Ukraine’s Energy Policy: Strategic Path or Tactical Squirming?

April 27, 2011
James George Jatras, Deputy Director

Ukraine’s size, location, resources, and talented and hardworking people make it an essential economic asset for its neighbors, both East and West, and an indispensable participant in any equation of European integration and development. But there are two resources that stand out in particular: The first is Ukraine’s potential as the “Saudi Arabia of agriculture,” one of the world’s most richly endowed repositories of black earth at a time when food security is an increasing global concern. The second is Ukraine’s location as an energy transit country between other states of the former USSR, especially Russia, and the rest of Europe to the west. The first, agriculture, remains largely neglected, as the American Institute in Ukraine (AIU) will address in the near future.

The second, energy transit, remains Ukraine’s most contentious and seemingly intractable problem. By all appearances that problem is not being ameliorated by Kiev’s evident inability to focus on some difficult and unattractive tradeoffs that will only become less appetizing as time goes on. Among the interrelated factors boxing Kiev increasingly into a narrow field of maneuver –

  • The miserable, and worsening, state of Ukraine’s energy transport infrastructure, and the obvious question of who will pay to fix it.
  • The threat presented to Ukraine’s centrality as a conduit country by alternative routes with competing political orientatons, notably the competing South Stream (Moscow) and Nabucco (Washington) pipelines.
  • Moscow’s desire for a merger of Naftogaz Ukrainy with Gazprom – generally understood as Russian absorption of Ukraine’s No. 1 national asset – and not just a joint venture, as Kiev would prefer.
  • Moscow’s pricing formula pegging gas to oil, which is climbing steeply.
  • Asymmetrical and mutually exclusive Russian and European Union proposals for economic integration, in which East-West energy relations would be fundamental.

Confronted with these factors, Kiev can take two paths. One is to take a long, hard-headed, strategic look at Ukraine’s assets and liabilities and make the best deal possible under the circumstances. The other is to make ad hoc tactical decisions without any clear sense where Ukraine will or should end up. While not conclusive, the available evidence points strongly to the second.

Ukraine's approach to the threat of its reduced importance as an energy transit country, which is what South Stream represents, is simply to try to kill South Stream rather than find a way to turn the new situation to its advantage. A recent statement by Energy Minster Yuriy Boyko is an expression of concern at the prospect of Ukraine's reduced importance: "South Stream is a political project of our Russian partners, who want to create an excess of transit capacities for gas, like what they did back in the day for oil," says Energy Minister Yuriy Boyko. But given the level of commitment Moscow has given to South Stream, second only to Nord Stream, it is highly unlikely to be derailed by anything Kiev can do. In any case, even western experts admit that "even if both pipelines [i.e., Nord and South] are built and operate at maximum capacity, they will not keep pace with projected growth in European demand" and Ukraine's role, though diminished, will still be essential. In short, instead of wasting efforts on a losing fight to block a southern route, Ukraine should be anticipating how to maximize its importance in a transit picture that includes multiple routes.

With respect to Russian energy pricing, the Kiev administration has again identified a simple course: prosecute former officials, including former Prime Minister Yulia Timoshenko, who agreed to what now appears to have been disadvantageous deal for Ukraine. But how will that solve Ukraine’s fundamental pricing dilemma? “‘Ukraine would like to keep prices down by getting a political deal with Gazprom, but on the other hand would like to comply with the EU member countries’ terms [and keep its European Energy Community options open],’ and these two goals are virtually irreconcilable,” observes Andrei Belyi of the Higher School of Economics. Throwing Timoshenko or former Naftogaz chief Oleh Dubyna into jail won’t change that. In any case, simply due to market factors in light of the spreading Middle East crisis and rising oil prices, and European – especially German – complaints, Russia is likely to revise its gas-oil pricing link.

With regard to identifying funds to reconstruct Ukraine’s crumbling energy infrastructure, it’s all well and good for Ukraine to ask Moscow to put up the funds for an asset of which they would not be allowed to be joint owners: “I would like to confirm the intention of the Ukrainian side to carry out a general reconstruction of the gas transit system to increase Russian natural gas deliveries to European countries by about one third,” said Prime Minister Mykola Azarov. “I count on Russian companies to take an active part in our gas transit system, which provides core pipelines and construction of main pumping stations.” But it doesn’t take any special powers of prediction to see that the Russians will be willing to pay for refurbishment of a jointly owned asset but not a joint venture asset. The other alternative will be European financing, as called for by western analysts: “The dire state of the Ukrainian economy should provide the EU with the necessary impetus to act. Time is a factor as Ukraine’s negotiating position continues to weaken. Ukraine cannot be viewed as a business opportunity alone, but rather as a long-term partner imperative to ensure European energy security. Without greater EU investment, Gazprom will likely force Ukrainian cession of ownership rights over its pipeline network in future negotiations over gas prices and modernization.”

But identifying the EU – which has its own problems – as the alternative to Russia is not the same as getting the funds. The infrastructure problem thus leads straight into Ukraine’s dilemma as to whether it better economic integration option is with the EU or with the Russia-Kazakhstan-Belarus Customs Union (CU). So far, Ukraine has tried to eat its cake and have it too by declining CU membership in favor of a proposed “3 + 1” formula of non-member association with the CU while also pursuing a free trade arrangement with the EU. It won’t work. Ukraine can receive CU prices as a CU member – “4 + 0,” not “3 + 1” – which President Yanukovich says he won’t do. But it is unlikely that a simple free market arrangement with the EU – while actual membership remains in the realm of far off to never – will lead to the needed support. The fact is, for Ukraine the CU door is open now. The EU door is not. v

By trying to play half measures with both Europe and Russia, Ukraine finds itself without the full benefits of either orientation. Meanwhile, its bargaining options continue to narrow.