Energy Policy and Structural Reform

Author(s): Christian von Hirschhausen and Volkhart Vincentz

Source: Eastern European Economics, Vol. 38, No. 1, Economic Reform in Ukraine (Jan. - Feb.,
2000), pp. 51-70
Published by: M.E. Sharpe, Inc.
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EasternEuropeanEconomics,vol. 38, no. 1, January-February
2000, pp. 51-70.
? 2000 M.E. Sharpe,Inc.All rightsreserved.
ISSN 0012-8775/2000 $9.50 + 0.00.

CHRISTIANVON HIRSCHHAUSENAND
VOLKHART
VINCENTZ

Energy Policy and Structural Reform

AlmosttenyearsafterUkraine'sindependence,its energysectorremainsa major

obstacleto structuralchangeandeconomicdevelopmentin Ukraine.Aftertwo
yearsof stop-and-gopolicy,in the fall of 1994Ukrainestarteda new attemptat
transformingto a marketeconomy.Newly elected PresidentLeonidKuchma
led the way to seriousstabilizationeffortsandto an agreementwiththe Interna-
tionalMonetaryFund(IMF).The period 1995-96 saw a significantreduction
of inflationbasedon a tightmonetarypolicy anda sounderfiscalpolicy.Un-
fortunately,theprogressin structural reformshas not corresponded to the com-
parativesuccess of macrostabilization. Institutionsand regulationshave been
only slowly adjustedto a marketeconomy,the speed of privatization has been
muchslowerthanhadbeenhoped,andredtapestill aboundsat all levels of the
economichierarchy.Thus, in fall 1998, Ukrainewas forcedto follow Russia
into financialinstabilityfromwhichit has not recoveredin late 1999.
Despitemanypersistentbureaucratic hindrances,the structureof the Ukrai-
nianeconomyhas changeda greatdeal since planningwas abolished.As ex-
pected,the servicesectorexpandedquiterapidly,althoughnot sufficientlyto
compensatefor the outputdecline in other sectors. Concerningstructural
change, much attentionand money were lavished on the energy sector.En-
ergy is considereda strategicbranchbecausethe economyas a whole is highly

This article will be publishedas a chapterin the forthcomingbook Economic

Reform in Ukraine: The UnfinishedAgenda, ed. Anders Aslund and Georges de
Menil (Armonk,NY: M.E. Sharpe,2000).
Christianvon Hirschhausenis a seniorresearcherat the GermanInstitutefor Eco-
nomicResearch(DIW)in Berlinandmemberof the GermanGroupof Advisorsto the
Governmentof Ukraine.VolkhartVincentzis a seniorresearcherat the Instituteof East
EuropeanStudies,Munichand a memberof the GermanGroupof Advisorsto the
Governmentof Ukraine.

SI
52 EASTERNEUROPEANECONOMICS

vulnerable to interruptions in energy supply. Political and national reasons

call for a reduction of dependence on specific foreign sources of energy by
diversifying imports. The public importance attached to the branch and its
inherited status as a backbone of economic development is reflected in a strong
and influential energy lobby whose interests are difficult to reconcile with
the necessary structuralchange.
Furthernore, in purely quantitative terms, the importance of the energy
sectorhas grown in recentyears. Its sharein industrialproductionhas increased-
because of the disproportionate rise in energy prices-from about 15 percent
in 1991 to 35 percent in 1995, and thereafter stabilized at 37 percent in 1999.
In real terms, production in the fuel industry has declined somewhat more
than production in industry as a whole. The energy sectors, fuel and electric-
ity, absorbed over half of industrial investment in 1996 compared to 30 per-
cent in 1990. Wages in the fuel sector were always the highest among industrial
wages. In the 1990s, wages in electricity production outgrew average indus-
trial earnings. Surprisingly, since the beginning of reforms, the electricity sec-
tor has not only managed to avoid shedding labor, but has even increased its
labor force by 50 percent since 1991. Altogether, the energy sector has suc-
ceeded in increasing its share of total factor inputs.
The role of energy in restructuringthe Ukrainianeconomy must be judged
from several perspectives. A reliable energy supply is essential for the func-
tioning of the economy. But economizing on consumption seems to be the only
way to ensure an adequatesupply because domestic energy resources have been
largely exhausted. The single most importantissue of structuralreform in the
next years will be energy conservation. The real challenge for the energy sector
is to organize the efficient procurementand distributionof energy and to pro-
vide correct prices to energy consumers. As will be elaborated below, this re-
quires price increases, institutionalchanges, and better regulations.
In this article, we analyze the reform process in the energy sector and draw
some policy conclusions. Section two describes reforms made to date or en-
visaged in the energy sectors. In section three, the supply side of the energy
issue is considered, with an emphasis on the burden of financing. Sections
four and five deal with the demand for energy, the potential of energy saving,
and the incentives to do so. We conclude with basic proposals for a horizontal
structural policy beyond sectoral programs.

Reforms in the Energy Sector and Options for

Further Restructuring

Reforms of the energy sector were significant in the first stage of transition
(1994-95), when bold decisions were made, including the full-scale liberal-
 JANUARY-FEBRUARY
2000 53

ization of the power sector, as well as the restructuringand modernization of

the coal sector. This provided an important impetus for economic reform in
Ukraine as a whole. Yet the results of these ambitious reforms, in terms of
enterprise performance and economic stabilization, have not arrivedas quickly
as was initially hoped. A certain discrepancy exists among different segments
of the energy sector: whereas oil has been liberalized to a certain extent, natu-
ral gas and power, albeit formal vertical unbundling, remain under strong state
control. In the coal mining industry, structuralreform has so far been insuffi-
cient to relieve the state budget from heavy subsidies.

Gas: ContinuedUnbundlingIs Necessary

Gas is the most important fuel for the Ukrainian economy; it is also the one
that creates the most severe fmancial imbalances. Although gas prices have
been raised significantly so as to reach and even surpass European market
levels, consumption has decreased only slightly, by 30 percent since 1990.
Domestic production has been reduced continuously since 1990 due to the
depletion of reserves. Hence, gas imports have become the critical factor for
the Ukrainian energy supply. The net gas bill for 1997 was about $5 billion,
that is, more than 50 percent of the total net energy bill and over 25 percent of
all Ukrainian imports. Therefore, the solution to the current account deficit
problem is closely linked to reform of the gas sector (see Tables 1 and 2).
The history of reform of the gas sector is the history of a battle between the
Ukrainian government, fighting for strong state control in the sector, and the
international fmancial institutions, mainly the World Bank, fighting for verti-
cal disintegration and the introduction of competition. So far, the government
seems to have won the battle, with highly doubtful results. Only in the first
instance, in 1994-96, were steps taken toward a more competitive gas sector.
Since September 1995, local gas distributors have had the right to refuse gas
delivery to consumers in the case of unpaid bills. Still more importantwas the
unbundling of the formerly integrated industry structure. In accordance with
the decision of the State Oil and Gas IndustryCommittee of January26, 1996,
five distribution enterprises obtained concessions for independent gas trade;
these were already partially private enterprises. As of April 1, 1996, five com-
mercial enterprises took over gas distribution countrywide.'
Unbundling the industry structures was the right decision for two reasons:
first, it could have created commercially independent and fully responsible
business entities. As these were responsible for settling gas bills directly with
suppliers, Russia's Gazprom in most cases, they were able to put consumers
under pressure either to pay for their gas bills or to reduce their gas consump-
tion. Second, the deregulation of the gas sector would have facilitated the
54 EASTERNEUROPEANECONOMICS

Table1

NaturalGas Balances for Ukraine,1990-1997 (billioncubic meters)

1990 1991 1992 1993 1994 1995 1996 1997

Supply
Imports (including transit) 204 203 212 211 205 191 189 187
Production 26 22 21 19 18 18 18 18
Storage out 20 21 21 17 19 20 -
Totalsupply 250 247 254 248 243 229 207 205
Demand
Transit
CIS 13 14 30 30 29 - -
Non-CIS 104 100 93 95 129 - -
Total transit 117 114 123 125 129 125 118 125
Domestic consumption
Industry 55 52 54 41 31 30 -
Power plants 34 31 25 21 20 14
Residential, communal
services 20 24 27 30 31 28 -
Losses/comp. fuel 6 7 9 10 11 11 -
Total domestic use 115 114 114 102 92 83 89 80
Storage in 18 19 17 21 22 21 -
Total demand 250 247 254 248 243 229 207 205

Sources:StateCommitteeforOil andGas, Ministryof Economy,andWorldBank.

partial privatization of the gas industry.Local banks and industrialenterprises

could have obtained stakes in the gas distributors, thus strengthening their
capital base and corporate governance.
However, reforms were brought to a halt when the Cabinet of Ministers
assumed direct administrative control over the gas industry again in late
1997 by creating the state holding company of NaftoGazUkraine to be in
charge of gas production and transport as well as of the upstream oil sector.
The official reason for this move was to streamline the sector and prepare it
for privatization, which, two years later, has not advanced at all. Instead, it
seems that the lucrative gas business appeared to be too valuable an asset to
some government officials to privatize. A partial sell-off to foreign inves-
tors, whether to Russia's Gazprom or to Western companies, was forbidden
by a law declaring the gas sector "strategic to the vital interests of Ukraine."
 JANUARY-FEBRUARY
2000 55

Table 2

Energy Bill for Gas Imports, 1993-1997 (billioncubic meters)

1993 1994 1995 1996 1997

Gas Imports 80 69 66 71 62
of which:
Russia 54 57 54
Average price (USD per
thousand cubic meters) 45 50 50
Value,millions of USD 2, 454 2, 855 2, 710
Turkmenistan 26 12 12
Average price (USD per
thousand cubic meters) 40 55 69
Value,millions of USD 1, 009 660 834
Average price total (USD per
thousand cubic meters) 43 51 53 80 80
Importvalue, millions of USD 3, 463 3, 512 3, 544 5,680 4,992

Sources: State Committee for Oil and Gas, Ministry of Economy, and World Bank.

An unbundling of the sector was also resisted for another reason that has
been largely overlooked: the gas industry has massive overemployment in
excess of 100,000 people (Hirschhausen 1999: 405). This is about 3-5 times
greater than in Russia, which itself is already well above the international
standard.
A major development was the adjustment of gas prices, both import prices
and domestic ones. Prices for gas imports from Russia fell from $80 per thou-
sand cubic meters to $50 per thousand cubic meters, a deal linked to the re-
duction of transit tariffs by 31 percent. This price is closer to a hypothetical
market price, and it also corresponds to a reasonable cost-plus price for Rus-
sian gas, estimated at $5 l per thousandcubic meters (Hirschhausen 1999: 401).
Domestic gas was sold at auctions at $20-30 per thousand cubic meters, pay-
able in cash. Domestically, the gas price was fixed at $67 per thousand cubic
meters for budgetary organizations and residential consumers in 1997. After
the 1998 devaluation, however, the price was raised to only 120-140 UAH
per thousand cubic meters, or the equivalent of $30-35, leaving little incen-
tive for traders to sell to this consumer group.
The insufficient price adaptations and the problem of unpaid gas bills have
led to a Ukrainian debt to Russia of about $1 billion and to Turkmenistan of
about $250 million. The Russian government and Gazprom have repeatedly
56 EASTERNEUROPEANECONOMICS

proposed a debt-equity swap in order to obtain some ownership of Ukrainian

gas pipelines and underground gas storage.
The challenge facing the Ukrainian gas industry is to further deregulate
the sector and to set up an independent regulator. Just as in the case of the
power sector, the Ukrainian government seems to be attracted by the British
model of regulation, where an independent regulator (OFGAS) is supposed to
control the regional monopolists, and gradually to introduce competition in
production and distribution.2For such a model to work, the monopolist of
high-pressure transportation would have to grant third-party access to any
enterprise wishing to transport its own gas through the grid. With regard to
distribution, the long-term goal should be to introduce real competition there
as well. Large consumers, industrial users, and commnunitiescould purchase
gas directly through a wholesaler, whereas small consumers would choose
among different local suppliers. Technical compatibility between the newly
emerging transport and distribution systems has to be assured. As the most
recent experience in southwest England shows, this is not as easy as econo-
mists would like to think. Should the government wish to continue to subsi-
dize certain regions or social groups, it would have to set up a specific title in
the budget, the amount of which must be fixed beforehand.

Oil:A Needfor DownstreamDevelopment

The Ukrainian oil sector was formally liberalized early in 1994, since which
time it has experienced profound changes. Price liberalization led to some
relief in the supply shortages of previously chronically scarce petroleum prod-
ucts. The lines at gasoline stations ceased, as long as Ukrainian customers
were willing to pay increasing prices. Lines and gasoline shortages reemerged
in the summer of 1999, as this willingness to pay diminished.
Imports of crude oil were reduced sharply with the reform. In 1997, only 9
million tons were imported from Russia, including Tatarstan,that is, 17 per-
cent of the 1990 level. Yet, Ukrainian traders imported petroleum products
not only from both Russia and Belarus but also from the Baltic countries.
Drastic increases in import prices boosted the oil bill. Supply from domestic
oil resources, about 4-5 million tons per year, can contribute only modestly
to the overall supply of energy. Domestic oil reserves will not become a sub-
stitute for imports.3
Ukrainian dependence on crude oil imports will not change in the medium
term. Hopes for a diversification of supplies do not hinge on viable alternatives,
for example, the Caspian region or Iran,but on the ability of Ukrainiancustom-
ers to pay. Table 3 illustrates the quantitativechanges in the Ukrainian oil in-
dustry over the past years, and the significantoil bill of about $2 billion per year.
 S7

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58 EASTERNEUROPEANECONOMICS

Initially, there was great hope for the success of the large refining sector,
which has a capacity of over 60 million tons, but this hope has been crushed.
Under socialism, a large petrochemical complex was built in Ukraine. It de-
pended upon crude oil imports from Russia, and supplied not only Ukrainian
consumers but also the rest of the Soviet Union. Today, domestic refming is in
a slump, as its output has plummeted from 52 million tons in 1991 to only
about 13 million tons in 1997. Ukraine's six refineries have undergone sev-
eral rounds of restructuring,ownership change, and foreign, mainly Russian,
investment. Yet, none has achieved steady profitability with reasonable ca-
pacity utilization. In order to make the refineries profitable, three furthersteps
seem to be necessary:
* the high degree of vertical integration should be decreased; refineries
should become economically independent business units with the right to buy
and sell on their own accounts, and having sole responsibility for reducing
costs and generating profits;
* the multifunctional refineries should concentrate on their core business,
that is, crude oil refining; other activities should be unbundled, or at least
obtain full commercial independence (cost-centers): these are downstream
activities (motor oil, alcohol and chemicals, and hygienic products), horizon-
tal service (R&D, maintenance, transport,and energy supply), and social ser-
vices (canteens, holiday resorts, public transportation,and security, with an
exception made for housing and heating);
* the vertical industrial policy of the government should be transformed
into a horizontal policy. At present, updated versions of the cabinet's Decree
On the Development of the Oil Processing Industry(774/93 of September 21,
1993, most recently updated in 1998) promise government investment subsi-
dies of about $1-1.5 billion to the industry. According to these programs,
each of the six refineries is to be modernized. This program does not seem
financially feasible, nor is the development of all six refineries justified. In-
stead, the state should create conditions conducive to the competitiveness of
the sector in general. Among these measures is to transform the individual
refineries into independent enterprises, to grant all producers equal access to
infrastructure(ports, railway, wagons, etc.), to relieve factories of their social
assets, and to resolve the problems of interenterprisedebt.

Coal: Insufficient Structural Reform

The restructuring of the Ukrainian coal industry is the most urgent political
and economic challenge of energy policy. Coal is the only energy resource of
which Ukraine has substantial reserves. Yet, most current coal production is
unprofitable. Direct and indirect government subsidies to the coal industry
 JANUARY-FEBRUARY
2000 59

comprise the largest subsidy in the country's budget. In 1994, direct fmanc-
ing amounted to 3.2 percent of GDP, that is, more than half of the envisaged
budget deficit; nevertheless, in 1998, the industry produced losses of about
2-3 percent of GDP.
The coal industry has been hard hit by the end of socialism. Formerly,
Ukraine was considered to be a country with rich coal reserves. But when
evaluated by market criteria, only a small part of the proven reserves turned
out to be competitive on internationalmarkets because of rising costs for trans-
port, labor, and energy. Hence, coal production has plunged from 189 million
tons in 1985 to about 50-60 million tons in the late 1990s. Production is likely
to level out at about 30-40 million tons of primary coal extraction. Instead,
imported coal from the neighboring countries of Russia and Poland will play
an increasing role. In 1995 alone, imports more than doubled and have re-
mained stable at more than than 10 million tons (see Table 4).
Attempts at structuralreform started as early as 1992, with the dissolution
of the Soviet Ministry of Coal and the independence of the Ukrainian coal
industry. In 1995, the twenty-three production associations and six large in-
dependent coal mines were corporatized, that is, they were transformed into
commercially independent state enterprises. Yet, the coal industry is still run
in a very Soviet fashion. Centralized planning of quantities, trade, and prices
persists. Cross-subsidies between efficient and inefficient mines are main-
tained, which prevents efficient coal mines from reaping the benefits of pro-
ductivity gains. Domestic trading is dominated by the Ministry of Coal, which
prescribes quantitative delivery targets for each mine and fixes the prices, as
in Soviet times. Mines can freely sell only the coal produced in excess of state
plan targets. Coal imports, too, are still controlled by the state coal-trading
agency, Ukrglavugol. Nontariff entry barriers such as discrimninatorytrans-
port rates are used to restrict imports.4
The restructuring of unprofitable coal mines is blocked by regional resis-
tance in areas whose economic survival depends largely on coal mining and
related activities. The scaling down of coal mining operations was an expen-
sive process in Western Europe; in post-socialist countries it can turn into a
nightmare. The 100 Ukrainian mines have been grouped into four categories,
ranging from category I "hopeful" to category IV "hopelessly uneconomic."
However, only four mines have been considered "hopeful." Restructuring of
the mines is not only constrained by the lack of financial resources, but above
all by the absence of any concept of regional diversification. Although three
mines have been slated for closure, and twenty more identified for scaling down,
not much has really happened locally to accelerate the conversion. This, in turn,
provides the conservative coal lobby with arguments to halt restructuring.5
To turn the coal mines into independent enterprises seems the most urgent
60

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JANUARY-FEBRUARY 61

reform task for the coal industry.At the least, each mine should be made into
an independent cost center. Investnent decisions should be made at the level
of the associations, not at the central level. Coal production should be sepa-
rated from coal transportation and distribution. The role of the Ministry of
Coal should be limited to distributing information, supporting environmental
clean-up, and assisting in the retraining of personnel.

Electricity: From Socialism to a Barter System

The Ukrainian power sector has embarked on one of the most ambitious re-
form programs so far in all post-socialist countries. Inspired by the British
experiment of the 1980s, Ukraine decided in May 1994 to set up a "pool sys-
tem."' This decision was hailed as a breakthroughto more efficient electricity
consumption and the modernization of the power industry.
However, the implementation of this imported regulatory model faced
serious problems, and the initial concept was undemined. Instead of mon-
etized trade controlled by an independent regulator, individual barter con-
tracts between producers and consumers dominated. "Prices" were not fixed
by the market but through bilateral barternegotiations. Only 10 percent of the
electricity was actually sold for money. A quota system for state consumers was
maintained, obliging producers to supply mainly communal consumers. Heat-
ing, which is often related to electricity production, was not regulated at all,
leading to cross subsidization and furtherdistortions. The Regulatory Agency,
which was supposed to become independent,was controlled by the Ministry of
Energy (Minenergo), both physically (it is situated directly in the Minenergo
premises) and personally (most of its staff came from the Minenergo). More-
over, Minenergo abused the electricity market as a source of finance for itself,
levying a 6 percent "ministerialcharge"on each transaction,the use of which is
unknown.
As of late 1999, the power sector still suffers from low revenues, unstable
input supplies, and a lack of financing for modernization. Electricity con-
sumption per unit of industrial production has risen rather than decreased
since 1993. Electricity production by fossil-fueled power plants has been re-
duced by 60 percent since 1990, while nuclear power generation remains
stable. Ukraine has turned from a large net exporter in the 1980s into a net
importer of electricity, and it is dependent on the Russian power grid, with
which it is integrated. Table 5 provides basic data on the development of the
power sector since 1980.
Furtherreform depends on two policies: the real, not just simulated, imple-
mentation of a market-oriented pool system and price reform. The pool sys-
tem is technically in place, though, as explained above, it works only as a
62

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 JANUARY-FEBRUARY
2000 63

single buyer. Technically, Ukraine has to develop its own system of frequency
stabilization to become independent from the Russian grid. When operated
independently, that is, cut off from the Russian grid, such as in winter 1998,
the frequency falls dangerously low, hovering around 49.5 Hz. The regula-
tory framework is formally set up: the National Electricity Regulation Com-
mission (NERC), created in early 1995, is supposed to ensure the proper
functioning of the energy market and price regulation.
Price reform remains essential for the success of reforms. The average price
of about 0.10 UAH/kWh (i.e., about U.S. $0.025) only covers the marginal
cost of production. It does not allow producers to accumulate funds for the
modernization of equipment, especially for the replacement of old transmis-
sion lines. Indirect subsidies, for example, in the form of cheap steam coal,
should be abandoned. A furtherincrease in prices seems inevitable if the power
sector is to finance its modernization, which, in the medium term, will lead to
cheaper and more efficient energy supply to the economy.

Energy Supply and the Current Account Deficit

About half of all energy consumed in Ukraine is supplied by domestic pro-

duction, which has declined faster than net imports of energy in recent years.
If nuclear energy is not counted as domestic production, as its raw material
(nuclear fuel cells) is almost completely imported, the share of indigenous
production is only about 25 percent. In the medium term, a significant expan-
sion of domestic energy supply is unlikely. Ukraine has to recognize that it is
an energy-poor country.Under socialism, this fact was hidden by artificialprices
that did not reflect the costs of the production and distributionof energy.
The increase of energy prices after Ukrainian independence was a major
shock for the economy. Various estimates show that this supply shock led to a
reduction of GNP by more than 10 percent.7The former government reacted
to this with stronger controls, especially of the foreign trade sector and the
exchange rate, and the accumulation of arrears.Both were shortsighted emer-
gency measures that did more harm than good. The financing of energy im-
ports is still the biggest burden on the Ukrainian economy. In 1998, energy
accounted for more than 40 percent of Ukrainian merchandise imports, and it
is the main source of the current account deficit. A reduction in energy im-
ports by 20 percent would balance the current account.

Energy Saving: Potential and Prerequisites

In Ukraine, the ratio of energy consumption to GNP is among the highest in

the world. Energy intensity is twice as high as in East European countries and
64 EASTERNEUROPEANECONOMICS

seven times higher than the average of the OECD countries. Per capita Ukraine
consumes about the same amount as the OECD countries. Given the vast dif-
ferences between the countries with respect to private cars and the usage of
electrical appliances in households, these data support the presumption of a
massive waste of energy. The situation is even worse when considering de-
velopment over time. Energy intensity has increased by 50 percent since 1992.
This holds true for the entire economy as well as for industry.These figures
indicate a large potential for energy saving.
However, two qualifications must be considered. According to some esti-
mates of the shadow economy in Ukraine, as much as 50 percent of produc-
tion is not recorded in official GDP calculations (Johnson et al. 1997). Given
that the expansion of the shadow economy took place mostly in the 1990s, the
increase in energy intensity appears less dramatic. It means that energy con-
sumption has grown almost proportionately with total production, both offi-
cial and unofficial. This result is not astonishing, considering that one way to
calculate the size of the unofficial economy is to use the data of electricity
consumption.
An opposite hypothesis holds that the insufficient adjustment of produc-
tion capacity to decreased demand has significantly increased fixed costs in
the economy. As long as production capacities are maintained, a significant
amount of energy is used independently of the level of production. In this
view, the adjustment of production capacities to effective demand will lead to
a significant improvement in energy efficiency. Although the growth of the
shadow economy in recent years is undisputed, there is little evidence that
this would fundamentally change the above statement about energy waste in
the Ukrainian economy. As long as a large part of the shadow economy con-
sists of trade with little energy intensity, it is unlikely that this hidden eco-
nomic activity can explain the high energy intensity of the economy.
Furthermore, data on industries and single products also show a high and in-
creasing energy consumption that cannot be attributed to the shadow
economy.8
The second qualification to energy intensity concerns the overall structure
of the Ukrainian economy. Since the beginning of transformation, the basic
industries- energy, metallurgy,and partlychemistry-have declined less than
industry as a whole. This structuralchange toward a growing share of basic
industries can partly explain increased energy intensity. These changes, some-
times denounced as deindustrialization,have increased the energy dependence
of the Ukrainian economy. If high energy intensity is caused by market-deter-
mined structural change, it is not worrisome. To some extent, the adjustment
of exports has contributedto this structuralchange. Ukrainianexports to coun-
tries that are not former members of the Soviet Union have grown dispropor-
 JANUARY-FEBRUARY
2000 65

tionately in recent years. The metallurgical industry accounted for the great-
est part of the export expansion until 1998, although in 1998 the crisis in
Russia-and earlier in Asia-contributed to the decline of Ukrainian exports.
Similarly, a significant part of Ukrainian refinery capacity is used by out-
ward processing. Russian firms export fuels, which, after being refined in
Ukraine, are reexported to Russia. Therefore, part of the higher energy con-
sumption resulting from the biased industrial structure is paid for by in-
creased exports.
The actual consumption of energy in different sectors of the economy pro-
vides an initial rough indication of the potential of energy savings. The po-
tential amount of energy saving is estimated to be about equal in the
commercial/residential sector and in industry. When assigning priorities to
specific conservation programs, one has to consider that improved energy
efficiency in industry will not only reduce the import bill but also should
increase the competitiveness of the firms by reducing costs. This should
further improve export performance if the exporting enterprises improve
their cost structure by saving energy. Energy conservation programs of
the commercial/residential sector are easier to administer than those in
industry because of the great diversity of technical measures to be taken
in the latter.
Given the vast potential for energy savings and the meager perspectives of
economic growth, it is likely that primary energy consumption in Ukraine
will continue to decrease. A study issued by the Gernan Advisory Group in
1998 concluded that primary energy demand in 2010 is likely to be around
130-160 million toe, that is, lower than in 1995 (Horn 1998). This is in con-
trast to the governmental program "Energy 2010," which estimated a level of
about 200 million toe. Even after 2010, energy consumption is unlikely to
reach pre-1990 levels. A revision of the official forecasts is of utmost impor-
tance in order to prevent politicians from financing an expensive expansion
of the indigenous production to meet the exaggerated government forecasts
of energy demand.

Price Signals and Incentives to Economize

The energy sector provides the most important contribution to structural ad-
justment of the economy as a whole if it sends correct signals about the eco-
nomic costs to its customers. The energy problem is first of all a problem of
prices, competition, and the absence of market interventions. Energy saving
has to be carried out by the energy users. This will happen only if they get the
correct incentives to do so.
In recent years, prices of energy have almost completely adapted to world-
66 EASTERNEUROPEANECONOMICS

market prices. The relative price of electricity was only 23 percent higher in
December 1995 than in December 1991. This seems low in comparison with
Russia, where the relative price of electrical power rose by 140 percent from
1991 until the end of 1995. Only in 1998 was there a significant increase in
relative energy prices, which had then risen by 63 percent since 1991. The
largest price adjustment for fuels took place at the beginning of the 1990s.
After 1992 the relative price of fuel declined steadily. However, in 1998 fuel
was 200 percent more expensive than in 1991, while in Russia the relative
prices had approximately doubled. The adjustment of relative fuel prices has
been uneven. In the beginning, the oil refining sector increased its prices
extremely fast; later the prices of the gas industry grew disproportionately
(Vincentz and Hirschhausen 1999).
It is difficult to assess the scope of remaining distortions in energy prices.
The prices of energy for households were supposed to climb to their full cost-
recovery level in 1998. But, as mentioned above, subsidies have not been
completely abolished in the energy sector. For example, cross subsidies among
production, import, transportation,and storage of energy persist. Despite the
far-reaching adjustment of energy prices, the International Energy Agency
estimates that still "average natural gas and power prices cover companies'
operating costs but are below full economic costs of supply."9If this is true,
further increases in energy prices are to be expected, but they will be very
modest compared to past price hikes.
A telling example of insufficient incentives for energy saving, despite ba-
sically correct prices, is the proliferation of arrears, both domestically and
from imports. The energy sector stands out with large international arrears.
Until 1994 a large quantity of gas supplied by Russia and Turkmenistanwere
unpaid. After these debts were consolidated, the problem persisted, although
it became less severe. Interestingly, arrears arose almost exclusively in the
highly concentrated gas sector and not with imports of oil. As long as state
guarantees for the payment of energy deliveries exist, enterprises have weak
incentives to pay and thus to economize. The IMF agreements have firmnly
stated as a condition that further accumulation of arrears violates the agree-
ments, but this has remained a moot point.
Furthermore, within Ukraine the large interenterprise arrears are closely
related to the energy sector. According to data from the Ministry of Statistics,
by mid- 1999 about 43 percent of the arrears (= payables) concerned deliver-
ies of electricity and fuels. About 23 percent of the receivables were related to
energy. The high share of the energy sector in arrearscan also be observed in
Russia. Based on these data, it emerges that the decline in Russian arrears in
the fall of 1995 was predominantly a change in arrears of the energy sector.
The concentration of nonpayments on energy products, in particularelectric-
 2000
JANUARY-FEBRUARY 67

ity, means that the latter is a net creditor to other sectors. This might be a
plausible outcome for Russia, where energy is by far the greatest source of
profit that might be used for the financing of other sectors of the Russian
economy. In Ukraine, such a justification for the crediting of other sectors
makes no sense. In any case, the energy arrears finally amount to a reduction
of actual paid energy prices. Energy deliveries, in Russia as well as in Ukraine,
are still considered an obligation imposed by the state, and their payment can
easily be deferred.'?
Thus, price distortions caused by arrears reduce incentives to save energy
and exacerbate the continuing payment crisis. As long as bankruptcy is an
exception, creditors have to single out those firms among its customers that
can and will pay. An efficient allocation of goods can only be achieved if the
energy sector stops delivering goods to firms that do not pay. To facilitate a
more selective delivery policy of the energy sector, all state guarantees to this
sector must be abandoned. In addition, debt-equity swaps and the develop-
ment of a secondary market for liabilities from arrearswill put more pressure
on the debtors and creditors to care about their payments. Present conditions
afford the debtor a rather comfortable position due to the lack of bankruptcy
procedures. Then, energy enterprises, as the main creditors in the system of
mutual nonpayments, should be subject to market sanctions and incentives
that force them to secure payments for their deliveries. This would ease the
payment crisis, and, more important,would provide incentives for energy sav-
ings in downstream industries. The primary task of energy policy should be to
promote energy conservation. In the end, this task must be carried out by the
energy-consuming industries, which react to the price signals by cutting their
energy costs.

Conclusions: Toward a Post-Soviet Energy

Sector in Ukraine?

Ukraine has not used the "window of opportunity" provided by the 1994 re-
form initiative to adjust the energy sector to the requirements of a market
economy. Instead, the sector has become the prime example of the faltering
transformation of the economy at large: just as reforrns in the energy sector
were halfhearted, so were the overall reforms in the Ukrainian economy. Even
though economic growth may begin in the early years of the next decade, no
radical impetus is to be expected with respect to structuralreforrn.
Nevertheless, the Soviet econoniic system will not return, and gradual re-
forms are still possible. These should adhere to the following principles:
1. The energy sector should be deregulated in steps, and cost-effective pric-
ing should be introduced. This demands the reduction of government activi-
68 EASTERNEUROPEANECONOMICS

ties that interfere with the responsibility of the firms. Policy-making respon-
sibilities with regard to energy policy have to be streamlined and concen-
trated. The very existence of old Soviet-type branch ministries, for example,
the State Committee for Oil and Gas and the State Committee for National
Reserve, is contrary to the proper functioning of markets. Conflicts of interest
among different administrations and unclear assignments of responsibilities
create inefficiencies and disturb the supply response of the firns. A major
reorganization of the energy administration,which East European transform-
ing countries carried out at the very beginning of transformation, should re-
duce the government's commercial role. The regulatory agency for the
electricity sector (NERC) needs full independence and a similar agency should
be created for the oil and gas pipelines. The depoliticization of commercial
activity will reduce the possibilities of rent-seeking, the proliferation of which
has damaged attempts at reform of the energy sector.
2. The lack of corporate governance can be tackled in several ways.
Privatization, decentralization, and the financial responsibilities of firms have
to be strengthened. The least progress in privatization has been made in the
energy sector. In the short run, more pressure must be placed on enterprise
management. The turnover of managers must be facilitated. The economic
success of a firm has to be the guideline in the assessment of enterprise per-
formance. The structure of the existing enterprises is generally not suited for
a market economy. These enterprises should be disassembled and from their
parts new entrepreneurialunits can arise, even from those firms that cannot or
should not be privatized in the near future.
3. The financing of production and investments will remain a major prob-
lem for some time. Capital markets are still functioning poorly at best. The
real interest rates for credits have been extremely high in the past few years.
The economic cycle of investment-sales-profits-investments has been de-
stroyed by demonetization in all branches of the energy sector, especially in
electricity and coal. This problem must be solved within a larger attempt to
restrain interenterprise arrears and nonpayment by final consumers. Large
foreign investment is not likely to come about in the near future. Priorityneeds
to be given to the small-scale refurbishment and modernization of existing
equipment. The restructuringmust, for the most part, be based on self-financ-
ing, which, in turn, requires rather modest profit taxes. Any possibility of
privatization through cash sales must also be used, since this procedure, to a
large extent, also solves the problems of corporate governance.
The energy sector will remain the Achilles' heel of the Ukrainian economy
for quite some time. Without the energy sector's recovery, the rest of the
economy will be penalized in its effort to become internationally competi-
tive. Without energy savings and a reduction in energy intensity, import de-
 JANUARY-FEBRUARY
2000 69

pendencewill continueto increase.Withoutestablishingeconomicprinciples

in the energysector,Ukrainewill be threatenedwith remaininga post-Soviet
economy,separatingit furtherfrom Europeanand world integration.

Notes

1. The five are:IntegratedPowerGrids,Intergaz,Olgaz,Itera,andUkrzarubezh-

neftegas(Interfax,April25, 1996).
2. Davidovici(1995); Parkerand Surrey(1994).
3. International EnergyAgency (IEA) (1996).
4. Ibid.
5. EconomicReview,April29, 1996. Opinionsdifferwidely on the real costs of
closing a mine.The UkrainianMinistryof Coal estimatestotal mine closurecosts at
about$20 millionpermine;this includessocialcost, unemploymentcompensation,the
creationof newjobs, andenvironmentalwork.The WorldBank'sestimatesarearound
$10 millionpermine(BusinessWeekly,October16, 1995).InPoland,theclosureof one
mine cost about$50-60 million;but the rateof returnof closing schemeswas rather
favorable,at about6-20 percentfor a ten-yearperiod(Radetzki1993).
6. PresidentialDecreeon MarketTransformation Measuresin theElectricitySector
of Ukraine(244/94).
7. Cf. Tarr(1994); McCarthyet al. (1995).
8. IEA (1996), pp. 73-75.
9. IEA (1996), p. 21.
10.Inview of thehighshareof overduereceivablesin the energysector,the Russian
governmentdecidedto constrainprice increasesof naturalmonopolies,to which the
energysectorsbelong, to 70 percentof industrialprice inflation(RussianEconomic
Trends4, no. 4, 1995:31).

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