EGM Focus: Ukraine's TSO unbundling beset by internal disputes

Author: Katya Zapletnyuk Lorena Ruibal


Gas market reform in Ukraine has hit a stumbling block over the unbundling of the grid operator, with managers of state-owned incumbent Naftogaz involved in a bitter dispute with the energy ministry over future control of the asset.

Ukraine has secured loans of around $1bn (€860m) over the past several years from international financial bodies, conditional on reforming its gas sector. These include: a $500m five-year revolving loan from the World Bank; a $200m loan from the International Financial Corporation, part of the World Bank Group; and a three-year revolving scheme for a sum of $300m from the European Bank for Reconstruction and Development (EBRD).

The transmission system operator (TSO) unbundling - a key condition put forward by the creditors - is now delayed and the country has been criticised by the Energy Community secretariat and the Commission. Some independent observers doubt the motives of Naftogaz’s management. Critics say Naftogaz may be reluctant to relinquish control over the lucrative TSO business, which accounts for around $2bn (€1.7bn) of the company’s profits.

The Ukrainian deputy prime minister Volodymyr Kistion told ICIS on 27 October thatNaftogaz is impeding the unbundling of the gas transmission system by refusing to hand over an asset inventory and acting without shareholder authorization.

Naftogaz insists that it is pursuing its own version of separating the TSO and is involving international experts, such as the Polish branch of PricewaterhouseCoopers (PwC), to help the process.

On 19 October Naftogaz said in a press release that it had submitted information to a special Energy Ministry commission confirming that the company has made all possible steps to effectively implement the official plan for its restructuring, including the separation of gas transport and storage operations.

The company also said it never received from the energy ministry any preliminary inventory of assets to be verified by Naftogaz.

The delays are frustrating industry stakholders and independent gas traders who see unbundling as the main condistion for gas trade development.

President of the Ukrainian Gas Traders Association Andrey Myzovets said that the process in being unnecessarily delayed, with Naftogaz’s management partly to blame.

“There was a Cabinet decree on separation of the transmission system. This plan was approved by the government and coordinated with Ukraine’s European partners. Any other scenarios of TSO unbundling will only cause further delays. That is why [Naftogaz] should stick to the plan approved by the government,” Myzovets said.

Apart from internal reforms, unbundling is paramount for Ukraine’s future role as a transit country for Russian gas going to Europe. The transit agreement between Naftogaz and Russian producer Gazprom is currently being reviewed in the Stockholm Court of Arbitration in parallel with the bilateral supply deal signed in 2009.

Hugues Mingarelli, head of the EU delegation to Ukraine, told the Ukrainian Gas Forum in Kyiv on 11 October that Ukraine’s prospects of maintaining its role as a transit country for Russian gas hinges on its ability to unbundle the TSO from Naftogaz - and not on fighting competition from planned alternative pipeline routes, such as Nord Stream 2, which would create alternative transit routes for Gazprom.

He also mentioned the need for specialists on the new grid operator’s board.

However, the dispute between Naftogaz and the government seems to have brought the process to a halt. Representatives from neither Naftogaz nor Ukrtransgaz (the subsidiary currently running the transmission system) attended the forum in Kyiv despite being invited, the organisers said.

Government position

Deputy energy minister Ihor Prokopiv said at the same event that the government and Naftogaz’s management disagreed over the control mechanism of the new TSO.

He said the government favours an independent manager in line with European standards, while Naftogaz does not want to renounce entirely the TSO business and advocates for a hybrid formula that would allow it to keep control of the transmission assets. This statement was echoed by several industry insiders.

The Ukrainian government in June 2017 approved a list of assets in the gas transportation system to be transferred to a new operator called Main Gas Pipelines of Ukraine (MGU) founded in 2016 to facilitate the process (see EGM 30 June 2017).

According to Kistion the government created MGU, approved the corporate governance plan for this company, resolved the issue of its financing and - in close cooperation with the EBRD - began the selection of independent directors. At this point 27 candidates have been nominated and a special commission under the energy ministry will hold interviews and select members of MGU’s Supervisory Board by the end of November 2017, he said.

“But when we proceeded to the preparatory stage of the asset transfer to a new operator, the process stopped, because Naftogaz - contrary to the protocol order of the Government of Ukraine - did not provide the results of the inventory of Ukrtransgaz’s state-owned and private property, as well as the assessment of its value and method of transfer of the asset to MGU.

“Instead, the monopolist is performing functions, which its shareholder - the Government of Ukraine - in no way authorized and is carrying out its ‘own’ version of unbundling,” Kistion said in a written response to ICIS questions.

He added that the government is awaiting the completion of the Stockholm arbitration between Naftogaz and Gazprom before proceeding with the completion of Naftogaz’s restructuring in accordance with the plan approved and agreed upon with the EU in 2016. This includes the transfer of gas transportation assets, including underground gas storage, excluding toxic and non-core assets, to MGU.

This should ensure effective management of the Ukrainian gas transport system with the participation of international partners, Kistion said.

Naftogaz’s plan

Naftogaz had said in June that it expected the transfer of transmission assets from Ukrtransgaz to an independent grid operator to take place within one month after the Stockholm Court’s has made a final decision.

But on 13 October, Naftogaz’s chief commercial officer Yuriy Vitrenko told ICIS that the incumbent has opted to follow the model used by Polish grid operator GAZ-SYSTEM to unbundle after the previous plan failed because of government inaction.

Earlier in October, Naftogaz announced the creation of a new branch within Ukrtransgaz to undertake all gas transmission functions. The branch, named Ukraine’s Gas Transmission System Operator (UGTSO), will incorporate all business processes, assets and staff necessary to ensure operation of the gas transmission system through Ukraine and will apply for TSO certification according to EU requirements. This is a preliminary step towards separation of the supply and transmission businesses.

“This branch is just to gather all the assets, people and business processes that then should be moved to a new owner,” he said. “We are not saying we’ll call the creation of the new branch unbundling, of course not, it’s not [the] idea at all.”

He said that the state-owned company had to resort to this plan, after the previous procedure could not be fulfilled because of the government. The arrangement consisted of the government creating a new transmission system operator, with an independent supervisory board, which, in turn, would appoint the management of the new TSO.

“This plan failed, the ministry did not appoint an independent supervisory board, and because of that the management was also not appointed,” he said on 13 October. But the deadline for submitting applications was 27 October, according to the call for proposals published on the ministry’s website.

“Without the supervisory board, it would mean that the government would control [the new TSO] directly through the ministry of energy, for example. And there would be no unbundling because it would be a group of people, not at the Naftogaz level, but the cabinet of ministers that would control both production and trading and transmission and that’s prohibited by the third energy package.”

“That’s why we have to do the job by ourselves, we hired consultancy firm PwC, which is now working with Ukrtransgaz to some extent and using their experience in the unbundling of the Polish gas system,” he said.
“Now with this branch we are just making a nice package, when we get the decision from Stockholm arbitration court, which will allow us to amend the transmission contract, we can assign the right and obligation of this contract to a third party, which was forbidden by Gazprom,” he said.

The details of Naftogaz’s plan were further elaborated by the director of PwC Polska, Pawel Dobrowolski, as published on Naftogaz’s website.

Dobrowolski said the first stage will establish a branch within Ukrtransgaz. The branch is expected to accumulate core functions, employees and assets necessary for the unbundling in Q4 2017. This branch would serve as a basis for creating a lean TSO of 200-300 employees that will perform core functions.

At the final stage, a full-fledged TSO with all necessary functions will start operation. The newly established company will be ready to apply for a certification under EU regulations and can be legally transferred to an entity designated by the government, Dobrowolski said.

Snam/Eustream proposal

In the meantime, Slovak TSO Eustream and Italian counterpart Snam presented an unbundling plan under the memorandum of understanding signed in April with Naftogaz and Ukrtransgaz.

Speaking at the Ukrainian Gas Forum on 11 October, the head of EU affairs and strategy at Eustream, Milan Sedlacek, said the model would allow transmission assets to stay under Ukraine’s ownership.

Sedlacek said the proposed model had already been fully implemented in other European countries, is fully compliant with EU regulation and compatible with the EU’s Third Energy package. He also said it fits the unbundling process described in a Cabinet of Ministries of Ukraine resolution.

According to Sedlacek, the plan secures long-term transit contracts, envisages investment into transmission network modernisation and includes the framework for final privatisation, while maintaining transit access under Ukraine’s ownership via a shell asset company.

“Eustream is very well positioned and motivated to help, offering its experience and know-how. Together with Snam, exhaustive analytical work has been done,” Sedlacek said.

Naftogaz’s Vitrenko remained lukewarm towards the proposal. He told ICIS: “We are interested to an extent. Snam and Eustream are interested in managing the new TSO, and - as I mentioned - we are interested in unbundling being done in parallel to management.”

He added that aside from Snam and Eustream, there were consortia of other European TSOs interested.

Vitrenko declined to unveil the names of the other candidates, but said they were leading European TSOs.

Eustream and Snam are yet to submit their proposal to the Ukrainian government.

Independent observers say that Eustream’s position as the TSO operating the Velke Kapusany border point between Ukraine and Slovakia where Russian gas enters the European Union, makes the company well positioned to manage Ukraine’s new TSO. Eustream has a long-standing business relationship with Gazprom.

“They would be motivated to maintain transit, or even reverse flow [of gas imports from the EU to Ukraine],” said Michael Grossmann, associate partner at Grant Thornton Ukraine.

Naftogaz CEO Andriy Kobolyev said that Naftogaz was negotiating with four interested TSOs from the EU but did not make any official comment regarding the Eustream-Snam proposal.

The potential loss of Russian transit business could cost Ukraine about €3bn, according to Naftogaz’s estimates.

Mingarelli said the EU is “working and reflecting on the recent infrastructure projects to maintain Ukraine’s predominant role as gas [transit] country”.

He pointed out, however, that the European Commission has no clout to stop commercial projects, such as Nord Stream 2, and that it is up to companies to develop new infrastructure.

France’s ENGIE, Austria’s OMV, Anglo-Dutch Shell, and Germany’s Wintershall and Uniper have backed Gazprom’s proposal to build Nord Stream 2. Construction is scheduled to start in 2018, by agreeing to contribute up to €950m each to finance half of pipeline’s total cost.

The project, which would mirror the original Nord Stream route and carry an additional 55 billion cubic metres/year to Europe by 2020, has been met with strong opposition in Kyiv, as it provides Gazprom an alternative route to send gas to its European customers effectively bypassing Ukraine. and