For the last 10 years the West has considered Ukraine a troubled country: Kyiv’s timeline since 2010 includes the election of a petty criminal for president eventually chased out of the country by a popular uprising, a Russian occupation of Crimea and a bloody war in Donbass, stories of corruption and, finally, an appearance in President Trump’s impeachment trial.
Amid this turbulent time, however, there was at least one success story — the Ukrainian economy. Despite the 2014 Russian invasion, which deprived Ukraine of territories that accounted for around one-quarter of its GDP — the country has done surprisingly well in recent years by most development metrics.
Since 2014, Ukraine abandoned dependence on imports of Russian natural gas. It also successfully stabilized its national currency, the hryvnia; its currency reserves recently reached their 8-year highs at $28.5 billion, and the yields on both its dollar- and euro-denominated bonds hit record lows in January.
By early 2020, average nominal wages exceeded in dollar terms the previous 2013 peak. And in late 2019 a landmark transit deal was signed with Gazprom that secures Ukraine’s role in its European supplies for at least five years, and will earn the country around $2.4b a year. But even after securing a respectable level of macroeconomic stabilization, the former industrial powerhouse of the Soviet Union faces the deterioration of its outdated infrastructure.
The energy sector — from power generation to end-user distribution — is the clearest example of the Ukraine’s infrastructure woes. Ukraine’s antiquated nuclear reactors, which are already decades older than their intended lifespan, will need to be decommissioned within the decade.
Its coal-fired power generation is now less efficient than in Soviet times. Its electric grid survived the entire post-Soviet period with little modernization or repair. Around 64 percent of the high-voltage grid is 40 years old or even older, with electricity losses amounting to 10 percent of the entire electricity produced in the country.
The Ukrainian government started to address these issues in the 2000s, but reforms have been slow until now. Although the attractive “green tariff” was adopted in 2008 to incentivize investment in renewable energy generation, most of the new solar and wind farms were commissioned in 2019. Last year, the wholesale electricity market was finally liberalized after almost 10 years of debates. This marks a major policy progress, but there is yet one more critical reform needed to make Ukraine’s energy sector a competitive and reliable actor in the 21st century.
To develop and prosper, the country needs a crucial change in electricity distribution pricing. New pricing mechanisms will bring about gradual but vital improvements to Ukraine’s grid. The government is considering implementation of a Regulatory Asset Base (RAB) approach to pricing that was successfully introduced not only in all EU countries between late 1990s and 2004, but also in Georgia and (for a short time) in Russia.
The proposed RAB tariff system is designed to guarantee grid stakeholders (both current and prospective owners) healthy returns on their investment through introducing a normative rate of return based on weighted average cost of capital (WACC). In other words, grid infrastructure owners would be compensated by the government based on a percentage of the value of their existing assets. RAB would provide electricity distribution facilities with much needed revenue for repair and modernization and for the construction of smart grids which are absent in Ukraine.
For RAB to be effective, current asset holders must be compensated at the same rate of prospective investors, lest funding be disproportionality funneled to grid expansion, when maintenance is just as, if not more, important. Experts believe the grid needs upwards of $12.5 billion by 2030 for its modernization.
Reforms have slowed, however, as the government is proposing to apply the rate of return much lower than the WACC even for the new assets — and almost nothing (1%) for old facilities. Such an approach undermines the entire infrastructure modernization project.
Authorities are still are trying to secure cheap electricity prices for end users — households and industry. The electricity price for households in Ukraine is roughly 14% of Germany’s, and for business it is less than 26% thereof. If left unchanged, this policy would exacerbate the longtime problems that exist in Ukraine’s economy.
Because of exceptionally low electricity and heat prices, the country is one of the most energy intensive among post-Soviet states. Ukraine consumes 2.9 times more power for producing a unit of GDP than the neighboring Poland. Generation and distribution companies, many of which are still owned by the state, suffer losses every year and consequently have little chance of being privatized in the near future.
Ukraine has made significant strides in managing its economy and for this it has been rewarded: In June, the International Monetary Fund approved an 18-month-long financial assistance program to Ukraine, and three weeks ago the first part ($2.1 billion) of a $5 billion loan was disbursed.
But the country should do its best to abandon the old Soviet-style approach to its infrastructure, reject the outdated perception of energy as a free public good, and build its strong private sector around the rejuvenated electricity production and distribution. In many nations, utilities have become the most traded companies at the stock exchange, and Ukraine, with total market cap of less than 4% of GDP, should use this opportunity to set up a vibrant stock market crucially needed for attacting foreign investors.
Furthermore, the international financial institutions must address issues of vital importance for the country’s development — chief among them energy. Next time the World Bank convenes to decide whether to disburse another tranche of Ukraine’s loan facility, their managers should pay attention to the progress of the vital energy sector reforms that are desperately needed for the country’s economic advancement.
If Ukraine wants to catch up with the EU and integrate its grid with Western neighbors while securing its lasting independence from Russia, it needs to reform the grid through an equitable and transparent RAB tariff — and quickly.
• Vladislav Inozemtsev is senior associate at the Center for Strategic and International Studies and the co-author of a recent report “Securing Capital Investment in Ukraine’s Grid: The Road to the Future published by the International Tax and Investment Center.”