March 9, 2015 | by Dalibor Rohac Print

Photo by Ervins Strauhmanis (license)

In early March, the Ukrainian government announced substantial gas price hikes for households and local, municipally owned heating companies. For families consuming large amounts of gas, the price per cubic meter may increase six-fold, with further increases planned for later this year and early next year.

The price increases are a response to Ukraine’s longstanding subsidy problem. Ukraine imports most of its natural gas from Russia and the government has maintained artificially low prices for final consumers, presumably to keep down the costs of living. According to a 2013 World Bank brief, prices for heating in Ukraine were around 50 percent of those in Poland and 40 percent of those in Baltic countries. “On average, Ukrainian households pay around 20 percent of the full import price of gas.”

Gas subsidies are extremely costly and are at the heart of Ukraine’s current fiscal troubles. Around 7 percent of Ukraine’s GDP goes toward keeping the prices down, and a reduction of subsidy spending has been the key condition for the IMF’s rescue package extended to the ailing Eastern European economy earlier this year.

Because of its inefficiency, subsidizing gas prices is a rather unfortunate method of helping the poor. Low gas prices encourage overconsumption, particularly among the wealthier households, siphoning finances that could have been used to help those in need. The World Bank estimates that the top income quintile of households receives more than twice as much in subsidies than the bottom quintile.

If one is concerned about climate change, subsidizing the use of fossil fuels from the public purse does not make much sense either. Because of its massive subsidies — which are extended not just to households but also to industry — Ukraine counts among the most energy-intensive economies in the world, roughly 10 times the OECD average.

The existence of different subsidies for different groups of customers is an invitation for illegal arbitrage. With household prices that are almost six times lower than the prices charged to industrial clients, it is not a surprise that around 2 billion cubic meters per year is lost to fraud, according to Dmytro Marunych, co-chairman of the Energy Strategies Fund in Kiev.

The reliance on gas prices as a tool of social policy has made Ukraine vulnerable to the whims of its Eastern neighbor, Russia. Gazprom has been supplying gas to Ukraine at lower prices than to other European countries, in order for the Kremlin to exercise leverage over Ukrainian politics. It could threaten to increase the price at the least convenient moment, thus inflating the fiscal burden of Ukrainian subsidies.

Other post-communist countries addressed the problem of artificially low energy prices a long time ago. They privatized the energy sector, removed explicit and implicit subsidies, and replaced direct price controls with pricing mechanisms based on actual costs. Ukrainian policymakers have not done any of this. The gas sector is dominated by Naftogaz, a state-owned holding company that manages domestic oil and gas exploration and production; imports; storage; transit from Russia to the EU; and domestic sales. The size of the company, its convoluted nature, and the multitude of its different activities make it difficult to monitor its costs and performance. This makes the true costs of subsidies opaque to the general public.

Ukraine’s use of energy subsidies as a tool of social policy is not unique. Many Arab countries, such as Egypt, have long used the same tools to buy social peace — typically with disastrous results. The longer such mechanisms are in place, the more difficult it is to change them. Egypt, for instance, has seen a series of failed attempts to remove subsidies over the past two decades and it remains to be seen whether the price hikes enacted by President El-Sisi’s government prove to be durable.

As I argued in Cato Policy Analysis on Egypt’s subsidies, published in Fall 2013, subsidy reforms suffer from the problem of a lack of credibility. Governments that face pushback when they try to remove the subsidies often give up and reintroduce them. After a few tries, even the most serious reformers will have difficulties convincing their fellow citizens that this time is different.

The solution to the credibility problem is for the reform to be quick, far-reaching, and irreversible. The point is not to just increase prices to market levels but to deregulate, marketize, and privatize gas and energy sectors to remove the incentives for political manipulation of prices in the future.

The current move in Ukraine does reduce subsidies but will still keep the household prices well below the import costs. A successful subsidy reform also requires a number of tedious and technical steps. Naftogaz should have its activities split into different companies, and any cross-subsidies between those need to be eliminated. Those companies ought to be privatized through open international tenders, while existing legislation has to be changed to prevent political discretion over energy prices. On all those fronts, Ukraine has a very long way to go.

The opinions expressed in this commentary are solely those of the author. 

Dalibor Rohac portrait
Dalibor Rohac is a policy analyst with the Cato Institute’s Center for Global Liberty and Prosperity. His work focuses on international political economy and development. Learn More about Dalibor Rohac >