energy bill, Ukraine's economy actually adjusted well to the new realities. Despite the price increase, Ukraine's economy grew an impressive 6.8 percent in 2006 -- triple the growth from the previous year (when Ukraine's energy was being subsidized by Russia). Average consumer price inflation fell from 14 percent in 2005 to an estimated 9 percent in the past year, while foreign direct investment doubled. Just as important for a strong market economy, consumption has grown far more rapidly in the private sector then in the public sector.

Private initiative seems to have played the decisive role. In 2006, the industrial output in the metallurgy sector has grown over 10 percent from that of 2005. Ukraine's steel manufacturers, feeling the gas pinch, have turned to pulverized coal -- of which the country is the world's ninth-largest producer -- to run their blast furnaces. In a recent interview to the Associated Press, one of the managers of a Ukrainian metallurgical plant optimistically stated: "Within several years, we plan to fully stop the use of natural gas in blast furnace production. In steelmaking, we already aren't using any gas now."

Besides the economy's impressive adjustment, the Ukrainian parliament has adopted a final series of bills -- effectively liberalizing trade in goods and lowering export duties -- to harmonize Ukraine's economic legislation with World Trade Organization norms.

With WTO accession on the horizon, analysts predict that 2006 is just the beginning of steady economic growth for the country. According to forecasts by the Economist Intelligence Unit, Ukraine's real GDP growth is expected to hover around 5 percent over the next two to three years.

Regardless of the manner in which Gazprom's decisions via Ukraine were undertaken one year ago, Ukraine's experience has indicated that subsidized energy is a dead-end scenario -- no matter the perceived political underpinnings. Just this past year, Russia moved to raise energy prices for friend and foe alike, when Georgia, Moldova, Armenia and Belarus all saw a rise in their bills.

In the long run, it is in the interests of these former Soviet states to liberalize their economies and move away from energy-intensive industries where they hold no comparative advantage. This process will not be easy, but the gains far outweigh the costs.

Igor Khrestin is a Russian studies researcher at the American Enterprise Institute. Ilya Bourtman is an MA candidate at Johns Hopkins University's School of Advanced International Studies, specializing in energy.