An interesting development is happening in Ukraine. International donors are pushing the country to the right steps. Progressive reformers are desperately trying to institute the necessary changes. And then there are those folks familiar with «Ukrainian realities» who are starting to learn how to get rich off these reforms.

Last year, a major corruption scandal took place over Grigorishin’s transformers. Recently, a no-less-serious scandal erupted over the Rotterdam+ price of coal in Ukraine. The first impression was that the oligarchs are stealing again. However, few are aware that all these developments are merely side-effects of the rise in electricity rates. In short, this is the other side of the reform coin. What should have become resources to modernize grids and generating capacities, and eliminate budget-draining cross-subsidies became the latest tempting tidbit waiting to be snatched. The scent of easy money for businessmen bottled in Ukraine is irresistible and seems to have deadened their sense of self-preservation.

And so what? Does the entire history of rising rates have to be stopped and rewound? Not necessarily. So let’s start with the beginning.

In January 2016, the average bill for a household was around UAH 120 per month. Just a year ago, it was around UAH 70. In March, rates went up again and electricity will only get more expensive in the future. By next year, the average cost for consumers will rise another 58.8%, to UAH 1.2277 per kWh.

Every hike represents billions of hryvnia of additional income for the sector. With the rising costs of heating and gas, it’s pretty clear why this is being done and where this money is going (see NAK Naftogaz Ukrainy's annual report for 2014), but with the power utility rates, it's not so obvious. In fact, the minute there’s a decision to raise rates, the question of who’s going to make money off it becomes a matter for horse-trading among interested parties.

The reason why gas rates were increased was widely explained as due to the cost of imported gas, then why did power rates have to be more than doubled when the country has inexpensive atomic energy and produces enough power that it’s been exporting electricity for more than 20 years? For most Ukrainians, it’s remains a mystery.

To explain why electricity rates are going up, we have to start with the fact that residential electricity is subsidized. The power that Ukrainians pay for is actually more expensive than the price written on their bills. Because Ukraine is a socialist country, the regulator decided that the “oligarchs” should pay for ordinary consumers, meaning business. This caused a lot of problems and systemic distortions but nothing has been changed so far. Residential electricity is rated below its production cost, while commercial users cover the difference. Is that fair? Business would say that expensive electricity costs Ukrainians in other ways, in more expensive goods and services. For example, the recent rise in the cost of centralized water was a direct result of more costly electricity for businesses.

Subsidies distort the situation. Still, if we combine what residential users are paying with what commercial users are paying, we can see the real production cost. If Ukrainians paid UAH 100 a month for electricity based on a rational rate, then UAH 16.90 would go to cover line losses, UAH 3.30 would be for high-voltage power lines, UAH 12.20 for bringing the grid to your building. The cost of the electricity itself would be UAH 67.60 out of that 100. For more on the structure of power rates, see here.

Interestingly, Ukrainian households pay only UAH 49.00 of those UAH 100, which does not even cover the cost of fuel, never mind the cost of delivering to the residence.

Cross-subsidization of residential customers by commercial ones is the main reason why electricity rates need to be raised. Still, it’s not a straightforward matter. There are other issues, such as depreciation of equipment and networks and the growing cost of fuel, which are causing even more problems than subsidies.

1. Depreciation of power station fixed assets

   The equipment at most of Ukraine’s power stations was brought online in the 1960s and 1970s, so their fixed assets are mostly depreciated by 70-80% at this point. This makes the safety—and security—of station operations a major issue. It also increases production costs for generating power because of the high relative costs of fuel. To reconstruct or modernize power capacities, estimates are that UAH 150bn¹ would be needed at current prices.

   ¹ According to estimates by Concorde Capital

2. An underfinanced network

   The grid itself is in not much better shape than generating facilities. According to the best estimates, 70% of the network has already reached its lifespan. One consequence of this is problems hooking up new enterprises and industrial parks. Dozens of investors have decided not to put their money into Ukraine because of problems with getting on the power grid, which means the loss of jobs and opportunities to expand exports and substitute imports. This problem is reflected in Ukraine’s position in the 189-country Doing Business Index: it was 137th for “access to the power grid” in 2016. About UAH 15bn a year is needed to properly finance the country’s network. At the moment, electricity rates are financing only about 20% of the necessary sum or UAH 3.5bn annually through investment programs.

3. Cross-subsidization

   In 2015, cross-subsidization cost UAH 43.8bn². This is 50% more than was spent repairing the country’s roads in 2015. In practice, it means that one group of customers is paying the bills of the other group. The result of this kind of subsidization is distorted incentives and the shifting of the cost of electricity to the cost of goods and services.

   ² NCRERS’s Annual Report on the activities of the National Commission Regulating Electricity and Residential Services for 2015.

4. Rising production costs

   Fuel rods for Ukraine’s atomic energy stations or AESs are imported, as is coal and gas for the TESs and TETs or co-generation plants. As the hryvnia has devalued, fuel for the AESs has more than doubled³ in cost over the last two years. The cost of coal has grown about 70%, while gas now costs 50%⁴ more in hryvnias. Obviously, this kind of trend makes the question of additional financing urgent.

   ³ There is no precise information about the cost of fuel for AESs but we assume that the dollar value has stayed largely the same. ⁴ The average price for imported natural gas in 2013 was US $412.50 per 1,000 cu m.³. In QI of 2016, Ukraine imported gas at US $197.10 per 1,000 cu m.³.

In 2015, utility customers paid UAH 154bn⁵ for electricity. This amount is considerably larger than even what Naftogaz Ukrainy received in 2015 from its natural gas customers—UAH 112.8bn⁶. The bulk of this money obviously went to cover production and delivery costs for electricity. In Ukraine, all power generation companies hand their “production” over to the national grid, which is represented by DP Energorynok, the state enterprise for wholesale electricity. Energorynok averages the price and after the electricity is sold on to customers, each utility gets its share, proportional to its contribution.

However, in addition to those generating power, other companies get a share of this pie, such as the wholesale grid operator UkrEnergo for transmitting power, and smaller network operators for distributing it.⁷.

So far, rates have been raised three times. Where did this money go? We compared the income from rates in 2016 and in 2015 and this is what we saw:

What did these operators do with the money? Actual data is unavailable, but little went towards reconstruction or reducing subsidization (see How the increase in rates proved useless). For instance, financing for the AES investment program grew about 10% in 2016, to UAH 4.0bn from the planned UAH 3.6bn for 2015, although even the roughest estimates, AES operators received at least UAH 6.5bn additional income from the new rates. A similar situation can be seen with the retail operators: investment program financing among licensees remained almost unchanged. The only one accumulating money for reconstruction is the grid operator, Ukrenergo.

These numbers strongly suggest that nearly the entire increase in rates simply disappeared. In other words, so far, the increases in rates have only been used to offset growing current expenditures. If this is the result of reforms, no wonder people are disenchanted.

The unsatisfactory result of the first stage of rate increases raises a reasonable question: Why did we do this, anyway? Let’s model a situation where residential electricity rates remain cheap. And, indeed, calculations show that an additional 12 kopeks/kWh charged to commercial users⁸ and the increase in residential rates in 2015 could have been avoided altogether. Why don’t the oligarchs just pay for everything?

But things are not so simple. Electricity is one of the basic resources for any kind of manufacturing. When making their decisions, investors first of all look at the availability of power. And that’s where Ukraine has a problem. First of all, electricity rates for commercial customers are already among the highest in Europe, so that even the relatively inexpensive workforce in Ukraine is not sufficiently attractive. Secondly, to buy even this expensive electricity, the business needs to be hooked up to the grid, and in Ukraine, this process is one of the most complicated ones in the world (see Enchanted power grids, or The anatomy of an investment curse). So, the latest decision to transfer the cost of electricity to commercial users is just another blow to Ukraine’s competitiveness and one more step towards the next devaluation of the hryvnia (see The anatomy of chronic devaluation). That’s why leaving electricity cheaper for residential users while raising it for commercial ones is the best way to ensure that the average salary in Ukraine will stay at about US $100 a month for a few more decades.

Keeping rates for residential users low through cross-subsidization is wrong and one of the reasons underlying the economic problems of the last two decades. Leveling out residential and commercial rates would be the right solution. However, the results of 2015 puts the matter squarely on how effectively the additional income is being used by operators. Estimates show that the rise in rates over 2016-2017 will bring in at least another UAH 20bn in additional revenues every year. The question then is, who gets this money? Many are willing and an entire war is being waged over this tempting «morsel» (see How UAH 10 billion of corruption was legalized). Few of those wrangling to get their share cares at all about modernization or development, never mind the problems facing customers. For instance, the Rotterdam+ scheme simply made it possible for certain folks to get their hands on the money from overpriced coal. Under the circumstances, the risk is that even as rates rise, the industry’s problems will remain unsolved unless there is strict public oversight. So, if people are going to take on the burden of the new rates, they will also have to squeeze out of them the maximum of public benefit as well.

The first thing that this additional revenue should go to is, obviously, to modernize the power stations. Government officials never wanted to “bother” their citizens by raising the cost of electricity. “Better that they make US $100 a month but don’t worry about the cost of utilities,” has been the thinking of all of those in power since time immemorial. As a result, Ukraine now has the same situation with electricity as it has with local mini-buses: money suffices to cover gas and the driver’s salary, but not to cover repairs to the vehicle. How this affects passenger safety and comfort, everyone can see.

The same situation faces the electricity industry. Most cogeneration plants or TESs and TETs have already worked their resource lifespans, while the AESs are always asking for more financing to add on power blocks. In contrast to worn-out buses, however, here it’s a matter of not just safety and comfort, although rotating blackouts are not pleasant for anyone, but of energy security and the competitiveness of the economy. When your car starts breaking down all the time and gets less than 10 miles to the gallon, sooner or later you’re going to end up walking.

If Ukraine doesn’t to do the equivalent of becoming a pedestrian in terms of electricity, any further hikes in rates can only be in exchange for modernizing the industry. Investment plans need to be made public and transparent and have public support: people should know what it is they are paying so much for. If not, rate hikes are nothing more than another kind of financing corruption.

The expansion of generating capacities is only part of the story. The other side of the coin is how the output is delivered to customers and that’s a much more serious problem. Power distribution operators have neither the money nor the motivation to repair, let alone expand their networks. Like the country’s bankrupted banks, oblenergos have money, but not for everyone. And so the only interest is in moving what little they have access to, to their own accounts.

Introducing “incentivized” rating policies is the only way to resolve this problem. The essence of this is that operators get rewarded for setting up new networks and reconstructing them in the form of a percentage of their investment. That is, if you put money into your network, you are guaranteed a certain profit. However, the real issue is that money is needed to provide this incentive. The cost of this is around UAH 3-4bn a year, which would be enough to properly finance all the grids. Getting these funds out of customers means raising residential rates by at most 10 kopeks per kWh.