June 24, 2014
The Road to Energy Independence
Thank you for the kind introduction. The panel discussion here today was inspired by a joint project of the U.S. Embassy and Ms. Pavlenko’s DiXi Group. It encouraged Ukrainian citizens to think deeply about Ukrainian energy policy and devise a roadmap to energy security. I believe the idea of an energy security roadmap is a good one, especially at this crucial time as the country debates its future direction. Ukraine truly is standing at a crossroads, with one path leading to further debt and dependence, the other to a sustainable, modern economy.
Since my arrival in August, one of my top priorities has been to assist Ukraine in developing its energy potential. Much about this country has changed over the past year, but the strategic importance of energy issues has remained a constant. In truth, Ukraine has everything it needs to become energy secure; what it requires is the political will to do so. Now, when we talk about energy security in Ukraine, we’re really talking about natural gas. Today I’ll discuss the devastating effect Ukraine’s reliance on imported gas has had on its economic health and then examine some pathways toward energy independence.
The Macroeconomic Consequences of Poor Gas Policy
As we all know, the Ukrainian economy is struggling and looks increasingly vulnerable to a painful adjustment. Poorly conceived gas policies are largely to blame. Energy inefficiency, gas-related corruption, unsustainable subsidies, and a lack of source diversification over the past 22 years have debilitated Ukraine’s fiscal health. By any measure, Ukraine’s macroeconomic situation is poor: the current account deficit widened to 9 percent of GDP in 2013; currency reserves fell 23 percent last year; and the country spent most of its three billion dollar loan from Russia as soon as it was received. Heating and gas subsidies devour 7 percent of GDP per year, about 13 billion dollars, creating a giant hole in the national budget. This is unsustainable, as we saw in November when Ukraine was forced to grasp for a financial lifeline, and radically changed its foreign policy direction at the same time.
Ukraine’s energy subsidies are a legacy of the past. While the Soviet Union failed at providing blue jeans or toilet paper, it excelled in delivering cheap inefficient energy to its citizens, which Ukrainian customers still feel to be a state-given right. The Government of Ukraine has tried its best to preserve these low prices. From the time Ukraine signed its 2009 contract with Gazprom until January of this year, it paid one of the highest gas prices in Europe, while charging customers only about a quarter of the actual cost. These subsidies might be understandable if they achieved an important social goal, but analysts from the IMF, World Bank, and other institutions have shown that they are poorly targeted, with only 13 percent of subsidies going to the bottom income quintile and 85 percent of poor Ukrainians receiving no utility subsidies at all. Most of the subsidies benefit Ukrainian industry.
A wise energy policy would progressively raise gas and heating tariffs to market levels, while creating an assistance program for poorer citizens. International experts are ready and willing to assist in crafting such an assistance program. Economists have shown that market-based gas tariffs would both spur energy efficiency programs and reduce overall demand.
In addition to market-based pricing, Ukraine should do all it can to expand the diversity of its energy supply, particularly from domestic sources. This would ensure that it always pays competitive prices and would free it from dependence on the fickle goodwill of foreign suppliers. I believe the American experience provides a valuable example in this situation. President Obama describes his energy program as an “all-out, all of the above strategy that develops every available source of American energy—a strategy that’s cleaner, cheaper, and full of new jobs.” This includes expanded offshore production, unconventional gas, renewable energy, biofuels, and energy efficiency programs. By taking a broad-based approach to energy supply, the U.S. has made great strides toward energy independence – in the five years since President Obama was inaugurated, our oil imports have fallen by 44 percent and we have actually become a natural gas exporter. Economists are now talking about re-shoring – the return of factory jobs to the United States to take advantage of gas prices that are a third of Europe’s and a fifth of Japan’s.
When we look at unconventional gas and offshore gas production, Ukraine has already taken a very positive step by expanding its use of production sharing agreements to bring in Western energy majors. In the offshore sphere, EDF and Vanco are both set to begin work in the Black Sea, and the Skifska block will hopefully come on line soon. On the unconventional side, Shell is opening up the tight sands of eastern Ukraine, and Chevron and Eni will soon begin exploring the shale belt in the west.
The next step will be to expand the government’s regulatory capacity. Its agencies and legal system are still adapting to the PSA model. The U.S. has provided assistance via educational exchanges that have allowed Ukrainian regulators to study in the United States with experienced counterparts, but more remains to be done.
Coal mine methane is another type of unconventional gas the government of Ukraine should consider pursuing. By stimulating and capturing this gas, they can revitalize the Ukrainian coal industry and provide a valuable source of natural gas, while reducing harmful greenhouse gas emissions. The U.S. has been pursuing CMM gas since the 1970s, with good success. Even in 2011, during the present shale gas boom, 7.3 percent of all U.S. gas came from coal beds.
Another means to boost domestic production is through enhanced extraction of depleted Soviet-era oil and gas wells. U.S. and European energy companies have long experience with revitalizing old fields and I encourage the Ukrainian government to see what technology and services they have to offer.
Ukraine has made good progress with renewable energy sources. Wind and solar power production in Ukraine surged 125 percent during the first four months of 2013. The government should continue to encourage the construction of solar, wind, biomass, windmill, and small hydro power plants. Biomass has especially great potential, thanks to Ukraine’s agricultural strength, with some experts believing it could yield 5 billion cubic meters per year, equaling about 15% of Russian imports. To realize its full potential, however, Ukraine should eliminate its local content law, which deters foreign investors and helps create damaging monopolies among green energy producers, inhibiting growth.
Lastly, Ukraine should continue to increase its reverse flow capacity with Europe, particularly through its memorandum of understanding with Slovakia’s Eustream. The European spot price for gas is temporarily higher than other sources, but history has shown the dangers of relying too heavily on a single supplier. The ideal outcome would be for Ukraine to implement the Third Energy Package and fully integrate into the Energy Community. This would give Ukraine access to an entire continent of potential suppliers, while providing its huge underground gas storage system a lucrative role as an Eastern European energy hub.
While expanded domestic production will provide great long-term benefits, the most significant near-term solution is for Ukraine to improve its energy efficiency. Ukraine currently uses three times as much energy per unit of GDP as EU countries, making it the most energy-intensive industrialized nation on earth. Many of its factories, municipal buildings, and apartment complexes were built during Soviet times, when natural gas was practically free and no one worried about energy efficiency. To this day, outmoded communal heating systems, single-pane windows, and thin insulation are still the norm in much of the country.
Twenty-two years of neglect have further eroded Ukraine’s energy efficiency at all levels. Experts say 80 percent of the gas transit pipelines in Ukraine are pocked with hydrogen embrittlement, leading to steep transit losses. A similar situation is found with residential heating, which accounts for 30 percent of Ukraine’s yearly gas consumption. According to a Cabinet of Ministers report, 70 percent of all heating distribution and transmission networks need replacement, and 45 percent of the heat produced by heating utility companies never reaches the consumer.
To put this in perspective, reaching Poland’s efficiency level would reduce Ukraine’s gas needs by 30 percent, eliminating much of the demand for imports. Foreign investors and donors have provided a lot of assistance in this area. For example, a U.S. Agency for International Development program helped 25 cities improve their district heating through municipal energy plans and energy efficient technologies. The EBRD and International Finance Corporation have also done excellent work in this sector. However, much work remains to be done.
There are a few things the Ukrainian government could do which would cost almost nothing. The first would be to empower local homeowner associations to borrow the funds needed for energy efficiency projects in high-rise apartment buildings. Secondly, it could work with private banks to create loan options for businesses and homeowner associations looking to improve their energy efficiency. Given the huge scale of the problem, however, the Ukrainian government should consider raising gas tariffs and reinvesting some of the savings into large-scale energy efficiency projects.
To sum it all up, energy security is national security. As Ukraine debates its future direction, I fervently hope it chooses the road to energy independence. Temporary gas discounts and foreign loans will not solve this country’s underlying problems; however, by boosting domestic production, expanding import options, and improving energy efficiency, Ukraine can achieve its European choice and create a vibrant, modern economy. The United States has been, and will continue to be, a steadfast ally in this endeavor. I thank you for the opportunity to speak with you today.