How We Improved Corporate Governance at Naftogaz
The agency problem
Every company has a management structure headed by top executives. However, these executives might be acting in their own interests or in the interests of some other people to whom they are loyal rather than in the best interests of the company. This is the so-called “agency problem.”
This problem is usually resolved by “corporate governance”, a system that allows to appoint and dismiss the top management, set goals for them, oversee and regulate their actions in a fashion that would ensure that they act in the interests of the company.
With state-owned enterprises (SOEs), the agency problem exists on two levels. On the first one, the management might not be acting in the interests of the company. On the second one, the government, which is the nominal owner of the SOE, might be demanding from the management that it act in the government’s political or corrupt interests rather than in the interests of the people whom it is supposed to represent.
As far as Ukrainian SOEs are concerned, we might occasionally see glaring manifestations of this problem on both levels. CEOs might be appointed not due to their professionalism and integrity, but because they are loyal to whomever is lobbying for their appointment. These CEOs then proceed to act in the interests of their “sponsors”, with some skimming along the way (if skimming happens on a scale not commensurate to where the CEO is in the pecking order, the CEO might get into trouble).
This vicious circle can corrupt and distort the whole system of government as such, because people then seek to become part of it not in order to represent the interests of the people, but with a view to personal enrichment made possible by controlling state-owned enterprises.
If this vicious circle is not broken, we can not expect positive change in state-owned companies and the country as a whole. This is why I made attempts to promote a reform of corporate governance at Naftogaz as early as 2007. Unfortunately, back then, I never managed to even begin implementing it.
The second attempt
After returning to Naftogaz in 2014, I tried again. This time around, external circumstances were more favorable. Specifically, there was external pressure on the government to enact European market reforms, and I had to take advantage of it.
One of my first moves was to suggest to the political forces that were forming the coalition in 2014 that implementation of OECD guidelines on corporate governance in SOEs be included in the coalition agreement. It sounded nice, so MPs agreed to it.
Then we found a partner who could help us develop and promote this reform – the European Bank for Reconstruction and Development (EBRD).
EBRD included relevant provisions in the loan agreements that were to be signed by the bank and the Ukrainian government. It was only after we had submitted to the Cabinet of Ministers the draft regulatory acts that had to be passed in conjunction with the loan agreement that our opponents realized what they would lose as a result of this reform.
But the advantage was ours. And not just because we were well-prepared. The main thing was that this reform got the backing of Western governments. Their representatives made it clear that changes in this sphere would be a test for the Ukrainian government with respect to its readiness to enact real European market reforms in the interests of the Ukrainian people. It was a sort of an “ambush attack” that was indeed well-prepared, but that succeeded mostly due to the element of surprise.
Unfortunately, as happens so often, certain “compromises” were subsequently reached at the stage of governmental approvals, where I could no longer control the process. These compromises reared their ugly head later on down the line.
And although the element of surprise was already gone – our opponents have instead opted for the tactic of imitating resolute action – we were able to defend the changes that had already been made.
For example, we were able to create at Naftogaz a Supervisory Board with a majority of independent members. The Supervisory Board controls the internal audit department.
In conjunction with an external audit (there had been no audit in 2012-2013) conducted by one of the most reputable international companies, this enabled us to significantly increase transparency, accountability and the degree to which the company is isolated from political interference and graft.
This has in turn increased trust on the part of our international partners, sometimes even before we could show we were deserving of it. They knew the company’s management was not corrupt and they could back us up.
This had a positive effect on the Stockholm arbitration proceedings against Gazprom, since the image of Naftogaz and its management has markedly improved, and thus arbitrators could trust that corruption at the company had become a thing of the past.
The increased transparency has also helped us gain better control over our subsidiaries, which makes it possible to use synergies from the integration among companies comprising the group. Moreover, I maintain that without this reform, Naftogaz might well have not been able to regain control over Ukrtransgaz.
To sum up, the corporate governance reform was essential in transforming Naftogaz into a profitable company and a net contributor to the state budget. But the process of introducing necessary changes is still far from being complete, which is why it’s too early to consider the results of our innovations to be irreversible.
Goals we have yet to achieve
1. Actual transfer of authority to control and regulate the company’s executive body from the Cabinet of Ministers to the Supervisory Board.
2. Replacement of other mechanisms of external control that are geared towards government agencies (not state-owned enterprises) with an effective system of internal control.
3. Rescinding of government decisions that introduced confusion as to equity rights with respect to subsidiaries and assets.
4. Adoption by the government of an ownership policy that would adequately explain to the Ukrainian people why Naftogaz should remain in state ownership. Establishing guidelines for the company’s activities that could become the foundation for strategy development and assessment of outcomes.
5. Accountability for the return on invested capital, i. e. measuring the performance of the company (both as a whole and in its separate business areas) as a ratio of its profits to a fair valuation of its assets and comparing this ratio to alternative capital allocation options. In other words, there should not be a situation where a SOE is unprofitable or its profits are too low compared to the possibility of selling its assets and getting a better return on these funds.
6. Introducing a reward system for motivating employees, and disclosing compensation levels of the top management in accordance with best practices for state-owned enterprises.
All of this is crucial to creating a stable system that would minimize the risk of mismanagement, specifically by isolating the company from political interferences and the associated corruption. The ball is in the court of the Cabinet of Ministers, because many changes do not require changes on the legislative level. For example, the Cabinet can easily approve the new version of the Charter of Naftogaz, which has been approved by the Supervisory Board and submitted for the Cabinet’s review long ago.
It’s no surprise then that competent international experts criticize the government’s policies and point out that the main obstacle to enacting corporate governance reform is corruption. According to the OECD report for 2018, “most of the functioning SOEs are not operating efficiently. Moreover, many of them operate at a loss either due to corruption, mismanagement and/or onerous public policy objectives carried out by SOEs.” The report separately highlights the fact that the reform is backsliding on the governmental level (despite proclamations of its importance).
An example would be the government regulatory act that prohibited paying out bonuses at state-owned companies. The same OECD report notes that “established supervisory boards seem to be often prevented from carrying out their functions in line with commonly accepted corporate norms and struggle to maintain their independence. Cabinet of Ministers has retained in many cases the rights to nominate the CEO and to approve the corporate strategy, financial plans, etc.”
Seeking to split up, rather than centralize, ownership of state assets, as we have seen with the attempts to split up Naftogaz, is a typical behavior of politicians who wish to preserve possibilities of interfering in the company’s operations and benefitting from graft.
*The feature series "Naftogaz Against Gazprom" is running in partnership with Yuriy Vitrenko, Executive Director of Naftogaz Group. Opinions expressed in these features do not necessarily reflect the views of Naftogaz Group or NV editorial team.