Ukraine Tackling Gas Corruption Means Potatoes for Poor

Galina Pavlik barely scrapes by on her monthly pension of $290. Like many Ukrainians, the 73 year-old Kiev resident depends on gas to heat her three-room apartment. The bill swallows about a sixth of her income.

The new government will soon need people like Galina to pay even more for power and gas as it wrestles with protracted economic and political crisis. In the wake of a diplomatic showdown between the West and Russia over Crimea’s March 16 vote to secede from the country, Ukraine’s future now depends in large part on its ability to secure $35 billion in U.S. and European Union aid. Cutting energy subsidies, considered economically wasteful and a magnet for corruption, will be key to getting that help, even if it means more pain for households.

“I will have to eat only potatoes and the cheapest sardines to be able to pay more for gas,” said the pensioner, who has supported the interim cabinet headed by Arseniy Yatsenyuk that replaced the Russian-backed government of President Viktor Yanukovych. “I can’t afford to pay more.”

Ukraine’s system of subsidies for household gas has long been abused. Typically, distributors buy government-allotted gas at low prices intended for families and resell it for far higher prices to businesses. Analysts estimate that the scheme robs hundreds of millions of dollars a year from state coffers in added subsidy costs, further destabilizing Ukraine’s economy, which is already teetering on the verge of default.

Kiev Region

The average gas price for families in the Kiev region was $76 per 1,000 cubic meters last month, while industrial clients paid about $447. As much as 2 billion cubic meters a year is lost to fraud, estimated Dmytro Marunych, co-chairman of the Energy Strategies Fund in Kiev.

“The Ukrainian energy sector is extraordinarily corrupt,” said Judy Dempsey, senior associate at Carnegie Europe. “There’s been no kind of attempt whatsoever to tackle this issue because the country’s oligarchs controlled it. The new government will have to bite the bullet.”

Olena Yurieva, a spokeswoman at state energy company NAK Naftogaz Ukrainy, declined to comment when reached by phone in Kiev.

Last week’s arrest of Ukrainian billionaire Dmitry Firtash in Vienna indicates that a crackdown may have started. Firtash made his fortune as an intermediary between Russia and Naftogaz.

Oleg Arestarshov, a spokesman for Firtash, didn’t reply to e-mails or phone calls.

Hostile Russia

At the same time the government is grappling with corruption at home, it is being hit with higher import prices from an increasingly hostile Russia.

More than half of Ukraine’s gas consumption is covered by imports from Russia, which canceled the 33 percent discount in the gas price granted to Yanukovych late last year and threatened to cut supply. Ukraine will have to pay Gazprom about $368.50 per 1,000 cubic meters of gas in the second quarter, one of the highest prices in Europe, Ukrainian Energy Minister Yuri Prodan said on March 10.

Prime Minister Yatsenyuk is struggling to convince the International Monetary Fund that the former Soviet republic is serious about overhauling an economy that regularly tops global rankings of corruption.

“The discount has to be removed,” Ukrainian Economy Minister Pavlo Sheremeta said in an interview in Kiev, referring to gas subsidies. “It’s obvious we have to deal with it because we don’t have any other options.”

Economic Costs

The Washington-based IMF, currently negotiating a loan in Kiev, estimates subsidies reached about 7.5 percent of the country’s economy in 2012 as prices for residential gas and heating cover just “a fraction of economic costs.” In December, it called the energy sector “inefficient and opaque.”

Phasing out the subsidies has been a long standing condition for two IMF loans since 2008, which the fund stopped disbursing because the governments at the time balked at implementing the measures.

Not only is gas intended for households diverted to gas filling stations or industrial clients enriching corrupt middlemen, the practice can also cause shortages in villages and towns, according to Vitaliy Radchenko, a coordinator of energy projects at CMS Cameron McKenna in Kiev.

‘Sick Animal’

“Naftogaz is clearly incapable and inefficient,” Radchenko said. “It’s like a sick animal.”

To turn things around, Ukraine will also need to improve efficiency -- the economy requires 10 times as much energy to produce goods and services as the average industrial economy, according to the International Energy Agency. A complete overhaul of Ukraine’s energy industry would require an investment of as much as 170 billion euros ($236 billion) over the next two decades, the agency estimated.

Previous Ukrainian governments, including that of Yulia Tymoshenko, haven’t encouraged indigenous production of the country’s proven gas reserves, estimated at 1.1 trillion cubic meters. Production-sharing agreements signed with Royal Dutch Shell Plc and Chevron Corp. for exploration of shale gas by Yanukovych’s government marked the first major effort to bolster domestic production.

Domestic Production

The fate of Ukraine’s offshore Black Sea projects coveted by Exxon Mobil Corp. and Eni SpA is now unclear. The March 16 referendum in Crimea supported seceding and joining Russia. While the vote was condemned as illegal by the EU and U.S., it’s not clear if the government in Kiev will retain control over oil and gas licenses in the Black Sea.

Still, there’s a large potential for domestic production. Soviet Ukraine was a net exporter of gas to Russia until the discovery and development of the giant gas fields in western Siberia in the 1970s. It ranks 24th on the list of countries with proven reserves of natural gas.

“We’re dealing with potentially a very rich country,” Carnegie’s Dempsey said. “But the energy infrastructure has been completely neglected.”

Until that changes, impoverished Ukrainians like Galina Pavlik are stoic about the prospect of more hardships to overcome next winter. “We’re not going to riot,” she said. “I will have to come up with some plan to pay for it.”

Before it's here, it's on the Bloomberg Terminal.