How Do We Win the War?
Despite important accomplishments, the standoff between Naftogaz and Gazprom is not over. In order to achieve a final victory, Naftogaz, the civil society, the government, and our international partners need to unite around a shared purpose.
In my previous articles, I have outlined how the Russian Federation uses Gazprom as a tool in its hybrid war against Ukraine and how Naftogaz, after the new team took charge in 2014, has defied expectations by winning all the important battles against Gazprom.
Specifically, we were able to achieve the following:
- secure gas supplies to Ukraine from Europe despite the fact that Gazprom halted its supplies in the summer of 2014 and even tried to block Ukraine from finding alternative sources of gas; thanks to this, Ukraine was able to avert an economic and humanitarian disaster and did not allow Putin to bring it to its knees;
- win the arbitration case at the Arbitration Institute of the Stockholm Chamber of Commerce; as a result, instead of owing Gazprom over USD 81.4 billion, we are entitled to receive USD 2.6 billion plus interest from Gazprom.
 This amount includes all financial claims actually set forth by Gazprom under the take-or-pay clause for the period from 2012 to 2016, the impact of take-or-pay if it were applied to the period from 2017 to 2019, the impact of applying the original contract price from April 2014 to 2019 instead of the price as revised by the tribunal, as well as payment for gas volumes off-taken in the first half of 2014 but not paid for as of the time when the gas was off-taken. The estimate is calculated as of the date of the tribunal’s final decision in the transit contract case, February 28, 2018.
These are our common victories. They unite all Ukrainians and our international partners who help us to defend ourselves from the Russian aggression and to achieve a better future for our children.
But the standoff between Naftogaz and Gazprom is not over. Tensions are in fact rising:
- Gazprom has refused to comply with the decision of the arbitral tribunal – it has not paid the USD 2.6 billion awarded to Naftogaz and is not supplying gas at the revised price.
- Instead, Gazprom has appealed the decision to a Swedish appeals court on clearly manufactured grounds.
- Since the enforcement of the arbitral tribunal’s award is not currently stayed by the appeals court, we have started the enforcement process around the world, but Gazprom is trying to use all means possible to avoid or at least delay this until the final ruling of the appeals court which is not expected to be rendered until the end of the first half of 2020.
- Also, Gazprom has started a new arbitration in Stockholm against Naftogaz, seeking, against the rules, a relief that would basically reverse the decision of the previous tribunal.
- In parallel, Gazprom is finishing the construction of Nord Stream 2 and TurkStream – projects that could allow it to do without the Ukrainian gas transit system altogether.
- For continuing transit via Ukraine, Russia is demanding terms that are absolutely unacceptable: for Naftogaz to waive its entitlement to the payment of USD 2.6 billion (plus interest) by Gazprom and restore “the balance in the relationship”, which effectively means going back to the time when Ukraine spent more money purchasing gas from Russia than it earned from transit. On top of this, Russia offers no guarantees with respect to transit volumes and the associated payments and is trying to block the application of European rules. This hurts Ukraine’s interests too.
- In response, Naftogaz’s counterclaims in the new arbitration case are for Gazprom to compensate losses resulting from Gazprom’s failure to supply gas in 2018–2019. Naftogaz is also demanding compensation for non-compliance with the contract clause on revising the transit rate for 2018–2019 in line with European rules. The overall sum of this compensation is currently estimated at USD 10.4 to 14.8 billion. For comparison, this constitutes almost a third of total central government revenues in Ukraine. The validity of our claims in the new arbitration case has been confirmed by a report put together by independent international experts; Naftogaz has submitted this report to relevant stakeholders.
 In line with European rules, Naftogaz is claiming a revision of the transit tariff for 2018–2019 so that it would cover accelerated depreciation and costs of impairment of the Ukrainian gas transmission system. According to international accounting standards, Naftogaz has to recognise these expenses in 2018–2019 given that it cannot reasonably expect transit to continue after 2019.
- Additionally, in its fight against Gazprom, Naftogaz is beginning to utilise its rights deriving from European competition law. Naftogaz will shortly submit to the European Commission a complaint regarding Gazprom’s violations of competition law, specifically referring to Nord Stream 2 and blocking other companies from transporting gas through the territory of Ukraine to the European market. This complaint contains a detailed analysis of the violations, prepared with participation from leading European lawyers and experts.
We need to ask ourselves what our shared purpose in this fight is and why we need to win.
Our shared purpose
1. That Ukraine realises the potential of its gas transmission system and receives a fair income from gas transit.
2. That as long as Ukraine has a need for imported gas, its supply will be reliable and the price will be fair, and that Ukraine will have no need to sacrifice its independence for it.
3. That we receive fair compensation for our economic losses under the current contracts with Gazprom.
What would be a fair price, a fair fee, and a fair compensation? Of course, Ukraine would want to have the lowest price possible for gas and the highest profit possible from transit. But even if we are talking not about preferential treatment (which Russia has never given us and is not giving us now), but about fairness, then what we want is what should be accorded under the application of standard European rules. Russia, as an aggressor state, should not be allowed to profit from its hostile policy toward Ukraine. On the contrary – it should pay a high price for its violations of international law. This would be fair. And this fairness is in the interests of Naftogaz, of Ukraine, and of our international partners.
How important and difficult will it be for us to achieve this shared purpose?
As noted above, Russia is setting out absolutely unacceptable conditions for continuing the transit relationship, while concurrently finishing the construction of the Nord Stream 2 pipeline which will allow it to bypass Ukraine.
If there is no transit and we do not obtain compensation from Gazprom, this will cause an economic recession already in 2020. No revenue from transit means GDP declining by approximately 4 percent (considering the multiplier effect). The IMF currently expects Ukraine’s GDP to grow by 3 percent in 2020; subtracting those 4 percent will result in a GDP decline of 1 percent.
Losing transit volumes could also lead to gas shortages in Ukraine as soon as this coming winter. Since we will no longer be important for Europe as a gas transit route to the European market, gas shortages in Ukraine will no longer be seen as a threat to gas supplies to Europe. This can undermine the potential for help being provided to Ukraine by its international partners. By way of reminder, it was this help that allowed us to survive the winter of 2014–2015.
Theoretically, the loss of transit could be offset by increasing domestic gas production, improving energy efficiency, and eliminating corrupt schemes by way of liberalising the market and making it play by European rules. First, however, this will take time, and secondly (and most importantly), in practice opposite trends prevail:
- For example, at Ukrgazvydobuvannya, a Naftogaz subsidiary that is the largest gas producer in Ukraine, extraction is decreasing despite a significant inflow of investments in the previous years (the daily gross volume of extraction in Q1 2019 is down compared to Q4 2018; the volume of marketed production is down in 2018 compared to 2017 and in Q1 2019 compared to Q1 2018). Now that Naftogaz has to deal with a huge cash deficit (as opposed to the earlier surplus), if nothing changes, extraction will drop even further in 2019.
- The sector is basically closed to new entrants from leading international companies which would be able to bring new technologies and investments. For example, they did not participate in new auctions for production licenses. At many auction lots, there was not a single bidder.
- So far, advances in energy efficiency are only happening as a result of price shocks – when people become concerned that they will have to pay much more. Loan programs and donor projects are having a relatively limited effect. The negative effect of infrastructure wear and tear is far larger.
- The process of reforming the gas market in the past several years can be described as “one step forward, two steps back”. The government has promised the International Monetary Fund that the market would be fully liberalised starting from April 1, 2020, but the necessary preparations have not been made, and thus there is a high risk of it being postponed for the third time (in 2015, the government promised to complete the liberalisation by 2018, then the deadline was pushed back to 2019, and then to 2020).
- There is very little support for this reform among the general population, mostly because of the way the government has communicated it to the public as well as because of intentional disinformation on the part of reform opponents. Among these opponents are the Russian Federation, together with its agents of influence, as well as Dmytro Firtash’s powerful oligarchic group which also has ties to Russia.
- The positive effect from the monetisation of subsidies is still indeterminate.
- The government’s selective application of the European rules transposed into Ukrainian legislation with the adoption of the Law on the Natural Gas Market in 2015, specifically demonstrated in its ignoring of the provision on compensating the company for the public service obligations (PSO) imposed on it; such approach unbalances the market, as well as discredits the reforms.
- Issues of gas theft and leakage, as well as proper accounting for volumes off-taken, remain unsolved.
- Much remains to be done in order to complete the reforms, including bringing regulatory acts of the National Energy and Utilities Regulatory Commission in line with European rules, creating a new infrastructure for managing credit risks, revising tariffs gas of regional distribution companies, ensuring trust in the independence and competence of the Regulator.
- There is a risk that the situation with interconnectors from Europe might worsen, which will mean new bottlenecks in diversifying gas supplies.
Given these trends, without receiving compensation from Gazprom, Naftogaz will not only stop being the largest net contributor to the state budget, but will go back to sucking dozens of billions of hryvnias out of it.
However, as you can see, it’s no longer just about Naftogaz. Thanks to our joint efforts, we averted an economic and humanitarian disaster in 2014–2015 and kept our independence. But the threats we are facing now mean that we have not pulled back far enough from the edge of the abyss. We might still fall into it.
The journey from the brink of an abyss to our shared purpose is long and hard, and we will make it only if we stand together
Unfortunately, for the past several years we have been seeing a negative trend toward infighting that could lead to our defeat – with disastrous consequences.
At the same time, in order to win this fight with Gazprom, we should push back against this trend and strive for a new level of cooperation between Naftogaz, the government, civil society and Ukraine’s international partners.
Here are the main considerations when considering this kind of cooperation.
It would be a mistake to think that Naftogaz’ existence is harmful or superfluous. It would be an equally great mistake to claim that Naftogaz had been created artificially by random people who were motivated by pure greed. If we keep to this interpretation, no reasonable person would ever want to cooperate with Naftogaz and be a part of this common journey.
That is why, in my previous articles, I have been busting the myths that exist around Naftogaz.
Specifically, I have shown that Naftogaz provides the gas that heats the homes of almost all Ukrainians (natural gas is the source of energy for heating in 87 percent of Ukrainian households). Therefore, Naftogaz is about something that is both tangible and indispensable.
Naftogaz provides a sixth of all central government revenues. This is relevant to whether the government has enough cash to pay pensions and salaries.
Naftogaz also ensures reliable gas transmission, which is one of the factors underlying Ukraine’s importance to Europe.
As the successor of the State Committee of Oil and Natural Gas, Naftogaz is the next stage in the long and illustrious history of Ukraine’s oil and gas industry. This history is in turn an important part of the history of pre-Soviet Ukraine, the industrialisation of the Soviet period, and the wild 1990s.
The decision to transform the State Committee of Oil and Natural Gas into a national company was and remains strategically sound. Admittedly, due to incompetence, corruption and Russia’s interference, this process has still not been completed, at least in some respects.
Our team at Naftogaz has been introducing quick changes since 2014, zeroing in on specific areas. These changes are an example of crisis management rather than full-scale transformation. I have led the efforts to prepare a plan for precisely this kind of transformation. Implementation of this plan has been in progress for almost a year now, under the leadership of Naftogaz’ CEO, although the results have not yet been unveiled publicly.
This means that we need to complete the transformation of Naftogaz into a modern national company.
2. There is a team in place that is a reliable partner
Our team, composed both of Naftogaz’s staff and outside counsel and experts, has won the previous battles with Gazprom and is fighting on. We have proven our professionalism and commitment by our actions.
To uphold the grounds for why I can be trusted, in the previous sections I have basically provided a performance report. In it, I cite specific information with respect to quantitative and qualitative changes in Naftogaz’s commercial operations – changes that I had personally initiated and implemented.
Besides, I am outlining the steps that led to these changes in order to refute claims that these positive changes happened independently of anything that we did. I also answer the logical question of where all the money that was earned thanks to these changes actually went.
And although I work at Naftogaz and in Naftogaz’s interests, I give a rather detailed description of why I see a need for specific reforms at the country level (both for professional reasons and for reasons of wanting the best for my country) – reforms that I initiated and helped to implement. Specifically, I’m talking about bringing corporate governance at state-owned enterprises closer to European standards, creating a competitive wholesale gas market, and solving the problem of hidden subsidies.
3. Suggested alternatives lack footing
Everything we do in our fight against Gazprom has a proper justification - it is backed by detailed economic analysis and corroborated by experienced international lawyers and experts. And this is the way it should be, because the problems we are facing are complex, having been compounded for multiple years, and we have to deal with a powerful opponent who is intent on bringing Ukraine to its knees. Confirmation for our actions comes from the success of our previous endeavours.
At the same time, alternatives that are being aired from time to time are nothing but hypotheses that need tangible proof. As soon as one starts analysing them, it becomes obvious that they are either conscious attempts at misleading everyone, or frivolous projects that play to someone’s private interests.
For instance, let’s look at the option of achieving a peaceful settlement with Gazprom in exchange for extending our transit contract. This effectively means giving up on the very real USD 2.6 billion (plus interest) in exchange for promises made by an unreliable and hostile counterparty, with no guarantees of transit volumes and revenues, but with keeping an exclusive right of this counterparty for gas transit through Ukraine. Besides, the counterparty would likely use the continuation of the contract to make everyone go easy on them with Nord Stream 2, allowing them to finish its construction. Then, Gazprom will be in a position to forgo Ukrainian transit altogether.
Another example: proposals keep popping up to replace Naftogaz with a new entity that would be a party in the contract with Gazprom, with the idea that the new entity would be better placed to come to an agreement with the Russians. This means a renewed attempt to create a new corrupt intermediary, similar to RosUkrEnergo, and to replace negotiators on the Ukrainian side with someone who would be more amenable to looking after someone’s private interests. These suggestions never move ahead, though, because the Russian side needs to solve its own problems, and these new entities cannot offer such solutions.
Calls are made to completely change the approach to gas transit, with the gas “changing ownership at the Eastern border, with a view to allowing European companies and transiters of Central Asian gas access to the pipeline and creating a “gas hub” in Ukraine. These calls are made in an accusatory tone that suggests that we are somehow opposed to this idea. In fact, we are not against it – we are actually actively fighting for it. The problem is that such changes currently run against Putin’s interests, and they are not going to materialise all on their own – we need to work to make them happen.
4. Although there is no real alternative, there are real risks
From my story about the Stockholm arbitration, you can see that the fight against Gazprom is a complex process, the success of which depends on a deep understanding of the desired outcome, the current situation and the way things used to be. Success also depends on the team’s ability to implement the necessary changes and adapt to changing circumstances.
Obviously, the team that is directly in charge of the relationship with Gazprom depends on the actions of Naftogaz’s executive board and its CEO. In turn, these actions depend on the effectiveness of control by the supervisory board, and if the company is insulated from political meddling and graft. Unfortunately, we’ve all been witnesses to the recent crises in the chain “executive board – supervisory board – the government.” These are fundamental problems that need to be addressed as quickly as possible, but also in a systemic fashion.
Another risk is a bogus version of unbundling the gas transmission function, a cover for the realization of corrupt interests, or a haphazard, “box ticking” unbundling, conducted in a manner that would undermine the legal position of Naftogaz in the new arbitration against Gazprom.
Success in diversifying gas supplies and later in the Stockholm arbitration was due in large part to the image of Naftogaz in the international arena. We were able to present Naftogaz as a company that is eradicating corruption both internally and externally, and that is rapidly changing and approaching international standards of corporate governance. If Naftogaz’ transformation into a modern national company, which started almost a year ago, fails, this will adversely affect the company’s image and can prevent us from winning in the standoff with Gazprom.
Cooperation: possible roles
If you agree that there is a need for cooperation in order to achieve our shared purpose, we need to outline the roles of all the main stakeholders.
- If only for reasons of legal standing, the company’s role in the fight against Gazprom is decisive. It has to make use of all available tools.
- An important contribution would be made by the company’s constructive participation in the trilateral negotiations among Ukraine, the Russian Federation and the European Union regarding gas transit in 2020 and beyond. A new long-term transit contract that would be based on European rules, specifically allowing the transmission operator to fully cover its justifiable costs including a reasonable return on invested capital, is our Plan A. We have been able to find common ground on this with the European Union, which is a significant accomplishment.
- Plan B, to be implemented in case Gazprom does not agree to this consolidated position advanced by Ukraine and the EU, is for Naftogaz to obtain the above-mentioned compensation totaling USD 10.4 billion to USD 14.8 billion. Besides, this Plan B is a credible threat to Gazprom, which should be an economic incentive for the Russian side to be constructive.
- Taking a broader view of Naftogaz’ possible role, the company can become an effective platform for international partners in doing business in gas production and transmission as well as in the energy efficiency sector. Naftogaz can also use its resources and expertise in leading reform of the gas market as well as of corporate governance of state-owned enterprises. All of this is important for achieving a victory in the fight against Gazprom.
The civil society
- Its role in this matter would include both manifesting public demand for necessary action on the part of the government and providing a proper response to disinformation that is deployed in order to undermine the interests of the Ukrainian society.
- Our shared purpose reflects the values prevalent in almost all parts of Ukrainian society. For Ukrainians with traditional values, an effective stand against Gazprom is a matter of their well-being and freedom from oppression. For those who share “Western” values, it is a matter of the rule of law, state sovereignty, European integration, efficient markets and equal opportunities. For the part of society with more paternalistic values, it is a matter of the government being able to provide social care.
- The most notable example of the civil society’s effective engagement is the Euromaidan, which put Ukraine on the path of European integration in 2014 and actually became the starting point of all these changes, first in the government, then at Naftogaz, and then in the relationship with Gazprom. In other words, this engagement is what made our victories possible. We have to thank the civil society for them.
- We need engagement of at least a critical mass of civil society representatives. This does not mean a new Maidan – this means an involvement in everyday processes. This will be an important factor in the overall success, and I understand that achieving it requires some hard work on the part of Naftogaz, specifically with regard to effective and honest communication.
In my story about the Stockholm arbitration, I have mentioned the positive role played by Prime Minister Arseniy Yatseniuk and his government. Unfortunately, save for some important help provided to us by the Ministry of Foreign Affairs and some representatives of other ministries, the only examples of the subsequent government’s involvement I can recall were of a destructive nature. I often got the impression that the government wished for our defeat and that we were winning not thanks to the government’s efforts, but in spite of them. I still want to believe that the stance taken by some representatives of the government was not intentional and that we can overcome these misunderstandings and unite around our shared purpose.
How would I see the role of the government? If we take a view that goes beyond our fight against Gazprom and encompasses the economy as a whole – I would like to see the government take a stand for an efficient market. The most crucial factors here would be the rule of law, transparency, and market integrity. All of this is important if we are to achieve our shared purpose. At the very least, it would be helpful to see more cooperation in the field of formulating and implementing a foreign relations policy.
Ukraine’s international partners
Unfortunately or fortunately, we need to be mindful of the fact that our accomplishments in the fight against Gazprom would have been impossible without the help provided by our international partners. I am pretty sure that without cooperation with them, we will not be able to achieve our shared purpose.
As I have noted above, this cooperation needs to be raised to a whole new level. For example, with respect to economic reforms, we need effective tools for better analysing and better controlling their implementation – so that reforms would focus on substance over form, and would proceed in the correct sequence, considering the need to involve stakeholders and ensure institutional development.
It is important to remember that the arena of the standoff with Gazprom is not limited to Ukraine. Thus, cooperation with international partners should extend beyond what is happening domestically. For instance, we could be joining efforts with the European Commission in the fight against Gazprom’s abuse of its dominant market position in the EU, encouraging other European countries to adopt laws similar to the one passed recently in Denmark in relation to export pipelines from Russia (thus considering security factors and other strategic considerations), securing help on the political level for making Gazprom comply with the decision of the arbitral tribunal in Stockholm.
Of critical importance is the position taken by Germany. It is no longer a secret to anyone that Germany is actively promoting the Nord Stream 2 project on the political level. Without going into the reasons for this, it would be nice to see Germany at least setting out a few preconditions for the Russian Federation: complying with the rulings that have already been rendered in Stockholm, ceasing and desisting from abusing its dominant position in the markets of the EU and the Energy Community member countries (with both the EU and Ukraine being contracting parties to the Energy Community Treaty), and even revising the gas transit tariff via Ukraine in 2018–2019 according to Gazprom’s contractual obligations. In other words, the German government should make it a condition for any joint project with Gazprom that Gazprom acts in good faith in regard to the European Union (in which Germany is aspiring to be seen as a leader) and in regard to Ukraine as Germany’s partner.
I’m not trying to impose these roles on anyone. I am just sharing how I see their distribution. Maybe you have a different opinion. Let’s discuss it. After all, our future is worth talking about, since this story of ours is far from over. The future depends on every one of us. We are responsible for how it turns out.
What we need is seeking to solve our real problems and not getting distracted by easy but misguided solutions that only compound these problems. I hope that for the sake of our shared purpose, we will be able to reach an understanding before it’s too late.
* Partner of the project “Naftogaz vs. Gazprom” - Yuri Vitrenko, executive director of the NJSC “Naftogaz of Ukraine”. Opinions and assessments published in the project materials may not coincide with the position of NJSC Naftogaz of Ukraine and the editorial staff of NV.
To read the whole story – switch to ‘Naftogaz vs. Gazprom’ special project’s page.