Forced to be Free? The Consequences of the Transition to European Netback Gas Prices for Ukraine’s Energy Dependency

On January 19, 2009, Russia and Ukraine signed a contract setting the price at which Ukraine would purchase Russian gas for the next decade. The agreement terminated the 2009 gas war—a dispute over gas prices that prompted Russia to withhold gas supply to Ukraine and Europe for over two weeks. It also committed Ukraine to purchasing Russian gas at high oil-linked prices, which was bound to significantly impact its gas-intensive economy. Competing business-administrative groups in Ukraine spun the conflict’s outcome in ways that furthered their respective agendas. The government of former President Viktor Yanukovych portrayed it in starkly negative terms, stressing its role in exacerbating Ukraine’s suffering in the financial crisis in that it inflated the fiscal deficit through higher energy import costs, and destabilized the economy. Like his predecessors in the office of Ukrainian president, Yanukovych argued that high gas prices are inimical to Ukraine’s state interests in order to further his own and his allies’ personal ends, while tacitly ignoring the extent to which the previous pricing mechanism had helped generate the kind of Ukrainian economy that could be severely crippled by a shock in a single source of energy supply. Meanwhile, the 2009 contract’s purportedly disastrous consequences was used to legitimize the jailing of its chief architect and key opposition figure Yuliya Tymoshenko, as well as to justify the president’s refusal to meaningfully reform Ukraine’s inefficient and corrupt energy sector. This prolonged Yanukovych's access to energy-related rents, and has helped bring the Ukrainian economy to the verge of collapse in months that followed.

Yanukovych’s ability to exploit the 2009 gas contract for propaganda purposes was bolstered indirectly by a near absence of scholarly publications assessing and contextualizing its impact. At the time of writing, only the Oxford Institute for Energy Studies and Margarita Balmaceda have produced relevant studies on the subject (Pirani, Stern & Yafimava 2009; Pirani 2011; Pirani 2012; Pirani 2013; Balmaceda 2013). However, these works have focused either on gauging the impact of Ukraine’s domestic politics on its energy policy, or on the effects of the external shock of higher gas prices on various domestic developments. Only limited attempts have been made to theorize how these have combined to affect the larger Russo-Ukrainian energy relationship in its historical context. This paper’s contribution is that of a theoretical framework for conceptualizing the relationship between the price of Russian gas for Ukraine, the latter’s energy dependency on Russia, and the impact of this dependency on Ukraine’s political and economic development. While the framework does not purport to provide an exhaustive account of Russo-Ukrainian energy and politico-economic relations, it may provide a useful lens for understanding the interaction between Russian gas prices and Ukraine’s multifaceted vulnerability to Russian pressures.

The theoretical framework presented herein is formulated through historical analysis of Russo-Ukrainian energy relations both prior to and after the transition to oil-linked gas prices in 2009. It suggests that there exists a negative correlation between the price of Russian gas and the extent of Ukraine’s energy dependency on Russia, which rests on three pillars: Ukraine’s high gas consumption, its energy poverty, and Russia’s status as a monopolistic supplier of energy to Ukraine. In addition, it discerns a positive correlation between the extent of Ukraine’s energy dependency on Russia and its political and economic vulnerability to Russian pressure. Consequently, Ukraine’s transition to high oil-linked gas prices since 2009 has reduced its energy and politico-economic dependency on Russia, rendering it freer to pursue a more pro-Western foreign policy, and providing impetus for domestic institutional reform. However, Ukraine’s ability to benefit practically from these gains will remain contingent upon its capacity to gear its political institutions towards serving the interests of the state, rather than those of dominant business-administrative elites.

After analyzing the dynamics of the Russo-Ukrainian gas trade up to 2009, this paper will  conceptualize and evaluate the theoretical framework in light of subsequent developments. While it considers the many facets of the Russo-Ukrainian asymmetrical interdependence in energy and politico-economic matters, its primary focus is on Ukraine’s many dependencies in this relationship and their links to the price of Russian gas—the fuel with the largest share in Ukraine’s energy mix. Throughout, “low gas prices” refers to prices for Russian gas that are below the level of European netback—that is, gas prices at the border with the European Union (EU). “High gas prices” refers to those prices that are tantamount to European netback levels and linked to the price of oil.

Russo-Ukrainian Energy Relations Prior to 2009

The Soviet Era

Urbanization, industrialization, and electrification were key tenets of the Soviet Union’s development strategy. As an integral part of the USSR, Ukraine became a key participant in the transformation of the former Russian Empire from a backwater on Europe’s fringe into an industrial powerhouse, not least through its provision of gas—a fuel necessary for industrial development (Pirani 2011). Throughout the 1950s and 1960s, Ukraine produced almost half of all Soviet natural gas, with production peaking in 1975 (Pirani 2012; Chow & Elkind 2009). From that point, however, its easily accessible reserves began depleting and in the 1980s Ukraine quickly transitioned to being a net importer of gas from other Soviet republics—in particular from Russia (Pirani, Stern & Yafimova 2009).

The development of heavy industry and manufacturing plants on Ukrainian territory rendered the economy gas-intensive at a time when its own energy prospects were deteriorating. However, Ukraine’s membership in a socialist state that included energy-rich republics like Russia ensured it access to cheap and plentiful energy while the Union lasted (Park 2011; Pirani 2012). In the USSR, energy was distributed to enterprises and municipal residences on the basis of need, and its costs were kept well below world energy prices to facilitate industrial development (Goldman 2008; Park 2011). Soviet Ukraine was thereby able to develop gas-intensive sectors under the assumption of energy abundance, even while the republic itself was becoming increasingly reliant on fuel imports from the West Siberian gas fields.

The accessibility of Russian gas produced a surfeit of Ukrainian fuel consumption and made feasible the postponement of technical upgrades that would have improved energy efficiency. By 1990, the energy intensity of the Ukrainian economy had become more than twice that of the world average (Stuggins, Sharabaroff & Semikolenova 2013). Meanwhile, Soviet Ukrainians, having been reared in a climate of plentiful energy, came to view Russia as a reliable supplier of gas, and considered cheap energy a basic social service (Aalto, et al. 2013; Park 2011). They also learned to accept Ukraine’s energy-intensive economy as the norm.

In addition to its reliance on Russian energy, during the Soviet era Ukraine became embedded in a system of gas and oil pipelines that saw Russia as the union’s most geopolitically important and energy-rich member (Balmaceda 2006). No direct pipeline connections were built between Ukraine and any of the Central Asian republics, some of which would in due course become net exporters of fossil fuels, including to Ukraine.1 As was the case with political relations, Russia mediated energy among the USSR’s constituent members through their structural subordination to it in the gas pipeline system.

Ukraine nonetheless acquired strategic significance denied to the other republics, due to its geographic location as a sizable ‘borderland’ between Russia and Europe, enabling it to become an integral player in Russo-European energy relations. For the economically stagnant Soviet Union of the 1970s, exports of gas to European states became a crucial financial band-aid that helped postpone structural economic adjustments. Unlike intra-Soviet energy transfers, the Russo-European gas trade rested on “market principles”, or rather their closest equivalent in a sector that to this day lacks a unified global market. In Europe, Moscow was able to link gas prices to those of oil and, given oil’s escalating value in the wake of the 1973 OPEC oil embargo, derived tremendous profits. Ukraine’s position as the conduit for over 90 percent of Russo-European gas transit and its extensive gas storage facilities, strategically located near the USSR’s Western border, made it a linchpin in pan-European energy flows (Balmaceda 2013).

1991-2008

After the implosion of the USSR, Ukraine’s importance as a transit state and a large consumer of Russian gas, coupled with Russia’s bleak economic outlook and desire to nurture a friendly regime in Kiev, enabled it to secure the perpetuation of relatively low Russian oil and gas prices. Until 2009, this arrangement helped conceal from the Ukrainian public the full implications of the fact that with independence Ukraine renounced its membership in an energy-rich state and had become energy-poor (Pirani 2007; Balmaceda 2013).

In the 1990s, Russia’s economic collapse rendered it particularly reliant on exports of fossil fuels to Europe (Pirani 2012). This came to furnish as much as 60 per cent of Russia's export revenue and 45 per cent of its federal budget (Chernavsky & Eismont 2012; Kryukov, Tokarev & Yenikeyeff 2011). Having inherited sovereign control over the gas pipeline system and storage facilities on its territory,2 independent Ukraine was in a position to either sabotage the flow of gas from Russia to its most lucrative Western markets or, conversely, enable the Russian gas export monopoly Gazprom to reap the highest profits in Europe by affording it low transit and storage fees.3 As independent Ukraine became the fifth largest gas importer in the world, the country also emerged as a very large and potentially lucrative foreign consumer of Russian gas in its own right (Balmaceda 2013). The post-1991 energy relationship between Ukraine and Russia thus became characterized by an “asymmetrical interdependence” (Balmaceda 2013, p. 93-94), whereby Ukraine remained reliant on Russia for roughly half of its energy needs, while retaining leverage over Russia’s energy sales in Europe and in Ukraine itself.

In theory, Ukraine could deploy its status as a crucial gas transit state and gas importer to mitigate its energy dependency by insisting on several things: a more transparent energy relationship with Russia, contractual and geographic diversification of its energy imports through  Russian gas pipelines,4 and Russian cooperation in helping Ukraine devise and implement a coherent national strategy for transitioning to European netback prices. However, domestic political developments, including the early capture of the Ukrainian state apparatus by powerful business-administrative groups with vested interests in the continued availability of cheap Russian gas (and the obfuscation of Russo-Ukrainian energy dealings), precluded any mitigation of Ukraine’s energy dependency until the external shock of high gas prices in 2009.5 

During the transition from the Soviet command economy to a more laissez-faire system, and the concomitant privatization of state assets, Ukraine’s gas-intensive chemical fertilizer plants, steelworks, and other industries of Soviet provenance were rapidly snatched up and redistributed among a few competing groups of business elites with ties to the president (Balmaceda 2013). Given Ukraine’s long isolation from international quality standards, its low export prices hinging on low input costs became its major source of competitive advantage in global markets. For the gas-intensive industries, keeping gas prices low through cheap imports from Russia—the country that could provide the cheapest gas possible—became the easiest path towards profit maximization. In the process, elites imperceptibly vested millions of Ukrainians employed in the gas-intensive industrial sector (particularly in Ukraine’s Southeast) with an economic stake in the maintenance of genial relations with Russia (Balmaceda 2009) and, indirectly, in the enrichment and empowerment of the oligarchs themselves.6

While guaranteeing a standard of living tolerable to the population, the low gas price regime served as a disincentive for Ukrainians to conserve gas and resulted in the overconsumption and over-importation of the commodity from Russia. It also breathed life into uncompetitive sectors of the Ukrainian economy, enabling them to muddle through without significant reforms (Balmaceda 2009). As a result, the first decade of Ukrainian independence passed without the emergence of any major domestic economic actor with a vested interest in energy supply diversification, and with Ukrainian energy consumers remaining generally insulated from economic pressure to adjust to the underlying reality of Ukraine’s post-1991 energy scarcity.

From 1991 to 2005, Ukraine’s internal political configuration—notably the weakness of its democratic institutions and lack of meaningful public oversight of the government’s workings—severely crippled its ability to manage its energy inefficiency and its dependence on cheap Russian gas.  In particular, it made possible the institutionalization of a two-tiered gas pricing mechanism for domestic energy consumers that, by making energy available to the public and residential sectors at heavily subsidized prices, would lead to Ukraine’s exorbitant consumption of Russian gas for years to come and the extensive theft of Russian gas transiting through Ukraine (which led to disputes with the Kremlin); the allocation of lucrative gas sales for the Ukrainian industrial sector to private gas distributors linked to powerful politicians rather than state-owned Naftohaz Ukrainy, generating endemic bankruptcy in the latter; the introduction of intermediary companies into Russian-Ukrainian energy relations, including Central Asian gas exporters like Turkmenistan, complicating dealings between the trade partners; and the development of a barter system to maintain gas deliveries from Russia and Turkmenistan into Ukraine, despite its recurrent liquidity crises which inflated gas prices and fuelled corruption (Balmaceda 2013). Ukraine was neither passive nor purely reactive in its dealings with Moscow, as its politicians and business elites played an active role in shaping the country’s energy prospects in ways that benefited them.

These policy outcomes, and particularly the way they fostered opportunities for illicit activities, combined to greatly complicate the dynamics of Ukraine’s energy dependency (Balmaceda 2009; Pirani 2011). Given the inherent opacity of illicit trade, the notorious absence of the rule of law in both countries, and collusion between competing cohorts (Russian and Ukrainian) of corrupt politicians and Gazprom officials, it became impossible to reliably quantify the exact amount of Ukrainian state debt for Russian gas (Balmaceda 2013). Further, as Ukraine’s energy sector became a breeding ground for corruption that implicated its major political figures, reform became increasingly difficult; since most politicians could be implicated in energy-related rent-seeking, any meaningful attempt to raise the issue would have spelled the end of any number of careers. Most crucially, Ukraine’s authoritarian, corrupt, and non-transparent domestic political environment hid from the public the extent of the country’s energy-related woes, including the true cost of nominally cheap Russian gas. This will be discussed in greater detail below.

 It should be noted that the relationship between Ukraine’s domestic politics and its energy relationship with Russia was bi-directional. While bad governance served to exacerbate Ukraine’s energy dependency, this circumstance, and importantly the availability of low Russian gas prices, made it politically inexpedient for politicians to make the uncomfortable choice to refuse cheap gas. This is not least due to the fact that such a manoeuvre would temporarily slow down growth in Ukraine’s most important economic sectors, and expose the decision maker to powerful opponents would could easily exploit the public’s ingrained sense of entitlement to cheap energy. Independent Ukraine effectively found itself trapped in a vicious cycle, in which cheap gas bred venal politicians, who bred cheap gas.

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