UKRAINE: Rada Reviews Natural Gas Sector; Allows Price Rise

UNCLAS KIEV 003933

SIPDIS

SIPDIS
SENSITIVE

DOE FOR LEKIMOFF, CCALIENDO

E.O. 12958: DECL: NA
TAGS: EPET ENRG PGOV SOCI RS UP
SUBJECT: UKRAINE: Rada Reviews Natural Gas Sector; Allows Price Rise
for Households

Ref: KIEV 3758

Sensitive but Unclassified. Not for Internet Distribution.


1. (SBU) Summary. The Verkhovna Rada (parliament) reviewed on
October 4 the preliminary results of its investigatory commission on
NaftoHaz and the natural gas sector. The commission reported
multiple instances of mismanagement, malfeasance, and possible
criminal acts within state-owned oil and gas monopolist NaftoHaz in
2005-6, and made recommendations to regulate more rigorously the
industry and the monopolist. On October 5 the Rada reversed its
vote of a week prior which canceled the huge price rises authorized
since July. Rada members were persuaded to reverse themselves after
Deputy Prime Minister Kluyev promised to reduce the price by 18%
from the July level and institute tiered pricing based on
consumption. Regional governments will therefore be able to charge
$68/tcm for gas this winter, 94% higher than last year. Consumers
remain strongly opposed to the increases and many say they cannot
afford them. The GOU's maneuvering underscored the reality of
higher energy prices for Ukraine and may have shifted blame for the
higher prices from the Yanukovych government to its predecessors,
while scoring a few populist points with the 18% price reduction.
End Summary.

Commission Finding:
Poor NaftoHaz Management, Questionable Contracts
-------------- ---


2. (U) The Verkhovna Rada's Temporary Investigative Commission on
the Gas Sector reported on October 4 its preliminary results at a
Rada plenary session and promised full results by December 30.
Commission Chairman and Socialist MP Andriy Derkach announced that
the GOU had lost control of the gas sector in 2005, and that
"incomprehensible and unprofessional" NaftoHaz negotiating positions
had led to the significant rise in gas prices in January 2006.
Derkach noted that evidence of possible malfeasance and other
illegal acts had been uncovered and directed to law enforcement for
review.


3. (SBU) The commission found the following reasons for NaftoHaz's
worsened financial state: a decrease in profits due to the 2005 halt
in gas re-exports; a sharp decline in payment discipline; a mistaken
NaftoHaz policy of covering working capital deficits with foreign
loans; and significant increases in non-production and management
expenses. (Comment: Oddly, the Derkach Commission did not list as a
reason the reduced revenue that followed NaftoHaz's loss of
higher-paying industrial customers to the NaftoHaz-RosUkrEnergo
joint venture UkrHazEnergo.) The commission found violations and
possible criminal offenses in NaftoHaz's foreign operations and
financial management. The majority of contracts for the supply of
gas to Ukraine and its transit through Ukraine, according to the
Commission, were signed in a non-transparent manner with significant
procedural violations.

Commission Finding:
GOU Can Reduce Residential Gas Price 30%
--------------


4. (U) The commission found that, based on cost data supplied by
Ukrainian gas producers, the GOU could reduce the residential price
of gas by 30% from the July 1 level of 414 UAH/tcm. To protect
vulnerable populations from rising gas prices, the Commission
recommended establishing a working group to create a new system of
subsidies for the 2008 budget. The Commission recommended that all
NaftoHaz profits from export, re-export, and transit of gas within
Ukraine fund energy price subsidies. (Note: Post is unaware of any
current export or re-export of NaftoHaz gas and Gazprom recently
reduced its planned 2007 sales volume to NaftoHaz, thus apparently
eliminating a portion that could have been re-exported.) The
Commission also suggested that the NERC cancel UkrNafta and
ChornoMorNaftoHaz's licenses to sell gas at unregulated rates, since
according to Ukrainian legislation these state companies should be
providing gas to residences at regulated rates.

Commission Recommendation:
Trust No One; Regulate Everyone
--------------


5. (SBU) The Commission preliminarily recommended greater government
oversight for the sector and for NaftoHaz, to include

-- The National Electricity Regulatory Commission (NERC) and
government ministries should verify NaftoHaz rate change
recommendations.

-- A special commission from Ukraine's Accounting Chamber should
review NaftoHaz gas procurements to ensure the company is purchasing

the lowest priced gas.

-- The Ministry of Fuels and Energy should develop a system to
review NaftoHaz contracts and agreements before NaftoHaz signs them.


-- The Ministry of Labor should develop a salary matrix for energy
sector employees, with bonuses or higher salaries only to be paid
from company net profits.

-- The Ministry of Fuels and Energy should ensure the sector adopts
international accounting standards.

-- The Cabinet of Ministers should simplify the organizational
structure of NaftoHaz.

-- Employment decisions should be based on professional ability, and
the Commission recommended reviewing the credentials of current
members of Boards of Directors and Supervisory Councils of Ukraine's
energy sector state companies, including NaftoHaz and its
subsidiaries.

Rada Flip Flops on Gas Rate Rollback
--------------


6. (U) Following the investigatory commission's report, the Rada
voted on October 5 to invalidate its over-ride of a presidential
veto of September 22, which had rolled back gas prices to January 1
levels and imposed a moratorium on future increases (reftel). The
October 5 decision was supported by 249 of 436 deputies. Party of
Regions, Socialist, and Communist deputies who initially supported
the rollback now voted to overturn it, while Our Ukraine deputies
who originally opposed the rollback voted to keep it in place. Only
Yuliya Tymoshenko Block deputies showed consistency in the two
votes, being for the rollback in both instances.


7. (SBU) A major reason for the Rada's reversal on gas prices was a
change in the Yanukovych's government's position on gas prices: the
Cabinet of Ministers asked the Rada to reverse itself, despite the
fact that the majority of ruling coalition MPs had voted for it.
Prime Minister Yanukovych said it was too early to lower gas prices,
noting that he was not yet confident it would be a "responsible
step." The parliamentary flip flop came after Deputy Prime Minister
Klyuev promised to introduce a range of compromise measures,
including an 18% reduction in the residential gas price (to 339
UAH/tcm) and a system of tiered pricing based on a family's monthly
usage and floor space. Communist Party leader Pyotr Symonenko
pointed to the 18% rate reduction specifically in explaining his
party's vote switch. (Note: Boyko later announced the 18% reduction
had been enacted, effective immediately, after an October 11 CabMin
meeting. The tiered pricing Boyko said would begin November 1.)


Local Governments Prepare for Winter Price Rise
-------------- --


8. (U) Across Ukraine, regional governors are preparing their
electorates for higher gas prices, which must be set at the local
level to coincide with the NERC's increased wholesale price (339
UAH/tcm) for regional distributors. Governors in Zaporizha, Kiev
Oblast, Lviv, Odesa and Poltava, as well as Kiev Mayor
Chervonitskiy, have spoken out on the need for higher, economically
justified rates. Zaporizha, Kherson, Sevastapol, Lviv,
Ivano-Frankivsk, Lutsk and Odesa have already raised rates, while
Sumy, Luhansk and Karkhiv plan to do so soon. Other major cities
have put off the unpopular decision until the last possible moment.



9. (U) Chernovitskiy's Kiev City Administration published a draft
resolution on October 10 to triple residential heating and hot water
rates. Residents would pay 2.03 UAH/m2/month for heat (up from 0.80
UAH) and 10.72 UAH/m3 for hot water (up from 3.72 UAH). For an
average-sized apartment of 50 m2, a household's monthly heating bill
would rise from 40 UAH ($8) to 101.5 UAH ($20),though Klyuev's
price-tier plan, which includes a 20% reduction for families with
household sizes of less than 100 m2, would reduce this payment to
$16/month. (Note: Ukraine's minimum wage currently is 375 UAH/month
($75),while pensions are 366 UAH/month ($73); a $16 monthly heat
payment is over 20% of a pensioner's income.)


10. (U) A September 15-20 Razumkov Center poll found that 72% of
respondents thought high residential gas prices were not justified.
48.5% of respondents blamed the government for the rise in prices,
while 19.1% blamed President Yushchenko and 6.7% blamed local
government. 14.4% answered that no one was to blame since the
prices were based on higher gas prices from Russia. Among
respondents who already are paying higher gas prices, 31.3%

responded that their families could not pay the new rates, and 56.9%
answered that they could pay, but it would be difficult. Only 5.5%
said the higher prices would not cause budget problems. (Note:
Until the May and July increases, the GOU had not raised residential
gas prices since 1999, aside from increases to cover overall
inflation.)

Comment
--------------


11. (SBU) The September gas price rollback vote created a minor
firestorm in the Ukrainian press and served as a platform to
highlight the preliminary findings of the Rada's investigatory
commission on the gas sector. The commission's recommendations were
heavy on regulatory oversight and allocations, light on transparency
and bringing modern management to NaftoHaz, and silent on
introducing competition to the sector, which would likely be the
only way to effect real reform and growth. The media scrutiny
highlighted the reality of higher gas prices, with one sound-bite
noting that until recent increases Ukraine was behind only
Turkmenistan in having the lowest residential gas prices in the CIS,
and in Turkmenistan gas for households was free. While the increase
brings residential gas rates here closer to international levels,
they remain below wholesale prices for imported gas. Some in the
GOU like to argue that they are not selling gas to households at a
loss because cheaper domestically-produced gas is "dedicated" to
household customers. However, this in turn leads the GOU to depress
prices at domestic well-heads, removing an incentive for greater
domestic gas production. The commission and media attention may
have shifted blame from the sitting Yanukovych government to the
previous one, but regardless of who is in the CabMin, increased
energy prices will be a bitter pill for Ukraine's most vulnerable
consumers.

TAYLOR