Ukraine's fuel and energy complex: how the war will change the basic sector of the economy

The electricity market in the times of war and rapprochement of Ukraine with the EU is becoming one of the key markets of cooperation with the Europe. Western countries have opened their markets for Ukrainian electricity and are ready to invest and support the industry financially.

Mind Intelligence analyzes, how the new circumstances will affect the market and the Ukrainian political and business landscapes. We’ll analyze the main trends and events that Ukraine will see in the coming years:

As a result of the war, Ukraine has already lost a significant part of its industrial and agricultural potential. It’s not only about the physical assets that were destroyed by the aggressor, but also about the broken supply chains and the loss of human capital.

The domestic energy industry, like all other branches of industry, also suffered quite significant losses. However, unlike others (in particular, mechanical engineering, metallurgy, defense industry, aircraft construction, shipbuilding, and others) it has a high chance of rapid recovery.

A key role is played by the significant demand for electricity in the EU. In the conditions of high prices on the European energy market, the European community is interested in having a supplier of relatively cheap energy. Because of this, financial support and investments from the West after the war end would be directed, first of all, to the restoration of this industry.

Generally, one should understand that investing in the restoration of such industries as mechanical engineering, metallurgy, defense industry, aircraft construction, shipbuilding is not a priority for the EU. The example of other countries that have gone through the procedure of preparation for joining the EU clearly shows that Western European countries do not have a great desire to invest in the development of competitors on the high-tech markets. They prioritize investments in infrastructure, agriculture and energy. The development of high-tech sectors of the economy will always be the task of the national government.

Actually, this trend is confirmed in practice. EU is already eager to help Ukraine actively, also financially, in integration into the European electricity market without even waiting for the end of the war. Instead, investments in all other sectors of the economy should not be expected at least until the war ends.

The interests of the EU, which is an economic organization at its core, are absolutely pragmatic and clear – to ensure affordable electricity prices for the economy. On the other hand, the Ukrainian companies, which have joined the European electricity market with great enthusiasm, have a different motivation. The current governing team sees the export of energy, first of all, as a source of currency income, which can be directed to finance a wide list of expenses, including electoral-oriented ones.

Record revenues from electricity export have already tempted the government to divert some of them to its own purposes. Firstly, the exporters were forced to fulfill the special obligations – to hold tariffs at an under-market level. Secondly, the authorities want to unblock the possibility of using Ukrenergo revenues that are accumulated in a special account and come from the sale of access to interstate crossings.

Currently, in accordance with the "Electricity Market Law”, they can be used exclusively for the development of the energy infrastructure of Ukrenergo. Now, several sources report that deputies of the "Servant of the People" parliamentary group are preparing amendments to the law, that will significantly expand the list of directions in which funds from the special account can be used.

Under the war conditions, such a policy is undoubtedly justified, but the problem is that the Ukrainian authorities, regardless of surnames, give up such a practice with difficulty. A classic example is the situation with the transit of Russian gas. For 30 years, country received colossal revenues from this source, that, instead of investing in the structural transformation of the economy, were directed to the implementation of electoral tasks (partly were simply stolen).

So, there is a high probability that the same situation will occur the export of electricity. Political elites will take control of the flow of income from exports and instead of using them for the purposes of strategic development of the state, they will solve their own narrowly political tasks.

Moreover, it’s worth realizing that focusing on maximizing revenues from electricity exports will have its own price for Ukraine. Integration with the European market will automatically raise electricity prices in the domestic market. Most citizens of Ukraine will not feel this, because the authorities will direct part of the income from exports to keep tariffs for the population at a relatively low level.

Instead, the state's economy will face a rather difficult problem. For a long time, relatively low prices for key energy carriers were an important factor that supported the competitiveness of domestic producers. A sharp increase in electricity prices in conditions where the national industry is much more energy-intensive than its European competitors will mean that it will find itself in worse starting conditions.

In addition to the problems mentioned above, there is a risk that electricity prices in the domestic market of Ukraine will rise essentially, but hopes for significant state revenues will not come true.

The situation is worth explaining. Currently, the state earns from the export of electricity in three ways:

• revenue from auctions for the distribution of interstate crossings (that is, electricity export capacity). As mentioned above, these funds go to the special account of Ukrenergo;
• from the export of electric energy produced by state corporations (primarily Energoatom and Ukrhydroenergo). These funds are one of the sources of companies' income, which then partially goes to the state budget in the form of deductions of part of the profit;
• receipt of 80% of the profit of electricity exporters, regardless the form of ownership of the supplying company. These funds are directed to GarPok (“Guaranteed Buyer” state company). They are actually one of the sources of subsidizing prices for the population.

The imposition of special obligations on exporters of electrical energy is a temporary solution that will be canceled at the end of the war. Only the first two points can be stable sources of state income.

Revenues from auctions for the distribution on the interstate crossings will be maximal if the high level of competition for the right to export electricity (access to the crossing) is maintained. At the last auctions, precisely because of a significant number of people willing to sell electricity in the EU, the price for access to the crossing increased significantly – thanks to this Ukrenergo's income increased sharply. In some trade transactions, exporters had to give Ukrenergo 80-85% of the income received from the export of electricity.

 

The situation will dramatically change for the worse for the state if the largest private producer and exporter of electricity will use political tricks to reduce competition at auctions for the allocation of export capacity. And this is an absolutely realistic scenario.

Currently, its competitors are state corporations (Energoatom and Ukrhydroenergo) and a rapidly growing sector of independent traders. The latter are not a significant problem. In case small companies pose a threat to the most powerful electricity exporter, it is always possible to introduce stricter requirements for participation in auctions or introduce a blacklist of unscrupulous traders, which has already been tested in the domestic market. Some of the independent traders are connected to the political elites, so it will be very difficult to expel them from the market, but they will be engaged in relatively small operations, so they will not generate significant losses for the key players.

It will be more difficult with state corporations, which are under the control of local groups and have serious support in the Presidential Office (PO) and the government. In the current political configuration, Energoatom and Ukrhydroenergo are unlikely to sacrifice their own revenues for the sake of private companies increasing their fortunes. They have an unlimited appetite.

There is no doubt that the largest private producer and exporter of electricity will actively try to limit competition for the right to export electricity with state-owned corporations. The only question that is remained open is how this would be done. Today it is already possible to predict what it will look like.

The fact is that the governing team recently came up with the idea of creating a single state trader, which will export the electricity produced by state corporations. The government will undoubtedly justify that such an idea will contribute to the increase of revenues from electricity exports due to the elimination of competition between state-owned companies, but it is quite difficult to agree with such a thesis, because they lose more while competing with private companies.

However, if we assume that such a structure will strangely fall under the control of yet another former manager of the largest private producer and exporter of electricity, who undoubtedly decided to move to the public sector for patriotic reasons, then the market situation will turn out to be extremely unfavorable for Ukraine. Guided by the interests of other players, the state exporter can collapse the income of Ukrenergo from the distribution on the intersections and reduce its own income from the export of electricity.

The economy of the state will face all the negative phenomena associated with the growth of electricity exports. But the growth of revenues from auctions for the distribution of the intersection and from the export of electricity produced by state corporations will be minimal from the real situation.

Thus, it is possible to predict with a high probability that energy will be the engine of economic development of Ukraine in the coming decade. On one hand, it is still better to export electrical energy than the energy carriers themselves, especially if state will focus on the development of nuclear power plants, alternative energy, hydro and hydro-accumulating power plants. On the other hand, concentration on the development of the export potential of the electric power industry will lead to destructive tendencies in the economy and politics.

The war has led to a weakening of the influence of the oligarch class. Currently, some of them are already losing their positions, some still have more resources of endurance, but regardless of this, their fortunes and influence will decrease.

At the same time, if the state can count on the help of international partners to rebuild its own assets, it will be much more difficult for the oligarchs to find a source of financial resources to restore enterprises destroyed by the war. Moreover, the Ukrainian economy, from which they got resources for their own development, will no longer be able to provide them with sufficient funds, no matter what corrupt schemes they invent to drain resources.

Without a doubt, their influence will be significant in the future. They will be able to come into contact with state leaders and influential politicians, bribe some of them, promote their own people to specific positions, and lobby for the adoption of certain beneficial to them decisions. But this will no longer be systematic control over key authorities.

Firstly, this will be hindered by limited financial resources. The oligarchs will be engaged in matters of their own salvation for quite a long time. Practically each of them has colossal internal and external debts, so their budget for political entertainment will be significantly reduced.

 

Secondly, such a model will not be tolerated by Ukrainian society, which is becoming more courageous in matters of state building. Corrupt connections between politicians and oligarchs are unlikely to remain unnoticed and without a harsh, and sometimes even aggressive, reaction.

Thirdly, the status of a candidate in the EU is not only a significant help in adapting to European values, rules and standards, but rather strict control by European structures over the state of affairs. Moreover, the Western partners – who are spending huge resources on Ukraine winning the war and showing an example that democracy and market economy are more effective than totalitarianism and state capitalism – will certainly be quite careful to ensure that the state does not returned to the oligarchic and corrupt political model. All these factors will lead to the gradual extinction of the oligarch class.

However, the situation will develop somewhat in the opposite direction. While the oligarchs are weakening, the first place in the economy and politics will take powerful state corporations, that accumulate large financial resources even in wartime. With high probability, their development will be similar to how oligarchic conglomerates developed.

The oligarchic model of the economy that we knew before the war developed according to a clear algorithm. The absolute majority of the current oligarchs made their fortunes by taking control of assets in the mining and metallurgical complex. Thanks to favorable conditions in world markets, these enterprises became a powerful source of currency inflow, thanks to which individual corporations began to grow into powerful oligarchic conglomerates.

At the very next stages, oligarchs diversify their business by entering sectors of the economy with higher added value. Moreover, they began to consolidate the mass media, finance political projects, think tanks, etc., thereby forming an infrastructure of influence on politics and society.

The war actually ended this period of Ukraine's development. Today, we can state that a new cycle is starting. Its difference is in the role of state corporations that will become the basic elements for forming of powerful conglomerates.

A key factor in this trend is the significant strengthening of state institutions. Today, having control over some of them means more influence than the fortunes of oligarchs. In this regard, a new generation of individuals with huge ambitions is gathering not in the private sector (as domestic oligarchs started), but in the circle of state authorities and powerful state corporations. Such persons will try to create not their own SCM, but their own "gazprom".

Given that the most profitable branch of the economy in the coming years will be the FEC, this is where the largest state conglomerates will emerge. These will include Naftogaz of Ukraine, Energoatom, Ukrenergo, and possibly the Energy Company of Ukraine (the authorities currently want to turn it into another powerful corporation).

The most powerful conglomerate in the country is already being formed on the basis of Naftogaz Ukraine. Recently, the corporation has acquired many assets, thanks to which it has strengthened its position not only in the industry, but also in politics. The initiators of this project are the president and influential groups in his environment. The current political team seeks to concentrate and centralize resources for the realization of a number of state and private interests.

As a president, Volodymyr Zelenskyi is a clear supporter of macro-structures and mega-projects. This not only means the projects of the "Large Construction" type, but also to other sectors of the economy. Even before the start of the war, he was looking for opportunities to influence the prices of the most electorally significant items – fuel, gas and electricity.

Having no opportunity to influence them by administrative methods, he became a supporter of the development of powerful state corporations, which will be guided not by the priority of maximizing income, as every normal commercial structure should, regardless of the form of ownership, but primarily by the task of stabilizing prices for the above-mentioned items.

In this situation, Yuriy Vitrenko became his associate: he is also a supporter of powerful state structures, and he found common ground with the president. Vitrenko began to promote projects for the development of the Naftogaz as the largest player in the gas market and, at the same time, in the motor fuel market. He justified this by the fact that a state corporation would be able to stabilize markets and prices without direct state intervention.

The war has strengthened Vitrenko's position. As the head of the corporation, he effectively performs many PO’s tasks, even if they are not in his area. In general, Naftogaz has become one of the key pillars of the government in many areas, from economic issues to tasks in the field of humanitarian aid.

Using close ties with PO Vitrenko forms a powerful multi-disciplinary conglomerate within the framework of the Naftogaz. Naftogaz is developing actively several additional areas: the segment of end-users of gas, import and trade of motor fuel, and electricity trade. At the same time, it absorbs not only state enterprises, but also the assets of oligarchs. It should not be excluded, that in the near future the Naftogaz will be able to take control of Ukrnafta and Ukrtatnafta and will try to become an active player in the electricity market.

Other state corporations in the energy sector will become a powerful base for the conglomerates. After the end of the war, they will be almost the only financially stable structures. This will allow them to absorb new assets, including those from Ukrainian oligarchs, and enter new market segments, thus displacing war-weakened private companies.

With high probability, we can state that Ukraine will find itself in a completely different situation at the end of Zelensky's presidential term than at its beginning. If in the first two years of Zelensky's presidency, he and his team actually redistributed spheres of influence in FEC and determined to which group the largest state corporations should be given, then in the next presidential elections, the clans that formed around powerful state energy corporations will have a significant influence on the result of elections.

The war significantly changed the structure of the Ukrainian energy industry. This is primarily due to the loss of control over Donbas and few southern territories. As a result of the war, Ukraine actually lost three powerful thermal power plants and several local TPP. Along with the loss of control over most of the Luhansk and Donetsk regions, Ukraine lost access to sources of thermal coal.

In the case of loss of control over the entire territory of those regions (and control over the Pokrovske mine), which is declared by the Russians as a priority task, the coal energy industry of Ukraine will suffer a critical blow. It will be cut off from the highest quality and cheapest raw materials (western Ukrainian coal is significantly inferior in key parameters to coal from Donbas).

The restoration of coal power to the pre-war level will be neither possible nor economically justified. Partly it will be influenced by Ukraine's membership in the EU – Union doesn’t tolerate investments in this energy segment.

In general, despite the fact that the reduction of the role of coal energy will have certain negative consequences (especially for some oligarchic clans), it will still be a positive shift for the state in a strategic perspective. The EU strives for the carbon neutrality of the economy, so Ukraine, as a member of this community, should undertake the relevant obligations and significantly reduce the role of coal energy, especially in the conditions of surplus electricity production from other sources.

 

 

Instead, one of the most destructive consequences of Russian aggression for the energy sector is the degradation of alternative energy. This sector was the most dynamically developing in Ukraine. Despite the fact that it was quite expensive for the state budget, green energy has become very important in the country's energy system. Last year, RES power plants produced about 13% of the total amount of electricity in the country.

According to the latest data, the production of green electricity has almost halved compared to last year. It’s worth noting that the assessment of Ukrainian green energy assets remained under the state of Ukraine is very difficult. Some of the power plants are located in the occupied territory, but they are still listed as the part of the unified energy system of Ukraine.

It is not known in what technical condition is the half of this segment of the energy industry. A large part of the producers disconnected the power plants from the grid, without informing about the reasons for such a decision. It is known that some of the power plants were physically destroyed, some were dismantled and taken away (this applies to both the occupied territories and the territories controlled by Ukraine), some investors disconnected the power plants from the grid for technical and economic reasons or for security reasons.

In general, the alternative energy sector is gradually sinking into a systemic and deep crisis, and there is a high risk that these trends will be long-term and very disruptive. The biggest threat to green energy is that Ukraine will temporarily lose control over Donbas and some of the southern territories. The fact is that the largest RES power plants are located precisely in those regions, due to climatic factors.

In addition, the system of state support for green energy has collapsed. Due to a lack of funds, the authorities have significantly limited payments under the green tariff. Back in March, the Ministry of Energy of Ukraine established payment limits (as a percentage of the estimated tariff) – from 15% for solar power plants to 60% for producers producing electricity from biomass. At the end of June, the limits were slightly increased, but from now on they are minimum payments at the level of 20% (the average rate for several categories of alternative energy producers) of what green energy producers should receive.

Sources in the companies working in green energy sector say that the situation is not critical, but very difficult. According to their information, more than half of the companies in the sector are able to cover their costs even in the current conditions, but the problem is that the war and restrictions on payments under the green tariff have fundamentally undermined the positive dynamics of the development of this energy sector.

After the end of the war, Ukraine will have no more than 40-45% of alternative energy capacities compared to the pre-war situation. At the same time, within 5 years after the end of the war, no new projects will be implemented (due to the long time required for the implementation of bureaucratic procedures and the implementation of investments). This will lead to a long-term trend of stable reduction of electricity production from renewable energy sources.

At the same time, alternative energy is unlikely to get the state support. For every Ukrainian government, the shrinking of the green energy sector is more of a relief than a problem.

The Ministry of Energy publicly states that the reconstruction of alternative energy will be one of the key priorities of the state after the end of the war. Moreover, it declares that the government's task is to build 7.1 GW of new RES capacity. In fact, it does not correlate with the interests of the authorities and the key players in the market.

The authorities do not want to spend huge amounts of money on paying for the green tariff. In turn, private companies that are present in this segment of the energy industry, in the best-case scenario, would like to restore their own power plants. They definitely do not want to see new companies, because they understand that the rapid expansion of this segment will cause a new set of problems related to payments under the green tariff.

We can already state that the prospects for the development of alternative energy in Ukraine are very vague. Unfortunately, even in the case of a positive end to the war with the Russian Federation for Ukraine, the best times for this segment of the energy sector are already in the past.

The motor fuel market will also undergo significant changes. The domestic Ukrainian market will be almost completely filled with import. Statements by the Ministry of Energy that Ukraine will restore its oil refining industry are fictional and should be seen as political declarations that will not be implemented.

First of all, new logistics were formed during the war. The key players of the domestic market of petroleum products have already found new partners abroad and have organized economically profitable deliveries of fuel to Ukraine. It turned out that the EU’s capacity is enough to fill the internal market. So the market model is now crystallizing and is likely to stay for a long time.

The only ones who will potentially be interested in the restoration of oil refining are companies that control oil production in Ukraine or have (or can have) stable access to the import of raw materials. In Ukraine there is only one informal group – under the conventional name "Privat" plus JSC Naftogaz of Ukraine. Undoubtedly, each of these entities has a desire to create its own vertically-integrated company, which will require at least one refinery. From an economic point of view, the reconstruction of the Kremenchuk Refinery would be the most profitable, but this will be hindered by complex relations between key shareholders.

Privat Group that controls Ukrnafta and the Kremenchuk Refinery will undoubtedly not invest its own funds in the restoration of the oil refinery. At the same time, it will not agree to transfer it and Ukrnafta under the control of the Naftogaz.

In turn, Naftogaz can potentially raise the necessary amount for the reconstruction of the Kremenchuk Refinery, but it will not do so without actual control over the mentioned enterprises. Even if the shareholders agree among themselves on the creation of a joint VINC, there are great doubts that they will be able to find a compromise over the matter of distributing the investments on the reconstruction of the refinery.

Secondly, the EU, where Ukraine is heading, clearly declares that it intends to abandon the use of internal combustion engines in the most important segments of the automotive industry. First of all, this applies to passenger cars. Disputes continue among the members of the European Community about the specific date from which the registration and/or production of passenger cars with internal combustion engines will be prohibited, but the general strategic vision that this should be done is no longer opposed.

It should be clearly understood that the EU will not be able to, and in fact does not plan to completely abandon gasoline and diesel fuel. It is about sharply reducing the volume of its consumption. And this is a fairly clear perspective of 10-15 years. This does not mean that oil refining will disappear in the EU, but it will determine that the EU, to which Ukraine should already belong by that time, will have a surplus of oil refining production capacities. In such a situation, the EU will not be interested in supporting the construction of new refineries on its territory.

Thirdly, from the economic point of view, the reconstruction of the refinery or the construction of a new powerful oil refinery is not an economically profitable project. If we analyze the strategy of foreign oil corporations, it can be noted that the availability of a significant amount of raw materials and at least a 30-year perspective of favorable market conditions are important factors when making a decision to invest in the construction of a refinery.

These factors are working against investments in refineries in Ukraine. Oil reserves are running out, and the cost of its production is constantly increasing. After the war, the production of own raw materials will drop significantly (the depth of the drop depends on the size of the lost territories). The prospects of the market itself, in case Ukraine joins the EU (which means that it will be forced to move within the framework of a policy of sharply reducing the consumption of petroleum products), are also rather vague. Foreign investors, whom the Ministry of Energy relies on in restoring the oil refining industry, will not invest in the construction of a modern, powerful refinery, knowing that in a few years the demand for petroleum products will start to decrease significantly.

Because of all the factors mentioned above, Ukraine should understand that the fuel market is at the stage of active transformation. The established import channels are enough to fill the domestic market. Instead, it is worth focusing on inclusion in modern trends in this area.