Price con­trols: The masochism mech­a­nism

Why Ukraine has to stop en­gag­ing in price con­trols on nat­u­ral gas as soon as pos­si­ble

The Ukrainian Week - - CONTENTS - Olek­sandr Kra­mar

Why Ukraine has to stop en­gag­ing in price con­trols on nat­u­ral gas as soon as pos­si­ble

No mat­ter how much the Gov­ern­ment com­plains about pres­sure from the In­ter­na­tional Mon­e­tary Fund over the is­sue of rais­ing nat­u­ral gas rates for res­i­den­tial cus­tomers, the Cab­i­net it­self is at fault that the gap be­tween res­i­den­tial and com­mer­cial rates has once again nearly dou­bled over the last few years. So point­ing fin­gers at the coun­try’s lenders only em­bar­rasses the Gov­ern­ment and the coun­try as a whole.

In Oc­to­ber 2016, nat­u­ral gas for house­holds cost UAH 6.88/cu m and start­ing at UAH 7.60/cu m for in­dus­trial users, depend­ing on the vol­ume used. To­day, the house­hold rate is barely higher at UAH 6,96, but com­mer­cial cus­tomers pay UAH 13.40 as of Oc­to­ber 1, 2018, pro­vided that they use at least 50,000 cu m monthly, have no out­stand­ing debts and pay in ad­vance. The rest pay as much as UAH 14.60/cu m.

This kind of gap is not the re­sult of some kind of one­time cat­a­clysm but hap­pened when rates for com­mer­cial cus­tomers kept creep­ing slowly up­wards as a re­sult of changes in prices on the Euro­pean gas mar­ket while house­hold rates were ar­ti­fi­cially — and ir­re­spon­si­bly — kept nearly un­changed by the Gov­ern­ment. To­day’s rate of UAH 6.96/cu m is about half of what it should be if the rate had re­sponded to mar­ket fac­tors all along.

In­stead of re­ject­ing price con­trols as a way of solv­ing this prob­lem once and for all, and suf­fer through the in­evitable pub­lic dis­con­tent and po­lit­i­cal pain, the cur­rent Gov­ern­ment has cho­sen the po­lit­i­cally and so­cially more ir­ri­tat­ing method of “death by the thou­sand cuts.” To­day, it’s clear that, in do­ing so, those in power have un­der­mined them­selves more than any­thing. Had res­i­den­tial rates shifted ac­cord­ing to mar­ket con­di­tions by the end of 2016, or at most early 2017, and price con­trols been re­moved, more than two years ahead of the elec­tions, Ukraini­ans would have be­come used to the new re­al­ity and adapted to it.

In­stead, the Gro­is­man Gov­ern­ment dragged out the res­o­lu­tion of this is­sue un­til the 2019 elec­tion cam­paign was pretty much in swing, of­fer­ing a so­cial ba­sis for a come­back by var­i­ous rem­nants of Yanukovych’s Party of the Re­gions. And if it fails to undo this Gor­dian knot “with one fell blow,” and con­tin­ues to bring prices to par­ity with Euro­pean prices in stages, then fuel rates will prob­a­bly be­come the main fo­cus of not just the pres­i­den­tial elec­tion, but of the next Verkhovna Rada and lo­cal elec­tions, sched­uled for 2020, as well.

MAR­KET FORCES VS FORCED PRICES

Com­plaints that Ukraine does not have a com­pet­i­tive do­mes­tic gas mar­ket may be ac­cu­rate, but they only con­firm the need to bring gas prices in line with the rest of Europe. There isn’t any sep­a­rate Ukrainian mar­ket for petro­prod­ucts, grain, me­tals, ores, oil, sugar, or veg­eta­bles, ei­ther. To­day, all mar­kets are global mar­kets. At most trans­port costs and lo­gis­ti­cal as­pects might dif­fer­en­ti­ate one re­gional mar­ket from oth­ers, but not much more. The Ukrainian seg­ment is just a small com­po­nent of the global mar­ket and so its prices can­not be rad­i­cally dif­fer­ent.

Be­yond this, if we com­pare the dy­nam­ics of prices for other goods and house­hold in­comes in Ukraine since the last time the gov­ern­ment raised res­i­den­tial rates for nat­u­ral gas, it’s clear that the in­crease nec­es­sary to bring rates to mar­ket par­ity does not es­pe­cially stand out in the over­all pic­ture. For in­stance, fuel has gone up 50-90% in the last 2.5 years. On April 29, 2016, a liter of 95-oc­tane gaso­line av­er­aged UAH 21.40, diesel was UAH 18.00 and LPG was UAH 8.05. To­day, they are UAH 31.40, UAH 29.10, and UAH 15.00 on av­er­age, rep­re­sent­ing in­creases of 47%, 62% and 86%. Of course, not ev­ery­one needs mo­tor fuel and its share of house­hold bud­gets, even among driv­ers, is of­ten less than the cost of heat­ing gas. A simi-

lar sit­u­a­tion can be seen with food, and food con­sti­tutes a far more sub­stan­tial por­tion of most house­hold spend­ing than util­ity pay­ments, as sta­tis­tics and polls can con­firm. Even of­fi­cial sta­tis­tics show that from April 2016 un­til Au­gust 2018, bread went up 39%, milk went up 40%, meat prices in­creased 43%, cream­ery but­ter jumped 48%, and eggs have in­creased over 67%.

Of course, the gen­eral pub­lic has been un­happy about all these in­creases in food prices, but it hasn’t dis­played the kind of hys­te­ria that has been ob­served for years now, over nat­u­ral gas rates. The best ex­pla­na­tion is that food prices have changed un­der mar­ket pres­sure, not price con­trols, go­ing grad­u­ally up and down with the sea­sons, al­though they ul­ti­mately end up higher.

Mean­while, the pur­chas­ing power of or­di­nary Ukraini­ans has also gone up sharply. Since mid-2016, the last time the gas rate was in­creased by fiat, the rise in wages has been much more no­tice­able than the price men­tioned here. For in­stance, the av­er­age wage in­creased from May 2016, when it was un­der UAH 5,000 a month, to UAH 9,170 in Au­gust 2018, a dif­fer­ence of 84%, while the min­i­mum wage has gone up 157%, from UAH 1,450 to UAH 3,723, the av­er­age pen­sion has gone up nearly 51%, from UAH 1,700 to UAH 2,562. The ex­cep­tion is the min­i­mum pen­sion, which has only gone up 28%, from UAH 1,130 to UAH 1,452.

This kind of in­crease in house­hold in­comes in most cases would more than com­pen­sate a rise in the res­i­den­tial gas rate if this had hap­pened un­der mar­ket con­di­tions, along with in­creases in rates for in­dus­trial users. Pen­sion­ers whose small in­comes are grow­ing the most slowly would feel the shift in rates much less if they were given more ac­ces­si­ble and more gen­er­ous sub­si­dies than other pop­u­la­tion groups. And all this would likely have led to far less fo­cus on the rate hikes them­selves. This, of course, would mean an end to price con­trols and mar­ket pric­ing mech­a­nisms.

If the price of bread, dairy, meat, de­ter­gent or cig­a­rettes were also sub­ject to price con­trols, imag­ine the out­rage among or­di­nary Ukraini­ans if these prices sud­denly jumped be­cause of gov­ern­ment fiat, rather than ris­ing grad­u­ally un­der mar­ket pres­sure. For­tu­nately, this has not been the case. Be­cause the gov­ern­ment has had no hand in any of it, these rises have been far eas­ier to ad­just to, so­cio-po­lit­i­cally, and have been ac­cepted as a nat­u­ral phe­nom­e­non, rather than lead­ing to the an­gry re­sponse that rate hikes for var­i­ous util­i­ties bring about.

The only al­ter­na­tive is to switch to mar­ket-based prices for all fu­els and util­i­ties while pre­vent­ing mar­ket mo­nop­o­lists from dic­tat­ing terms. Noth­ing else will pre­vent the politi­ciza­tion of this sub­ject and the so­cial tur­moil that sud­den, ir­re­versible rate hikes re­sult in. The gov­ern­ment needs to shed the bur­den of con­trol­ling en­ergy and util­ity prices and the re­spon­si­bil­ity that goes with this.

THE GOV­ERN­MENT NEEDS TO SHED THE BUR­DEN OF CON­TROL­LING EN­ERGY AND UTIL­ITY PRICES AND THE RE­SPON­SI­BIL­ITY THAT GOES WITH THIS

HOW NOT TO FOS­TER IN­VEST­MENT

It is more and more ob­vi­ous that the lack of a pre­dictable gas mar­ket and fur­ther price con­trols are key fac­tors that not only keep ma­jor Euro­pean play­ers from en­ter­ing the mar­ket, but also block the ex­pan­sion of do­mes­tic ex­trac­tion of nat­u­ral gas in Ukraine by pri­vate com­pa­nies. This, in turn, means that the coun­try loses op­por­tu­ni­ties to see prices re­al­is­ti­cally come down by ex­pand­ing do­mes­tic pro­duc­tion to cover do­mes­tic de­mand com­pletely and in­crease com­pe­ti­tion as new play­ers join the mar­ket. This is what hap­pened in the US, where prices were so high that just a decade ago there was talk of de­liv­er­ing Siberian gas through a transcon­ti­nen­tal pipe­line. To­day, the US has turned into one of Rus­sia’s main com­peti­tors on the global nat­u­ral gas mar­ket.

But for large-scale in­vest­ment in do­mes­tic gas ex­trac­tion, lack of cap­i­tal is no longer the prob­lem, but con­fi­dence among in­vestors that the rules of the game and rate pol­icy will be stable is. If the next gov­ern­ment is run by pop­ulists who de­cide that do­mes­tic gas should not be sold based on quotes on Euro­pean mar­kets but should be sub­ject to price con­trols based on op­er­at­ing costs, any­one who in­vests to­day will find them­selves suf­fer­ing huge losses.

The coun­try pays a very high price for this uncer­tainty: com­mer­cial ex­trac­tion has al­ready been cur­tailed. The Yat­se­niuk Gov­ern­ment was mov­ing to­wards con­sol­i­dated gas rates for all groups of con­sumers in prepa­ra­tion for switch­ing to en­tirely mar­ket-based rates, and pri­vate ex­trac­tion com­pa­nies in­creased ca­pac­i­ties 50% in very short or­der, from 2.8bn cu m in 2013 to 4.2bn cu m in 2016. But af­ter the “fi­nal hike” an­nounced by the Gro­is­man Gov­ern­ment in April 2016, the gap be­tween res­i­den­tial and in­dus­trial cus­tomers once again be­gan to ex­pand, spec­u­la­tion about fur­ther price con­trols grew, and so did ru­mors that the gov­ern­ment would na­tion­al­ize pri­vate ex­tract­ing com­pa­nies.

The re­sult was that in 2017, pri­vate com­pa­nies cut ex­trac­tion back to 4.1bn cu m, and for Jan­uary-Au­gust 2018, the lat­est Coal Min­istry fig­ures show that ex­trac­tion is about the same as it was for this pe­riod in 2017: 2.9bn cu m. In the mean­time, state ex­trac­tion com­pa­nies also cut back pro­duc­tion. Ukrgazvy­dobu­van­nia’s slow­ing dy­namic clearly can­not com­pen­sate for the re­duc­tion in out­put at Naftogaz’s sub­sidiary, Ukr­nafta. The re­sult is that 2017-2018 are turn­ing into time lost in terms of ex­pand­ing do­mes­tic nat­u­ral gas ex­trac­tion.

Mean­while, the gov­ern­ment has failed to in­tro­duce ef­fec­tive in­cen­tives that would get pri­vate do­mes­tic ex­tract­ing com­pa­nies to rein­vest sur­plus prof­its into ex­pand­ing their op­er­a­tions. Given that the sav­ings they en­tail are not be­ing di­rected to­wards in­creas­ing pro­duc­tion, to­day’s ex­tremely low fees for ex­tract­ing nat­u­ral gas al­low pri­vate com­pa­nies to re­move their prof­its from the sec­tor. Cur­rently, do­mes­ti­cally ex­tracted gas sells for UAH 9-10/ cu m while pro­duc­tion costs UAH 2-2.50/cu m, so com­pa­nies are pay­ing the bud­get leas­ing fees for the ex­ploita­tion of re­sources that amount to 14-29% of earn­ings. It’s high time that the size of ex­trac­tion leas­ing fees is tied to the pace of ex­pan­sion go­ing on at a given com­pany: the more the com­pany ex­pands, the lower the leas­ing fee, and where there is no ex­pan­sion or pro­duc­tion is be­ing cut, the fee should be higher. Those pri­vate com­pa­nies that can­not demon­strate at least 10% growth in ex­trac­tion an­nu­ally should be obliged to pay all sur­plus prof­its to the state bud­get by rais­ing the leas­ing fees on old wells to at least 60%.

Even at Ukrgazvy­dobu­van­nia, sur­plus prof­its are not be­ing prop­erly plowed back into the com­pany to ex­pand op­er­a­tions. Its fi­nan­cial re­port for H1’18 showed that op­er­at­ing costs were UAH 19.6bn to ex­tract 7.55bn cu m of nat­u­ral gas and 250,000 tonnes of pe­tro­leum with gas con­den­sate. This means the op­er­at­ing cost of 1 cu m of gas ex­tracted by the com­pany is slightly more than UAH 2.20-2.50/cu m. Net prof­its from sell­ing it at even to­day’s prices is more than dou­ble pro­duc­tion cost.

The sum men­tioned here does not in­clude the in­vest­ment needed to dy­nam­i­cally ex­pand ex­trac­tion, say, at least 10% a year. Nor is it coming. Any prof­its earned are trans­ferred to the state bud­get in the form of taxes and div­i­dends. The com­pany’s fi­nan­cial re­ports show that, of UAH 30.47bn in net prof­its in 2017, Ukrgazvy­dobu­van­nia paid UAH 22.85bn went out to its share­hold­ers in the form of “div­i­dends.” But the main share­holder, through Naftogaz Ukrainy, is ul­ti­mately the state. Yet only one quar­ter, UAH 7.6bn, went to other uses, in­clud­ing rein­vest­ment.

To­day, price con­trols on nat­u­ral gas are a lit­mus pa­per for the lack of in­de­pen­dence of the Ukrainian gov­ern­ment and its vul­ner­a­bil­ity to out­side pres­sure, and a quasi-tax be­ing used to fill the rev­enue side of a trou­bled state bud­get. With the me­di­a­tion of the state bud­get, they are try­ing to put to­gether a mod­i­fied scheme for cross­sub­si­diz­ing the part of the pop­u­la­tion that gets sub­si­dies through that part that pays for gas. But this also al­lows for cor­rupt earn­ings by oblast gas com­pa­nies and co­gen­er­a­tion plants that pig­gy­back on such schemes. In 2017, com­pa­nies in the Naftogaz group paid the bud­get taxes and div­i­dends worth UAH 107.3bn, more than half of which then went to sub­si­dies. For the first 8 months of 2018, UAH 88.2bn has al­ready been taken in, rep­re­sent­ing 18.7% of over­all Trea­sury in­come for this pe­riod.

So, in­stead of in­cen­tiviz­ing do­mes­tic ex­trac­tion and lower prices for gas by elim­i­nat­ing the need to im­port it, to­day’s ad­min­is­tra­tively es­tab­lished yet un­cer­tain rates func­tion as a quasi-tax against all those who pay the full rates for gas and heat­ing. What­ever price is set per cu m of nat­u­ral gas, be it UAH 7, 8.50 or 10-12, can­not pos­si­bly be jus­ti­fied: it is con­sid­er­ably higher than the op­er­a­tion cost of ex­trac­tion, and both far lower than and, more im­por­tantly, un­re­lated to those that would be es­tab­lished in re­sponse to mar­ket fac­tors.

The main thing is that any price con­trols were and re­main fac­tors that lead to po­lit­i­cal and so­cial in­sta­bil­ity without es­tab­lish­ing a pos­i­tive en­vi­ron­ment for do­mes­tic gas ex­trac­tion to grow dy­nam­i­cally. Un­der nor­mal mar­ket con­di­tions, it would not only grow quickly to cover do­mes­tic de­mand and of­fer the mar­ket con­di­tions for a con­sid­er­able re­duc­tion in rates, but would even­tu­ally pro­vide sur­plus that could be ex­ported. This is some­thing that can hap­pen if Ukraine moves to mar­ket-driven rates for gas and other en­ergy re­sources as soon as pos­si­ble.

In Oc­to­ber 2016, nat­u­ral gas for house­holds cost UAH 6.88/cu m and start­ing at UAH 7.60/cu m for in­dus­trial users, depend­ing on the vol­ume used. To­day, the house­hold rate is barely higher at UAH 6.96, but com­mer­cial cus­tomers pay UAH 13.40 as of Oc­to­ber 1, 2018

Mi­cro-manag­ing. When the gov­ern­ment reg­u­lates fuel prices, it be­comes vul­ner­a­ble to out­side in­flu­ence

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