UKRAINE: GOU SIGNALS INTEREST IN TRILATERAL BYPASS PIPELINE

UNCLAS SECTION 01 OF 03 KYIV 001461 SENSITIVE SIPDIS DEPT FOR EUR/UMB,EB/ESC/IEC - WRIGHT DOE PLEASE PASS TO LEKIMOFF, CCALIENDO USDOC FOR 4231/IEP/OEENIS/NISD/CLUCYK E.O. 12958: N/A TAGS: EPET EFIN ECON ENRG PREL UP SUBJECT: UKRAINE: GOU SIGNALS INTEREST IN TRILATERAL BYPASS PIPELINE PROJECT Sensitive But Unclassified. Not for Internet Distribution Summary -------------- ¶1. (SBU) Deputy Energy Minister Volodymyr Makukha signaled interest to DAS Matthew Bryza on July 24 in a possible EU/USG/GOU project to boost gas transit capacity through Ukraine in exchange for increased transparency in Ukraine's energy sector by constructing the Bohorodchany-Uzhgorod bypass pipeline. The pipeline would cost less that $1 billion and boost transit capacity by 20 bcm yearly, compared with Gazprom's South Stream with its expected $14 to $20 billion price tag and 30 bcm capacity. Makukha said the project could build on the work of the Russian/Ukrainian International Gas Transit Consortium (IGTC) which planned to build Bohorodchany-Uzhgorod but floundered over Gazprom insistence on managing Ukraine's entire gas transit network in exchange for providing gas to the pipeline. Getting Gazprom buy-in as a partner and a supplier of gas would be a challenge, Makukha said, but it was possible if Gazprom viewed the pipeline as a lucrative commercial venture that was managed in a professional and transparent manner in cooperation with western energy companies. Makukha said the GOU would respond to Bryza's proposal to convene a U.S.-Ukraine-EU working group to scope out the project by mid-September, after the GOU had discussed Bryza's idea internally. On a separate issue, Makukha said the GOU would convene a donors' meeting in November to secure $2.5 billion in loans for the modernization of the existing gas transit system. End summary. Bryza: EU Warming to Bohorodchany-Uzhgorod -------------- ¶2. (SBU) On July 24 DAS Matthew Bryza briefed Deputy Minister of Energy Volodymyr Makukha on his discussions earlier that day in Brussels on the idea of a EU/USG/Ukraine partnership to support the construction of the Bohorodchany-Uzhgorod bypass gas pipeline. Bryza recounted his explanation to EU partners that the bypass pipeline would boost Ukraine's transit capacity by roughly 20 bcm yearly and cost about $800 million, or a fraction of South Stream's projected $14 to $20 billion price tag and 30 bcm capacity. To earn U.S. and EU support for the project, Ukraine would have to guarantee that the project adhere to EU and U.S. transparency standards. ¶3. (SBU) Bryza said he discussed the idea with the EU COEST's regional and energy working groups, European Council Secretariat Chief Gretschman and the European Council Policy Planning Chief Schmidt in Brussels. In general, EU interlocutors reacted positively, albeit focused on Ukraine's unpredictable political situation and lack of transparency in the energy sector. Still, there was enough interest in Brussels for the three sides to discuss how best to explore the idea further. One possibility would be a trilateral working group to scope out key commercial and financial factors and define levels of transparency expected by both the USG and EU, Bryza said. The USG and EU also expected that commercial energy companies build and manage the pipeline; governmental support could take the form of political backing or, for example, the financing of a feasibility study or the sourcing of funding that might attract institutional lending from the EIB or EBRD. He asked Makukha whether the GOU would be interested in discussing the proposed project in greater detail. Makukha: Project Could Build on Work of Dormant Russian/Ukrainian Transit Consortium -------------- ¶4. (SBU) Makukha confirmed the GOU's interest. He pledged to discuss the idea with all affected parties in the government, and hoped to relay a first response to Bryza by mid-September, including on the issue of convening a working group. He suggested that the three sides build on the work of the International Gas Transit Consortium (IGTC),which had already discussed construction of Bohorodchany-Uzhgorod as part of a broader gas transit cooperation between Ukraine's NaftoHaz and Russia's Gazprom. The Kuchma government and the GOR established the IGTC in 2002, and it still existed as a legal entity, Makukha said, but it never got off the ground because the two sides could not agree on IGTC's scope. Gazprom hoped to use the IGTC to gain control over Ukraine's gas transit system, which went against Ukrainian law and was and remained politically unacceptable to Ukraine, he said. The Bohorodchany-Uzhgorod bypass idea floundered along with the general lack of movement in the IGTC, he added. (See paragraphs 11-14 for detailed background of the IGTC). Bryza stressed that a key motivation of this U.S. proposal was to rely on market forces and a commercial venture to protect Ukraine against Gazprom's push to KYIV 00001461 002 OF 003 acquire control of Ukraine's gas transit and storage infrastructure, while restoring Ukraine's reliability as a partner of the EU. Bryza noted this project could help advance Ukraine's integration into the Euroatlantic community by preventing Ukraine from being bypassed by South Stream. Makukha welcomed the idea of including gas storage in the project, and agreed to add metering at both ends of the pipeline. ¶5. (SBU) Makukha gave Bryza an in-depth overview of the previous planning for Bohorodchany-Uzhgorod. The IGTC's feasibility assessment confirmed that the pipeline would boost transit capacity by about 20 bcm yearly. Makukha explained that Ukraine's existing pipeline system could take in about 178 bcm yearly from Russia, but only pass on 120 bcm to countries farther westward. The IGTC planned to build the 240 kilometer pipeline in three stages over two years. The first 50 km could be built within 12 months and increase transit capacity by 5 bcm annually. A second stage would increase the length to 130 km and boost capacity to 16 bcm. The remaining 110 km would extend capacity to the maximum 20 bcm. Regional government authorities in the oblasts of western Ukraine had already procured a right-of-way for the entire route, which Makukha said was an added bonus for the new project because obtaining land rights in Ukraine was difficult. ¶6. (SBU) In all, the IGTC estimated that the pipeline would cost $1 billion. The consortium expected to amortize the project fully within 13 years with an 18 percent annual return on investment. The amortization period would likely be shorter now because gas prices had increased substantially since the partners made their projections. Gazprom and Naftohaz each paid in $20 million in capital to a joint venture established for the purpose. Thirty percent of the cost would have been financed by capital injections of the two partners, with the rest financed by borrowing, he said. Obtaining Gazprom's Buy-In -------------- ¶7. (SBU) Bryza asked whether the existing company might be expanded to include western energy companies alongside NaftoHaz and Gazprom, provided Gazprom acted as a commercial partner that did not try to take control of the project. Makukha said he could not predict Gazprom's reaction. During IGTC talks Gazprom made the delivery of additional gas for Bohorodchany-Uzhgorod contingent on Ukrainian willingness to give it management over the entire transit network, which the GOU refused. But solid EU backing, strong western commercial partners and high levels of transparency might make the project interesting for Gazprom, Makukha added. He said German companies had been initially interested in the IGTC project but later backed out. ¶8. (SBU) Bryza noted the U.S. would not be interested in the bypass project to enhance Russia's ability to transport Turkmen gas to Europe by linking Ukraine's gas transit system to the proposed pre-Caspian pipeline in Turkmenistan. Bryza asked about the possibility of procuring gas from independent gas producers in Russia. Makukha said he was skeptical that Russia and Gazprom would allow independent producers in the foreseeable future. Gazprom's desire for control was too strong, he said. "Insulating" Bohorodchany-Uzhgorod from Ukraine's Transit System -------------- ¶9. (SBU) Makukha pointed out that Ukrainian law explicitly forbids either private or foreign ownership of the existing gas transit network. In his view, however, the law would not apply to a fully new pipeline project. Bryza asked whether the management and governance of such a pipeline operation could be "insulated" from the main transit network, with all the transparency concerns associated with the latter. The ability to separate a new pipeline from the management of the existing network would help secure EU backing for the project. Makukha said that was possible, and cited a pipeline delivering Russian gas across Ukraine to Bulgaria and Romania. The stand-alone project had been completed with EBRD funding, Gazprom was providing the gas without simultaneously pursuing a political agenda, and all involved parties were satisfied with the pipeline's operations and management, he said. GOU to Hike Gas Prices; Seeks Donor Support for Transit System Modernization -------------- ¶10. (SBU) Makukha said the GOU planed to convene a donors' meeting in November to solicit $2.5 billion in loans for the modernization of Ukraine's gas transit pipeline system. The GOU hoped to get KYIV 00001461 003 OF 003 funding from different sources, including EBRD and the EIB. In response to a question by Bryza, Makukha said that donors had already indicated that reforming NaftoHaz would be a main condition for any loans. NaftoHaz's financial system remained precarious because GOU policies kept gas prices to households and utilities lower than cost. NaftoHaz was bearing the burden and effectively subsidizing gas prices on behalf of the GOU. NaftoHaz had once been a prime source of government revenue, but was now a major burden on the budget. Makukha predicted that the GOU would bring retail and utility tariffs in line with unregulated industrial prices in the foreseeable future. This would cause many Ukrainian enterprises to fail, which was a political cost that would have to be borne, as Ukraine's two-tiered gas pricing system was no longer sustainable. (Comment: Separately, other cabinet-level officials have told us that the GOU would announce price hikes for the retail sectors before this year's heating season begins. Previously, however, GOU officials were not ready to acquiesce to the failure of enterprises as a result of gas price hikes. End comment.) Background on the IGTC -------------- ¶11. (SBU) Many observers view the IGTC as one of several Russian attempts to gain more control over Ukraine's gas transit system. In 2000 for example, Russia suggested the establishment of a consortium that would take control over Ukraine's transit system in exchange for canceling gas debts accrued by Ukraine in 1996-1998. Ukraine turned down the suggestion at the time. ¶12. (SBU) At a June 2002 summit in St. Petersburg, Presidents Putin and Kuchma and German Chancellor Schroeder announced plans to create a Ukraine-Russia-German consortium to manage Ukraine's gas transit system, ostensibly to increase the reliability and security of gas supplies to Europe. Germany quickly opted out and Ukraine and Russia announced the creation of the International Gas Transit Consortium (IGTC) in October, 2002. To explain Germany's absence, the parties said they were more prepared to move forward and established a consortium that would welcome third parties. In January 2003, Gazprom and Naftogaz established a limited liability company registered in Kyiv, with each side owning equal equity and voting rights. As of April 2007, IGTC's statutory capital was UAH 186.55 million or roughly $40.5 million. ¶13. (SBU) The two sides failed to find a mutually agreeable business model. Gazprom was interested in either a concession or outright management of the pipeline, which was unacceptable to Ukraine. In turn, Russia refused to agree to the GOU's desire that the consortium jointly manage the entire transit of Turkmen gas on both Ukrainian and Russian soil. In early 2004, the parties agreed to build Bohorodchany-Uzhgorod. It was foreseen that the consortium would receive a concession to operate Bohorodchany-Uzhgorod along with the existing smaller pipelines Torzhok-Dolyna and Ivantsevychi-Dolyna in western Ukraine. The Orange Revolution brought discussions to a halt, and Russia showed little interest when President Yuschenko revived the Bohorodchany-Uzhgorod idea in early 2005. ¶14. (SBU) The IGTC was revived by the GOU in late 2006 after Yuriy Boiko (who headed Naftohaz when IGTS was established) became Minister of Fuel and Energy. In February 2007 President Putin publicly offered Russian support for IGTC and Ukrainian access to Russian gas fields in exchange for allowing the consortium to manage Ukraine's gas transit system. ¶15. (SBU) Comment: Reformulating the IGTC to offer Gazprom a commercially viable way to import gas to Europe as a minority partner with Naftohaz and European companies and without control over the project would set an important precedent. While Gazprom may reject this proposal, compelling it to do so would expose its penchant for control and thereby spur greater EU unity in pursuit of supply diversification. ¶16. (U) DAS Bryza cleared this cable. TAYLOR