Highlights

Main energy sector challenges in Ukraine included high energy intensity, weak governance, outdated infrastructure, and high dependence on a gas supply from a single source. Energy subsidies were a major fiscal burden.

After 2014, the World Bank actively helped Ukraine reform the energy sector, focusing on governance, efficiency, and security. The main areas of progress with World Bank support were energy tariff reforms, unbundling of the natural gas monopoly, diversification of the gas supply, and institutional arrangements for promoting energy efficiency.

At the same time, despite World Bank Group support, progress on reforming electricity markets and strengthening regulatory capacity has been slow. Institutional reforms and the virtual elimination of subsidies have yet to translate into more private investment in sector infrastructure and visible improvements in energy services for consumers.

Energy supply, services, and transit have played critical roles in Ukraine’s development. Ukraine’s energy sector has been shaped by multiple forces stemming from ideological (market-based or subsidized) and geopolitical contestation. These factors have fueled strong incentives for market capture and control by a few private players, weakened sector governance, and contributed to underinvestment in aging and inefficient infrastructure. The high energy intensity of the economy—a legacy of the industrial base, housing stock, and Soviet Union–era pricing policies—has made tariff reforms deeply unpopular and difficult in the face of limited progress in enhancing service quality and affordability. This chapter discusses Bank Group contributions to developments in the core areas of its energy sector support: (i) sector governance and transparency (including fiscal implications), (ii) energy efficiency, and (iii) energy security.

Sector Governance and Transparency

At the beginning of the review period, the Ukrainian energy sector was characterized by weak governance, outdated infrastructure, high dependence on gas imports from a single source, and large fiscal costs. The government resisted reforms to promote cost-recovery tariffs, competition, and independent regulation. The practice of “socializing” high energy costs through the budget had strained the country’s fiscal condition. By 2014, direct subsidies for underpriced gas, combined with other losses of Naftogaz (the state-owned gas monopoly), accounted for 7 percent of GDP (including 3.3 percent of GDP in direct subsidies). Before 2014, Bank Group support to the energy sector was dominated by investment lending (with technical assistance components), and meaningful institutional reforms did not begin until 2014. This step coincided with far-reaching tariff reforms and the suspension of gas imports from the Russian Federation, with the energy sector serving as a major contributor to the macroeconomic crisis.

Taking advantage of the political opening after 2014, the Bank Group helped establish a framework for competition, private investment, and independent regulation. In parallel with IMF and EU support, the World Bank increased its work on tariff and subsidy reform through DPLs and technical assistance, which (twinned with a better-targeted HUS program) virtually eliminated budget subsidies and generated enhanced transparency in the gas sector. The World Bank effectively leveraged donor funds to provide just-in-time and technical assistance and helped implement socially sensitive tariff and subsidy reforms across different ministries, development partners, and the energy regulatory commission.1 Bank Group and IFC advisory services and technical assistance supported aggressive “catch-up” tariff and social protection reforms and pushed for further unbundling and competition (the fiscal impact of energy tariff reform is covered in chapter 3). Other notable results included the strengthening of institutional arrangements for promoting energy efficiency by establishing the Energy Efficiency Fund;2 the strengthening of financial intermediaries, especially the state-owned UkrGasBank (through IFC technical assistance to develop capacity and governance); and the establishment and strengthening of the technical capacity of the National Energy and Utilities Regulatory Commission. Power sector investment projects included technical assistance for strengthening regulatory capacity and independence and developing a new model for the wholesale electricity market.3 Specific support was provided by the Bank Group for the government’s plan for implementation of gas sector reform (adopted in 2015) to comprehensively restructure the gas sector, including developing and implementing key legislation.4

The World Bank was the government’s main partner in the design and implementation of the unbundling of Naftogaz. Ukraine made this commitment as part of its 2014 Association Agreement with the EU. DPL prior actions, investment lending, and technical assistance supported the restructuring of Naftogaz and distribution companies, improvements in payment discipline, debt resolution in the energy sector, audits of Naftogaz and its subsidiaries, progress in transparent privatization, and partial channeling of gas-transit fees to the budget through a treasury single account. IMF and EU budget support and European Investment Bank investment and liquidity support were contingent on unbundling. The unbundling continued in 2019, with Naftogaz’s transmission and transit functions being separated from the rest of the company, in line with recommendations from the Bank Group study of unbundling options.

Cooperation with development partners was an important aspect of the Bank Group’s support for the energy sector. Joint work under the aegis of the Brussels declaration allowed donors to agree on an international financial institution–EU list of key structural reforms to enable investment in the gas sector. Trust funds played a vital role in supporting Bank Group analytical work on such topics as tariff and social protection reform and Naftogaz unbundling. After the 2014 crisis, the Energy Sector Management Assistance Program provided timely funding for a multisector World Bank team and used entry points from different sectors to forge consensus among counterparts and development partners to design and implement tariff and subsidy reforms.5

However, reforms have not been followed by commensurate private investment in the sector and did not enhance customer satisfaction and choice. Municipal-level ownership and coordination of reforms and the national government’s commitment to modernize services remain weak. Ukraine’s energy sector needs to attract substantial investments for modernization and efficiency improvements to provide the level of services necessary to sustain the reform effort, including accessing the EU single market for gas and electricity, enhancing the competitiveness of its industrial base, and managing greenhouse gas emissions in accordance with international commitments.

There has been little progress in enhancing competition in the electricity sector, which is still dominated by a few powerful private players. The energy and competition commissions have been unsuccessful in curtailing the market power of major private players or preventing them from padding supply costs, which are then passed on to the market (or ultimately borne by taxpayers). Debts to energy suppliers have been increasing because of unaffordable tariff incentives offered for renewable energy-based power generation, and the market power of a few players to manipulate costs remains unchecked, undermining the sustainability of earlier achievements in this area.

Energy Efficiency

Bank Group policy advice, lending, and support to institutional and financing mechanisms has helped put Ukraine on a more energy-efficient path. Bank Group–supported tariff and subsidy reforms, together with investments to improve the reliability and efficiency of aging and outdated supply infrastructure, have begun to reduce energy demand and create incentives for greater efficiency on both the supply and demand sides (table 4.1). Progress on competition in the gas sector, facilitated by the unbundling of Naftogaz (see the Sector Governance and Transparency section in this chapter), and steadily improving metering and management of district heating are expected to lead to improved services, enhanced accountability, and reduced corruption. Gas demand has dropped from 50.7 billion cubic meters in 2012 to 25.0 billion cubic meters in 2019 (of which about 20 billion cubic meters were produced from domestic resources). Total primary energy demand, energy intensity, and carbon dioxide emissions also dropped during the evaluation period by 37, 25, and 33 percent, respectively. Correspondingly, the monetary value of the domestic gas market decreased from $14.5 billion equivalent in 2012 to $7.7 billion in 2019.

Sources: International Energy Agency—Data and Statistics; Ministry of Energy of the Russian Federation; Naftogaz; National Energy and Utilities Regulatory Commission.

Note: bcm = billion cubic meter; GWh = gigawatt hour; ktoe = kiloton of oil equivalent; — = not available.

Elements of a strategy for the recovery of district heating have been put in place, but actual improvements in energy services have not been seen at the level of households. These elements include energy tariff reform, with targeted social protection; financing and technical support to businesses, including small and medium enterprises, supported by IFC technical assistance for energy-efficient investments; financing and technical support to households through an Energy Efficiency Fund (supported by the World Bank); joint IFC–Bank Group design and operationalization of an EU energy efficiency grant for residential buildings; and support to municipalities for energy-efficient district heating (the World Bank’s District Heating Energy Efficiency Project). At the same time, actual improvements in energy services (electricity, gas, and district heating) are not being seen at the level of households or experienced by consumers, with recent surveys indicating little net change in the perception of respondents about the quality of services (see appendix C).

IFC has played an important role in promoting energy efficiency. IFC developed energy efficiency–oriented financial products (investment loans and targeted credit lines for energy efficiency improvements through financial intermediaries). It partnered with the EU to jump-start the energy-efficient renovations of multifamily buildings, provided advisory services on cleaner production and residential energy efficiency, and helped structure public-private partnership transactions and transparent mechanisms to attract private sector financing.6 IFC also partnered with the state-owned UkrGasBank (which it would not typically do, given its private sector mandate) to increase lending to businesses to make them more energy efficient and competitive.

Energy Security

Bank Group support contributed to breaking the country’s dependence on gas imports from a single source. This outcome was achieved through difficult but effective tariff reforms resulting in a significant reduction in gas demand and a diversification of supply to European suppliers. The $500 million gas-supply guarantee (approved in 2016) provided by the Bank Group in partnership with the European Investment Bank promoted competition among gas suppliers by enabling a financially weak Naftogaz to procure gas competitively from European suppliers, breaking its dependence on Russian suppliers in an affordable manner. Furthermore, as a result of Naftogaz unbundling, the newly created Gas Transmission System Operator, unencumbered by domestic gas production and other nontransmission functions, was able to leverage Ukraine’s locational advantage to negotiate a favorable gas-transit agreement with the Russian Federation’s Gazprom for 2020–24. Gas-transit volumes dropped from approximately 86–88 billion cubic meters in 2012–13 to 62 billion cubic meters in 2014 (the year of the crisis) before rising to approximately 90 billion cubic meters in 2019, yielding a transit revenue of $2.7 billion (table 4.1). However, this revenue is unlikely to be sustained, given recent and ongoing developments in gas-transit routes.