Energy Policy and Structural Reform

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Energy Policy and Structural Reform

Author(s): Christian von Hirschhausen and Volkhart VincentzSource: Eastern European Economics, Vol. 38, No. 1, Economic Reform in Ukraine (Jan. - Feb.,2000), pp. 51-70Published by: M.E. Sharpe, Inc.Stable URL: http://www.jstor.org/stable/4380207

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EasternEuropeanEconomics,vol. 38, no. 1,January-February000, pp.51-70.? 2000 M.E.Sharpe, nc.All rightsreserved.ISSN 0012-8775/2000 $9.50+ 0.00.

CHRISTIAN VON HIRSCHHAUSENANDVOLKHART INCENTZEnergy Policy and Structural ReformAlmost enyearsafterUkraine'sndependence,ts energy ector emains majorobstacle o structuralhangeandeconomicdevelopmentn Ukraine.After woyearsof stop-and-go olicy, n the fall of 1994 Ukraine tarted newattempt ttransformingo a market conomy.Newly elected PresidentLeonidKuchmaledtheway to serious tabilizationffortsand o anagreementwiththe Interna-tionalMonetaryFund IMF).Theperiod1995-96 saw a significant eductionof inflationbasedon a tightmonetary olicyand a sounder iscalpolicy.Un-fortunately,heprogressnstructuraleformshas notcorrespondedo thecom-parative uccess of macrostabilization.nstitutions ndregulations ave beenonly slowly adjusted o a market conomy, he speed of privatization as beenmuchslower hanhadbeenhoped,andredtapestillabounds tall levels of theeconomichierarchy. hus,in fall 1998,Ukrainewas forcedto follow Russiainto financialnstabilityromwhich it has not recovered n late 1999.Despitemanypersistent ureaucraticindrances,hestructure f the Ukrai-nianeconomyhaschangeda greatdealsince planningwas abolished.As ex-pected,theservice sectorexpandedquiterapidly,althoughnotsufficiently ocompensatefor the outputdecline in other sectors. Concerningstructuralchange,much attentionandmoneywere lavished on the energysector.En-ergyis considered strategic ranchbecause heeconomyasawhole is highly

This article will be publishedas a chapter n the forthcomingbook EconomicReformin Ukraine: The UnfinishedAgenda,ed. Anders Aslundand Georges deMenil(Armonk,NY: M.E. Sharpe,2000).Christian on Hirschhausens a seniorresearcher t theGerman nstitute or Eco-nomicResearch DIW) nBerlinandmemberof the GermanGroupofAdvisors o theGovernment f Ukraine.Volkhart incentzs aseniorresearcher t theInstitute f EastEuropeanStudies,Munichand a memberof the GermanGroupof Advisorsto theGovernment f Ukraine.

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JANUARY-FEBRUARY000 53

ization of the power sector, as well as the restructuringand modernization ofthe coal sector. This provided an importantimpetus for economic reform inUkraine as a whole. Yet the results of these ambitious reforms, in terms ofenterpriseperformanceand economic stabilization,have not arrivedas quicklyas was initially hoped. A certain discrepancy exists among different segmentsof the energy sector: whereas oil has been liberalized to a certainextent, natu-ral gas andpower,albeit formal verticalunbundling,remainunderstrongstatecontrol. In the coal mining industry,structuralreformhas so far been insuffi-cient to relieve the state budget from heavy subsidies.Gas:ContinuedUnbundling s NecessaryGas is the most importantfuel for the Ukrainian economy; it is also the onethat creates the most severe fmancial imbalances. Although gas prices havebeen raised significantly so as to reach and even surpass European marketlevels, consumption has decreased only slightly, by 30 percent since 1990.Domestic production has been reduced continuously since 1990 due to thedepletion of reserves. Hence, gas importshave become the critical factor forthe Ukrainian energy supply. The net gas bill for 1997 was about $5 billion,thatis, more than50 percent of the total net energy bill and over 25 percent ofall Ukrainian imports. Therefore, the solution to the currentaccount deficitproblem is closely linked to reform of the gas sector (see Tables 1 and 2).The history of reformof the gas sector is the historyof a battle between theUkrainian government, fighting for strong state control in the sector, and theinternational fmancial institutions,mainly the WorldBank, fighting for verti-cal disintegration and the introduction of competition. So far, the governmentseems to have won the battle, with highly doubtful results. Only in the firstinstance, in 1994-96, were steps taken toward a more competitive gas sector.Since September 1995, local gas distributorshave had the right to refuse gasdelivery to consumers in the case of unpaid bills. Still more important was theunbundling of the formerly integratedindustrystructure.In accordance withthe decision of the StateOil andGas IndustryCommittee of January26, 1996,five distribution enterprises obtained concessions for independent gas trade;these were alreadypartially privateenterprises.As of April 1, 1996, five com-mercial enterprises took over gas distributioncountrywide.'Unbundling the industrystructureswas the right decision for two reasons:first, it could have created commercially independent and fully responsiblebusiness entities. As these were responsible for settling gas bills directly withsuppliers, Russia's Gazprom in most cases, they were able to put consumersunderpressure either to pay for theirgas bills or to reduce their gas consump-tion. Second, the deregulation of the gas sector would have facilitated the


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54 EASTERNEUROPEANECONOMICS

Table1NaturalGas Balances for Ukraine,1990-1997 (billion ubic meters)

1990 1991 1992 1993 1994 1995 1996 1997SupplyImports (including transit) 204 203 212 211 205 191 189 187Production 26 22 21 19 18 18 18 18Storage out 20 21 21 17 19 20 -Total supply 250 247 254 248 243 229 207 205DemandTransit

CIS 13 14 30 30 29 - -Non-CIS 104 100 93 95 129 - -Total transit 117 114 123 125 129 125 118 125

Domestic consumptionIndustry 55 52 54 41 31 30 -Power plants 34 31 25 21 20 14Residential, communalservices 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 205Sources:StateCommitteeorOilandGas, Ministry f Economy, ndWorldBank.

partial privatizationof the gas industry.Local banksand industrialenterprisescould have obtained stakes in the gas distributors, thus strengthening theircapital base and corporate governance.However, reforms were brought to a halt when the Cabinet of Ministersassumed direct administrative control over the gas industry again in late1997 by creating the state holding company of NaftoGazUkraine to be incharge of gas production and transportas well as of the upstream oil sector.The official reason for this move was to streamline the sector and prepare itfor privatization, which, two years later, has not advanced at all. Instead, itseems that the lucrative gas business appeared to be too valuable an asset tosome government officials to privatize. A partial sell-off to foreign inves-tors, whether to Russia's Gazprom or to Western companies, was forbiddenby a law declaring the gas sector "strategic to the vital interests of Ukraine."


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Table2Energy Bill for Gas Imports, 1993-1997 (billioncubic meters)

1993 1994 1995 1996 1997Gas Imports 80 69 66 71 62of which:

Russia 54 57 54Average price (USD per

thousand cubic meters) 45 50 50Value, millionsof USD 2, 454 2, 855 2, 710Turkmenistan 26 12 12Average price (USD perthousand cubic meters) 40 55 69Value,millionsof USD 1, 009 660 834Average price total (USD perthousand cubic meters) 43 51 53 80 80Import value, millions of USD 3, 463 3, 512 3, 544 5,680 4,992Sources: State Committee for Oil and Gas, Ministry of Economy, and WorldBank.

An unbundling of the sector was also resisted for another reason that hasbeen largely overlooked: the gas industry has massive overemployment inexcess of 100,000 people (Hirschhausen 1999: 405). This is about 3-5 timesgreater than in Russia, which itself is already well above the internationalstandard.A majordevelopment was the adjustmentof gas prices, both import pricesand 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 hypotheticalmarket price, and it also corresponds to a reasonable cost-plus price for Rus-sian gas, estimated at $5 l perthousandcubic meters(Hirschhausen1999: 401).Domestic gas was sold at auctions at $20-30 per thousandcubic meters, pay-able in cash. Domestically, the gas price was fixed at $67 per thousandcubicmeters for budgetary organizations and residential consumers in 1997. Afterthe 1998 devaluation, however, the price was raised to only 120-140 UAHper thousand cubic meters, or the equivalent of $30-35, leaving little incen-tive for traders to sell to this consumer group.The insufficient price adaptationsand the problem of unpaid gas bills haveled to a Ukrainian debt to Russia of about $1 billion and to Turkmenistan ofabout $250 million. The Russian government and Gazprom have repeatedly


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proposed a debt-equity swap in order to obtain some ownership of Ukrainiangas pipelines and undergroundgas storage.The challenge facing the Ukrainian gas industry is to further deregulatethe sector and to set up an independent regulator. Just as in the case of thepower sector, the Ukrainian government seems to be attracted by the Britishmodel of regulation, where an independentregulator (OFGAS) is supposed tocontrol the regional monopolists, and gradually to introduce competition inproduction and distribution.2For such a model to work, the monopolist ofhigh-pressure transportation would have to grant third-partyaccess to anyenterprise wishing to transport its own gas through the grid. With regard todistribution, the long-term goal should be to introduce real competition thereas well. Large consumers, industrialusers, and commnunities ould purchasegas directly through a wholesaler, whereas small consumers would chooseamong different local suppliers. Technical compatibility between the newlyemerging transportand distributionsystems has to be assured. As the mostrecent 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 inthe budget, the amount of which must be fixed beforehand.Oil:A Needfor DownstreamDevelopmentThe Ukrainianoil sector was formally liberalized early in 1994, since whichtime it has experienced profound changes. Price liberalization led to somerelief in the supply shortagesof previously chronically scarce petroleumprod-ucts. The lines at gasoline stations ceased, as long as Ukrainian customerswere willing to pay increasing prices. Lines andgasoline shortages reemergedin the summer of 1999, as this willingness to pay diminished.Importsof crude oil were reduced sharplywith the reform. In 1997, only 9million tons were imported from Russia, including Tatarstan,that is, 17 per-cent of the 1990 level. Yet, Ukrainian traders imported petroleum productsnot only from both Russia and Belarus but also from the Baltic countries.Drastic increases in import prices boosted the oil bill. Supply from domesticoil resources, about 4-5 million tons per year, can contributeonly modestlyto the overall supply of energy. Domestic oil reserves will not become a sub-stitute for imports.3Ukrainiandependence on crude oil importswill not change in the mediumterm. Hopes for a diversificationof suppliesdo not hinge on viable alternatives,forexample, theCaspianregion or Iran,but on theabilityof Ukrainiancustom-ers to pay. Table 3 illustratesthe quantitativechanges in the Ukrainianoil in-dustryoverthepastyears, andthesignificantoil bill of about $2 billion per year.


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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 Ukrainianconsumers butalso the rest of the Soviet Union. Today, domestic refming is ina slump, as its output has plummeted from 52 million tons in 1991 to onlyabout 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 furtherstepsseem to be necessary:* the high degree of vertical integration should be decreased; refineriesshould become economically independentbusiness units with the rightto buyand sell on their own accounts, and having sole responsibility for reducingcosts and generating profits;* the multifunctional refineries should concentrate on their core business,that is, crude oil refining; other activities should be unbundled, or at leastobtain full commercial independence (cost-centers): these are downstreamactivities (motor oil, alcohol and chemicals, andhygienic products), horizon-tal service (R&D, maintenance, transport,andenergy supply), and social ser-vices (canteens, holiday resorts, public transportation,and security, with anexception made for housing and heating);* the vertical industrialpolicy of the government should be transformedinto a horizontal policy. At present, updatedversions of the cabinet's DecreeOn the Development of the Oil Processing Industry (774/93 of September21,1993, 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 seemfinancially feasible, nor is the development of all six refineries justified. In-stead, the state should create conditions conducive to the competitiveness ofthe sector in general. Among these measures is to transform the individualrefineries into independent enterprises, to grantall producers equal access toinfrastructure(ports, railway, wagons, etc.), to relieve factories of their socialassets, and to resolve the problems of interenterprisedebt.Coal: Insufficient StructuralReformThe restructuringof the Ukrainiancoal industry is the most urgent politicaland economic challenge of energy policy. Coal is the only energy resource ofwhich Ukraine has substantial reserves. Yet, most current coal production isunprofitable. Direct and indirect government subsidies to the coal industry


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comprise the largest subsidy in the country's budget. In 1994, direct fmanc-ing amounted to 3.2 percent of GDP, that is, more thanhalf of the envisagedbudget deficit; nevertheless, in 1998, the industry produced losses of about2-3 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 whenevaluated by market criteria, only a small partof the proven reserves turnedout to be competitive on internationalmarkets because of rising costs for trans-port, labor, and energy. Hence, coal productionhas plunged from 189 milliontons in 1985 to about 50-60 million tons in the late 1990s. Production is likelyto level out at about 30-40 million tons of primarycoal extraction. Instead,imported coal from the neighboring countries of Russia and Poland will playan 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 dissolutionof the Soviet Ministry of Coal and the independence of the Ukrainian coalindustry.In 1995, the twenty-three production associations and six large in-dependent coal mines were corporatized, that is, they were transformed intocommercially independent state enterprises. Yet, the coal industry is still runin a very Soviet fashion. Centralized planning of quantities, trade,and pricespersists. Cross-subsidies between efficient and inefficient mines are main-tained, which prevents efficient coal mines from reaping the benefits of pro-ductivity gains. Domestic tradingis dominated by the Ministry of Coal, whichprescribes quantitativedelivery targets for each mine and fixes the prices, asin Soviet times. Mines can freely sell only the coal produced in excess of stateplan targets. Coal imports, too, are still controlled by the state coal-tradingagency, Ukrglavugol. Nontariff entry barriers such as discrimninatoryrans-port rates are used to restrict imports.4The restructuringof unprofitablecoal mines is blocked by regional resis-tance in areas whose economic survival depends largely on coal mining andrelated activities. The scaling down of coal mining operations was an expen-sive process in Western Europe; in post-socialist countries it can turn into anightmare. The 100 Ukrainianmines have been grouped into four categories,ranging from category I "hopeful" to category IV "hopelessly uneconomic."However, only four mines have been considered "hopeful."Restructuringofthe mines is not only constrainedby the lack of financial resources, but aboveall by the absence of any concept of regional diversification. Although threemines have been slatedforclosure,andtwentymoreidentified for scalingdown,not much has really happenedlocally to accelerate the conversion.This, in turn,provides the conservative coal lobby with argumentsto halt restructuring.5To turn the coal mines into independent enterprises seems the most urgent


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reform task for the coal industry.At the least, each mine should be made intoan independent cost center. Investnent decisions should be made at the levelof the associations, not at the central level. Coal production should be sepa-rated from coal transportationand distribution.The role of the Ministry ofCoal should be limited to distributinginformation, supporting environmentalclean-up, and assisting in the retrainingof personnel.Electricity: From Socialism to a Barter SystemThe Ukrainian power sector has embarked on one of the most ambitious re-form programs so far in all post-socialist countries. Inspired by the Britishexperiment of the 1980s, Ukraine decided in May 1994 to set up a "pool sys-tem."' This decision was hailed as a breakthroughto more efficient electricityconsumption and the modernization of the power industry.However, the implementation of this imported regulatory model facedserious problems, and the initial concept was undemined. Instead of mon-etized trade controlled by an independent regulator, individual barter con-tractsbetween producers and consumers dominated. "Prices"were not fixedby the market but throughbilateralbarternegotiations. Only 10 percentof theelectricity was actuallysold formoney. A quotasystem forstateconsumers wasmaintained,obliging producersto supply mainly communal consumers. Heat-ing, which is often related to electricity production,was not regulated at all,leading to cross subsidizationand furtherdistortions. The RegulatoryAgency,which was supposedto become independent,was controlledby the Ministry ofEnergy (Minenergo), both physically (it is situateddirectly in the Minenergopremises) 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, heuse of which isunknown.As of late 1999, the power sector still suffers from low revenues, unstableinput supplies, and a lack of financing for modernization. Electricity con-sumption per unit of industrial production has risen rather than decreasedsince 1993. Electricity productionby fossil-fueled power plants has been re-duced by 60 percent since 1990, while nuclear power generation remainsstable. Ukraine has turned from a large net exporter in the 1980s into a netimporter of electricity, and it is dependent on the Russian power grid, withwhich it is integrated.Table 5 provides basic data on the development of thepower sector since 1980.Furtherreformdepends on two policies: the real, notjust simulated, imple-mentation of a market-orientedpool system and price reform. The pool sys-tem is technically in place, though, as explained above, it works only as a


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single buyer.Technically, Ukraine has to develop its own system of frequencystabilization to become independent from the Russian grid. When operatedindependently, 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 properfunctioning of the energy market and price regulation.Price reform remains essential for the success of reforms.The average priceof about 0.10 UAH/kWh (i.e., about U.S. $0.025) only covers the marginalcost of production. It does not allow producers to accumulate funds for themodernization 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 further ncrease in prices seems inevitable if thepowersector is to finance its modernization,which, in the medium term, will lead tocheaper and more efficient energy supply to the economy.Energy Supply and the Current Account DeficitAbout half of all energy consumed in Ukraine is supplied by domestic pro-duction, which has declined faster than net importsof 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 indigenousproduction 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 isanenergy-poorcountry.Undersocialism, thisfact was hidden by artificialpricesthatdid not reflect the costs of the production and distributionof energy.The increase of energy prices after Ukrainian independence was a majorshock for the economy. Variousestimates show that this supply shock led to areduction of GNP by more than 10 percent.7The former government reactedto this with stronger controls, especially of the foreign trade sector and theexchange rate,and the accumulation of arrears.Both were shortsightedemer-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, energyaccounted for more than40 percent of Ukrainianmerchandise imports, and itis the main source of the current account deficit. A reduction in energy im-ports by 20 percent would balance the currentaccount.Energy Saving: Potential and PrerequisitesIn Ukraine, the ratio of energy consumption to GNP is among the highest inthe world. Energy intensity is twice as high as in East European countries and


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seven times higher than the average of the OECD countries.Percapita Ukraineconsumes about the same amount as the OECD countries. Given the vast dif-ferences between the countries with respect to private cars and the usage ofelectrical appliances in households, these data supportthe presumptionof amassive waste of energy. The situation is even worse when considering de-velopment over time. Energyintensityhas increased by 50 percent since 1992.This holds true for the entire economy as well as for industry.These figuresindicate 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). Giventhat the expansion of the shadow economy took place mostly in the 1990s, theincrease 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 tocalculate the size of the unofficial economy is to use the data of electricityconsumption.An opposite hypothesis holds that the insufficient adjustmentof produc-tion capacity to decreased demand has significantly increased fixed costs inthe economy. As long as production capacities are maintained, a significantamount of energy is used independently of the level of production. In thisview, the adjustmentof productioncapacities to effective demand will lead toa significant improvement in energy efficiency. Although the growth of theshadow economy in recent years is undisputed, there is little evidence thatthis would fundamentally change the above statementabout energy waste inthe Ukrainian economy. As long as a large partof 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 shadoweconomy.8The second qualification to energy intensity concerns the overall structureof the Ukrainian economy. Since the beginning of transformation,the basicindustries- energy,metallurgy,andpartlychemistry-have declined less thanindustry as a whole. This structural change toward a growing share of basicindustries can partlyexplain increasedenergy intensity.These changes, some-times denounced as deindustrialization,have increased the energy dependenceof the Ukrainianeconomy. If high energy intensity is caused by market-deter-mined structuralchange, it is not worrisome. To some extent, the adjustmentof exports has contributed to this structuralchange. Ukrainianexports to coun-tries thatare not former members of the Soviet Union have grown dispropor-


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tionately in recent years. The metallurgical industryaccounted for the great-est part of the export expansion until 1998, although in 1998 the crisis inRussia-and earlier in Asia-contributed to the decline of Ukrainianexports.Similarly, a significant part of Ukrainian refinery capacity is used by out-ward processing. Russian firms export fuels, which, after being refined inUkraine, are reexported to Russia. Therefore, partof 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 thecommercial/residential sector and in industry. When assigning priorities tospecific conservation programs, one has to consider that improved energyefficiency in industry will not only reduce the import bill but also shouldincrease the competitiveness of the firms by reducing costs. This shouldfurther improve export performance if the exporting enterprises improvetheir cost structure by saving energy. Energy conservation programs ofthe commercial/residential sector are easier to administer than those inindustry because of the great diversity of technical measures to be takenin the latter.Given the vast potential for energy savings and the meager perspectives ofeconomic growth, it is likely that primary energy consumption in Ukrainewill continue to decrease. A study issued by the Gernan Advisory Group in1998 concluded that primaryenergy demand in 2010 is likely to be around130-160 million toe, that is, lower than in 1995 (Horn 1998). This is in con-trast to the governmental program "Energy2010," which estimated a level ofabout 200 million toe. Even after 2010, energy consumption is unlikely toreach pre-1990 levels. A revision of the official forecasts is of utmost impor-tance in order to prevent politicians from financing an expensive expansionof the indigenous production to meet the exaggerated government forecastsof energy demand.Price Signals and Incentives to EconomizeThe energy sector provides the most importantcontribution 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 ofprices, competition, and the absence of market interventions. Energy savinghas to be carried out by the energy users. This will happenonly if they get thecorrect incentives to do so.In recent years, prices of energy have almost completely adapted to world-


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marketprices. The relative price of electricity was only 23 percent higher inDecember 1995 than in December 1991. This seems low in comparison withRussia, where the relative price of electrical power rose by 140 percent from1991 until the end of 1995. Only in 1998 was there a significant increase inrelative energy prices, which had then risen by 63 percent since 1991. Thelargest price adjustment for fuels took place at the beginning of the 1990s.After 1992 the relative price of fuel declined steadily. However, in 1998 fuelwas 200 percent more expensive than in 1991, while in Russia the relativeprices had approximately doubled. The adjustmentof relative fuel prices hasbeen uneven. In the beginning, the oil refining sector increased its pricesextremely 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 beencompletely abolished in the energy sector. For example, cross subsidies amongproduction, import, transportation,and storage of energy persist. Despite thefar-reaching adjustment of energy prices, the InternationalEnergy Agencyestimates that still "average naturalgas and power prices cover companies'operating costs but are below full economic costs of supply."9 f this is true,further increases in energy prices are to be expected, but they will be verymodest 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 andfrom imports. The energy sector stands out with large internationalarrears.Until 1994 a large quantityof gas supplied by Russia and Turkmenistan wereunpaid.After these debts were consolidated, the problem persisted, althoughit became less severe. Interestingly, arrears arose almost exclusively in thehighly concentrated gas sector and not with imports of oil. As long as stateguarantees for the payment of energy deliveries exist, enterprises have weakincentives to pay and thus to economize. The IMF agreements have firmnlystated as a condition that further accumulation of arrears violates the agree-ments, but this has remained a moot point.Furthermore,within Ukraine the large interenterprisearrearsare closelyrelated to the energy sector.According to data from the Ministryof 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 toenergy. The high share of the energy sector in arrears can also be observed inRussia. Based on these data, it emerges that the decline in Russian arrearsinthe fall of 1995 was predominantlya change in arrearsof the energy sector.The concentration of nonpayments on energy products, in particularelectric-


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ity, means that the latter is a net creditor to other sectors. This might be aplausible outcome for Russia, where energy is by far the greatest source ofprofit that might be used for the financing of other sectors of the Russianeconomy. In Ukraine, such a justification for the crediting of other sectorsmakes no sense. In any case, the energy arrearsfinally amount to a reductionof actual paid energy prices. Energy deliveries, in Russia as well as in Ukraine,are still considered an obligation imposed by the state, and theirpayment caneasily be deferred.'?Thus, price distortions caused by arrears reduce incentives to save energyand exacerbate the continuing payment crisis. As long as bankruptcy is anexception, creditors have to single out those firms among its customers thatcan and will pay. An efficient allocation of goods can only be achieved if theenergy sector stops delivering goods to firms that do not pay. To facilitate amore selective delivery policy of the energy sector, all state guarantees to thissector must be abandoned. In addition, debt-equity swaps and the develop-ment of a secondary marketfor liabilities from arrears will put more pressureon the debtors and creditors to care about their payments. Present conditionsafford the debtor a rathercomfortable position due to the lack of bankruptcyprocedures. Then, energy enterprises, as the main creditors in the system ofmutual nonpayments, should be subject to market sanctions and incentivesthat force them to secure payments for their deliveries. This would ease thepayment crisis, and, more important,would provide incentives for energy sav-ings in downstream industries. The primary task of energy policy should be topromote energy conservation. In the end, this task must be carried out by theenergy-consuming industries, which react to the price signals by cutting theirenergy costs.Conclusions: Toward a Post-Soviet EnergySector 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 marketeconomy. Instead, the sector has become the prime example of the falteringtransformationof the economy at large: just as reforrns in the energy sectorwere halfhearted, so were the overall reforms in the Ukrainianeconomy. Eventhough economic growth may begin in the early years of the next decade, noradical impetus is to be expected with respect to structural reforrn.

Nevertheless, the Soviet econoniic system will not return,and gradualre-forms are still possible. These should adhere to the following principles:1.The energy sector should be deregulated in steps, andcost-effective pric-ing should be introduced. This demands the reduction of government activi-


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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 NationalReserve, is contrary to the properfunctioning of markets. Conflicts of interestamong different administrationsand unclear assignments of responsibilitiescreate inefficiencies and disturb the supply response of the firns. A majorreorganizationof the energy administration,which East Europeantransform-ing countries carried out at the very beginning of transformation,should re-duce the government's commercial role. The regulatory agency for theelectricity sector (NERC) needs full independence anda similaragency shouldbe created for the oil and gas pipelines. The depoliticization of commercialactivity will reduce the possibilities of rent-seeking, theproliferationof whichhas 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 haveto be strengthened. The least progress in privatizationhas been made in theenergy sector. In the short run, more pressure must be placed on enterprisemanagement. The turnover of managers must be facilitated. The economicsuccess of a firm has to be the guideline in the assessment of enterprise per-formance. The structureof the existing enterprises is generally not suited fora market economy. These enterprises should be disassembled and from theirpartsnew entrepreneurialunits can arise, even from those firms thatcannot orshould not be privatized in the near future.

3. The financing of productionand investments will remain a majorprob-lem for some time. Capital markets are still functioning poorly at best. Thereal 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 inelectricity and coal. This problem must be solved within a larger attempt torestrain interenterprise arrears and nonpayment by final consumers. Largeforeign investmentis not likely to come about in the nearfuture.Priorityneedsto be given to the small-scale refurbishment and modernization of existingequipment. The restructuringmust, for the most part,be based on self-financ-ing, which, in turn, requires rather modest profit taxes. Any possibility ofprivatization throughcash sales must also be used, since this procedure, to alarge extent, also solves the problems of corporate governance.The energy sector will remain the Achilles' heel of the Ukrainianeconomyfor quite some time. Without the energy sector's recovery, the rest of theeconomy will be penalized in its effort to become internationally competi-tive. Without energy savings and a reduction in energy intensity, import de-


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JANUARY-FEBRUARY000 69pendencewill continue o increase.Without stablishing conomicprinciplesin theenergysector,Ukrainewill be threatenedwithremaining post-Sovieteconomy,separatingt further romEuropean ndworldintegration.Notes

1. The five are:Integrated owerGrids,Intergaz,Olgaz,Itera,andUkrzarubezh-neftegas Interfax,April25, 1996).2. Davidovici 1995);Parker nd Surrey 1994).3. InternationalnergyAgency(IEA)(1996).4. Ibid.5. EconomicReview,April29, 1996.Opinionsdifferwidelyon therealcosts ofclosinga mine. The UkrainianMinistryof Coalestimates otal mine closurecosts atabout$20millionpermine; hisincludes ocialcost,unemploymentompensation,hecreation f newjobs,andenvironmental ork.TheWorldBank'sestimatesarearound$10 millionpermine BusinessWeekly,October16,1995).InPoland,he closureof oneminecostabout$50-60 million;but the rateof returnof closingschemes was ratherfavorable, tabout6-20 percent or aten-yearperiod Radetzki1993).6. Presidential ecreeonMarketTransformation easuresn theElectricity ectorof Ukraine244/94).7. Cf. Tarr1994);McCarthy t al. (1995).8. IEA(1996),pp.73-75.9. IEA(1996), p. 21.10. Inview of the highshareof overdue eceivables ntheenergy ector, heRussiangovernment ecided o constrainpriceincreasesof naturalmonopolies, o which theenergy sectorsbelong, to 70 percentof industrial riceinflation RussianEconomicTrends , no.4, 1995:31).ReferencesDavidovici, Miriam. 1995. "Les agences britanniquesde reglementation:e cas

d'OFGAS.Paris."CERNAResearchPaper95--B1. Ecole des Mines de Paris.Hirschhausen, hristian on. 1999."GasSectorRestructuringnUkraine:mportDe-pendence,PriceFormation,ndSocioeconomicEffects." n Ukraine t theCross-roads:EconomicReform nInternational erspective, d.AxelSiedenberg ndLutzHoffmann.Heidelberg ndNew York:Springer-Physica.InternationalnergyAgency IEA).1996.Energ PoliciesofUkraine. 996Survey. aris.Horn,Manfred.1998."EnergyDemand n Ukraine n 2010."ExpertReport or theGermanGroupof Advisors o the UkrainianGovernment.BerlinandKyiv.Johnson, imon;DanielKaufmann;ndAndreiShleifer. 997."TheUnofficialEconomyinTransition."rookingsPapersonEconomicActivity27, no.2: 159-239.McCarthy,F.D., et al. 1995. "Extemal Shocks and PerformanceResponsesDur-ing SystemicTransition:The Case of Ukraine."UkrainianEconomicReviewI, nos. 1-2: 27-48.Parker,M., andJ. Surrey.1994. "UK Gas Policy:regulatedmonopolyor managedcompetition?" niversityof Sussex.EnergyProgramme, PRUSteepSpecialRe-port,no.2.


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70 EASTERN UROPEANCONOMICSRadetzki,Marian.1993. Polands HardCoal Industry:ProspectsAfterCompletedRestructuring.Stockholm:SNS.Report of the President. 1996. Ekonomichnii sotsial'nii rozvitokUkrainiv 1995rotsi [The Economicand Social Developmentof Ukraine n 1995]. March.Tarr,DavidG. 1994. "The Terms-of-Trade ffects of Moving to WorldPricesonCountriesof the FormerSoviet Union."Journalof ComparativeEconomics18,no. 1: 1-18.Vincentz,Volkhart, ndChristian on Hirschhausen.999."PricePolicies and Subsi-dies in the EnergySector of Ukraine." n Ukraineat the Crossroads:EconomicReformn Internationalerspective,d.Axel SiedenbergndLutzHoffinann.Heidel-

bergand New York:Springer-Physica.

Energy Policy and Structural Reform

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