Electric Grid’s Future the Key to Ukraine’s Energy Security

Electric Grid’s Future the Key to Ukraine’s Energy Security
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Recent comments from President Vladimir Putin about Russia’s loss of territory to neighbors during the Soviet Union’s collapse need to focus U.S. policymakers’ attention. These are not empty words: the Russian leader who just overwhelmingly won a referendum to allow him to remain in office until 2036, and subjugated the Supreme Court to his power, means business.

Target #1 on Putin’s territorial wish list is Ukraine, a frontline country that the U.S. poured billions to support. The Obama Administration coordinated an unprecedented array of sanctions to punish the Kremlin for the 2014 war, while the Trump Administration provided Kyiv with lethal aid. Thus, it is in U.S. national interests to keep Ukraine strong militarily, economically, and energy-wise.

Unfortunately, not all is well in Europe’s largest country. After the IMF agreed to provide Ukraine with a $5 billion loan in early June, financial experts hoped that the country is reaching macroeconomic stability. This is why the country’s Central banker’s Yakiv Smolii’s resignation was a shock. The next day, Ukraine cancelled a $1.75 billion Eurobond sale, causing the national currency and existing Eurobonds to plunge.

This comes as yet another blow to President Volodymyr Zelensky, who was elected last year with a sweeping mandate to overhaul his country. The country’s 6th President needs to enact much needed but largely unpopular reforms – including the winding down of industrial subsidies and revamping its troubled energy sector. The country has already lost the Crimea with its offshore gas reserves, while its coal-rich eastern region of Donbas continues to be occupied by Russia’s proxies.

On the eve of its 29th Independence Day Ukraine’s energy security remains tenuous. Although it abandoned the direct imports of Russian gas in 2015, Ukraine still derives roughly 3% of its gross domestic product from the transit of Russian gas to European consumers. That may end soon if the Nord Stream 2 pipeline becomes operational. At the same time, the upstream and midstream segments of its electricity sector (power generation and transmission lines) are dangerously dilapidated. The grid, which was inherited from the Soviet Union, has undergone minimal modernization. The current antiquated tariff regime leaves the struggling sector unattractive to private investment. 

Ukraine’s grid modernization is vital to attract foreign investment, to support renewable energy, and to ensure a reliable power supply to the budding high tech industry. Among Ukraine’s international partners and donors, the perception of the country’s energy security is often through the prism of power generation sources, in particular gas dependence and aging nuclear reactors.These clearly need to be addressed. However, the issue of grids through which this electricity is distributed  to industrial consumers and households is becoming increasingly acute and may go critical in the coming years.

The grids are not protected. In December 2015, Russian hackers simultaneously attacked six different energy companies, which led to a power outage in 103 towns and villages in Western Ukraine. A major hacker attack caused power outages in December 2016.

The Soviet-era, obsolete electric grid in Ukraine is a weak link threateningUkraine’s energy security. Grids are in dire need of modernization,and the needed investment is estimated by Ukrainian experts up to $12.5 billion until 2030. Every kilometer of the grid requires $1,500 a year investment while currently $200 is spent. To attract investors ready for such significant capital expenditure, the Government of Ukraine needs to offer extremely attractive, stable and predictable terms.

The accepted methodology used in Europe for establishing return on investment in infrastructure  is known as RAB (Regulatory Asset Base) tariff. It has been widely discussed in Ukraine but has not been officially introduced.The RAB approach means that the owner of the network receives income defined as a percentage of the asset value. A considerable part of these funds would be then invested in the grid development and maintenance.

In the new Report “Security Capital Investment in Ukraine’s Grid: The Road to the Future,” published by International Tax and Investment Center in Washington, D.C., my co-author Dr. Vladislav Inozemtsev of CSIS and I argue that RAB tariffs proved very successful when implemented as measures in transition  transitioning to electricity market in Czechia, Hungary, Poland, Romania and Georgia. But it will be critical that the tariff implementation follows other European countries’ model.  This means the rate of return cannot be lower than the weighted average cost of capital (WACC) in the country.This rate must be the same for all assets without dividing them into “old” and “new.” We believe that such an approach will allow not only to maintain and repair obsolete grid, but also ensure the long-overdue privatization of several distribution companies that are still state-owned.

If the reforms are not forthcoming, Western investors may leave Ukraine, as it happened in the past. Until March 2013, the AmericanAES Corporation owned two regional distribution companies (AES Kyivoblenergo and AES Rivneoblenergo) but pulled out and sold  its assets to the VS Energy associated with the controversial Russian politician, former vice speaker of the Russian State Duma Aleksandr Babakov, of the Panama Papers’ fame.

The threats to Ukraine’s independence and the well-being of its citizens comes both from home and abroad. In order to better defend the nation from foreign aggression, Ukraine needs to maintain a strong army and a thriving economy, attractive for investors. Without a competitive, modern and reliable power grid system, Ukraine is leaving itself dangerously exposed to infrastructure obsolescence and the Kremlin’s energy coercion.

Dr. Ariel Cohen is the Director of the Energy Growth and Security Program at the International Tax and Investment Center.

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