Energy Corruption in Ukraine: Causes and Cures

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2015/08/28 • Analysis & Opinion, Politics

Article by: Igor Herbey and Shane Suksangium

Energy corruption in Ukraine has been an ongoing problem ever since the country’s independence from the USSR in 1991. Up until Yanukovych’s downfall, the energy sector has always been dominated by these so-called oligarchs who are staunch allies with those in power, getting special privileges at the cost of the Ukrainian economy. The oligarchs would buy the cheap gas which has been subsidized by the state (intended to the poor) and sell it at a higher price to the consumers and factories alike. This action by itself already costs the state hundreds of millions of dollars in revenue. The gas subsidies which have been a core part of Ukraine’s energy policy have led to household overconsumption of energy while the government burns through their fiscal reserves to maintain their popularity.

The corruption in the energy sector is also one of the ways that enables Russian influence in domestic politics, as the Kremlin can give influential figures in Ukraine gas discounts in exchange that they do Russia’s bidding in Ukraine. Under the new pro-European regime, the country is attempting to:

  1. reform the sector in an effort to comply with EU-standards, align itself with the EU’s Third Energy Package;
  2. attract foreign investment after passing the Law on Natural Gas Market in April 2015;
  3. reduce leverage from Russia.

This essentially means that Ukraine has agreed to float energy prices at market level, instead of just selling artificially low prices, to ensure free and fair competition for gas production and distribution. Moreover this is also a step for Ukraine to align itself closer to the European Union.

How energy corruption works

The most common method of energy corruption is through the use of “middlemen.” These middlemen (read: oligarchs) would buy energy (mainly gas) at below-the-market price from Russia and then sell it to the government of Ukraine at a higher price (still below or market price), giving the oligarchs and government a win-win situation. What is interesting in this issue is that Russia and Ukraine are next to each other, so there is no reason for Naftogaz, Ukraine’s sole gas supplier, to buy energy through a middleman. There is simply no need for transportation, as these middlemen would not increase efficiency in any way.

In a particular case, oligarch Dmytro Firtash was able to secure gas at a highly-decreased price from Gazprom (a giant gas company, the majority of which is owned by the Russian state) due to his connections with the Kremlin, and gained permission from Naftogaz to use their pipelines due to his connections with Viktor Yanukovych. Moreover, Naftogaz already has a fixed contract to buy a certain amount of gas from Russia, meaning that they will be wasting money for no particular reason.

Another problem that occurred in the gas sector is different gas prices. Until recently, Ukraine had two gas prices: a subsidized gas price for households and a normal gas price for factories. This led to private gas distributors, not surprisingly controlled by the oligarchs or their allies, buying gas imported by Naftogaz at the cheaper price, but selling it to industries at normal price. Naftogaz itself thus lost large amounts of revenue due to selling cheap gas while the state loses large amount of money as they have to subsidize all these gas prices.

In order to portray the dire negative influence of the middlemen, detailed examinations of the middlemen, and their methodologies, will be provided throughout the article. The article will initially focus on Dmitry Firtash, and later will examine Serhiy Kurchenko.

Dmytro Firtash: Putin’s middleman in Ukraine

firtash.jpgDmytro Firtash is a major player in Russia using energy policy in order to influence Ukrainian politics. A former soldier and fireman only a decade ago, Firtash has become one of the key frontmen for Russian hegemony over Ukraine. Despite the high amount of publicity he has received recently, his past remains exceptionally murky. A founder of a trading company in Chernivtsi upon Ukraine’s independence in the early 1990s, Firtash soon moved to Moscow. From the early 1990s to 2002, almost nothing is known about his background, except for a deal with Central Asia where he received food supplies in exchange for natural gas. In 2002, he established a company called EuralTransGas, which distributes Turkmen gas in Ukraine. With the gas distribution infrastructure in place, in 2004 Firtash established a joint company with Gazprom called RosUkrEnergo, which distributed Russian gas in Ukraine. It was this RosUkrEnergo, the backbone of a group on companies which would become DF Group, which allowed Russia to control the Ukrainian gas sector.

The main mechanism over energy control which Gazprom has used with Firtash is selling over 20 billion cubic meters of gas to him below market prices over four consecutive years. According to Reuter’s calculations, the price through which Firtash was buying the gas was so low that Firtash’s companies made more than $ 3 bn in net profit through Gazprom. Russia has tried to deny the connections with Firtash, but a Reuters investigation has uncovered Russian customs documents which support these numbers. It must be also noted that the low price provided by Gazprom/Putin was also a major detriment to the Russian people, since the gas was sold to Firtash at artificially low prices, meaning the Russian treasury had to subsidize Firtash’s price instead of the money going to benefit the Russian people. It is not a surprise that President Poroshenko, upon his win in the May 2014 election in Ukraine, immediately flew to Vienna, where Firtash is hiding on bail from his extradition to the United States, in order to meet with Firtash and attempt to secure cheap gas prices.

As typical for Ukrainian oligarchs, Firtash utilized a chain of shell companies for importing gas into Ukraine, in order to make his connections with Russia, and his monopoly more obscure. Firtash’s company, Group DF, established a company in Cyprus (owned solely by Firtash), and a company in Switzerland (owned solely by Group DF).  It was these two companies which were used for importing the cheap gas from Russia.

By utilizing Firtash as a front man, Russia achieved influence over the gas sector of Ukraine, and over the agribusiness sector of Ukraine

Furthermore, another factor for how Putin used Firtash as a front man for influencing Ukrainian politics was by Putin influencing Russian banks to provide Firtash with vast, cheap credit lines. These vast lines of cheap credits allowed for Firtash to become a monopolist in the Ukrainian chemical and fertilizer sectors. It must be noted that Ukraine’s agribusiness sector is one of the main economic sectors of Ukraine. Therefore, whoever monopolizes the fertilizer sector automatically becomes one of the main influencers over the agribusiness sector. Hence, Firtash’s use of vast cheap credit, provided to him by Russia, allowed for him (and thus Russia) to become one of the main influencers over one of the main economic sectors of Ukraine. Therefore, by utilizing Firtash as a front man, Russia achieved influence over the gas sector of Ukraine, and over the agribusiness sector of Ukraine.

What did Ukraine specifically lose when Russia utilized Firtash to monopolize the Ukrainian gas sector and become a key influencer of the Ukrainian agribusiness sector? One of the detriments is that Firtash was one of the main financial backers of Yanukovych, using the fortune he acquired through Putin’s backing. Furthermore, since Firtash still controlled the gas sector when Poroshenko won the presidential election in May 2014, the new post-revolutionary government, inherited severe impediments from achieving gas independence from Russia. Not surprisingly, Firtash openly denies any influence by Putin, claiming he is “an independent businessman.”  Nevertheless, according to Viktor Chumak, the previous parliament’s chairman of the anti-corruption committee, “he [Firtash] is as political person representing Russia’s interest in Ukraine”.

Another issue that Ukraine faces apart from being influenced by Russia through middlemen oligarchs is the limited numbers of competition to undertake shale gas exploration projects which can allow the country to become energy-independent from Russia. The government currently subsidizes and artificially depresses prices for their allies to the degree that foreign firms cannot compete due to substantially higher production costs (relative to that of the oligarchs). Because the governments have favorites, these individuals are essentially monopolies, meaning that they will benefit from selling cheap gas at a substantially higher price while the state is forced to subsidize these prices. Because of this, the state will be spending unnecessary amounts of funds. Furthermore, if Ukraine hopes to join the EU, they will need to abolish subsidies and ensure that all investors get the same opportunity to undertake gas exploration.

The keyword to all this problem is deregulation. Petro Poroshenko’s government must ensure that there are no favorites in the energy sector and ensure that the price of energy is at market level so that other firms are willing to compete. This will break the power of the oligarchs and monopolies and ensure that the consumers receive a fair price of energy without the state subsidizing the cost. Cheap gas prices (although good for the consumers) will also reduce investments because of the low returns.

Government regulation and interventionism in the energy sector will also mean that foreign firms are not willing to come because of the strict processes to start a business. One major example is how Viktor Yanukovych made it extremely difficult for Lukoil to run its refinery in Odesa, forcing the Russian firm to sell its refinery to Serhiy Kurchenko, a good friend of Yanukovych’s son, Oleksandr. Overnight Mr. Kurchenko became a billionaire as a result of his relations with the previous administration.

Serhiy Kurchenko: the “chief financial officer” of the Yanukovych family

kurchenko.jpgSimilar to Firtash, Kurchenko also made a part of his fortune from importing Russian gas bought at preferential, cheap rates (through a little-known company called Lidergaz). Furthermore, much of the gas which Kurchenko distributed in Ukraine came from Dmitry Firtash. Many Ukrainian politicians and gas industry experts, after a brief of the Kurchenko-Firtash meetings by Reuters, believe that the cheap gas acquired through Kurchenko was a reward for Yanukovych from Firtash for political favors which Firtash acquired from Yanukovych in order to expand his business empire. Furthermore, Kurchenko had a reputation for being a wallet for Yanukovych- i.e., if one wants to pay off Yanukovych and/or acquire favors from him, then one uses Kurchenko as a broker.

According to the Ukrainian secret service, Kurchenko is viewed as “chief financial officer” of “the family,” which is a term for Yanukovych and his business associates (and Yanukovych’s son, Oleksandr). Although Kurchenko ardently denies any connections to Yanukovych and calls himself “an honest businessman,” a former executive of Lidergaz states that Kurchenko has a reputation for being a master of opaque commodity deals. These transactions are known to be executed in opaque arrangements, through multiple layers of complex deals. In other words, few, if any, transactions between Kurchenko and Yanukovych can be clearly found, but he does have a reputation for being the front man of Yanukovych’s corrupt business empire.

Another key aspect of Kurchenko are his notorious violations of the tax system, which are backed by Yanukovych. Kurchenko has a vast history of horrendous tax evasions, including violations going into the hundreds of millions. Furthermore, Kurchenko has developed an infamy for charging VAT on his deals, but never paying it to the government, and keeping the money for himself.

Reforms in energy sector crucial for Ukraine

Ukraine will also need to rely on its new European allies to help reform the energy sector. Ukraine uses 10 times more energy than the average industrial economy to produces its goods and services at the same level, as stated by the International Energy Agency. Europe should aid Ukraine in being more energy efficient by bringing in their energy-efficient technologies to allow Ukraine to import less gas from Russia.

The government of Ukraine can also diversify its gas sources (aside from domestic production) in an effort to secure cheaper and more secure gas. Right now, much of Ukrainian gas comes from Russia, meaning that the country can almost dictate what price it wants to sell to Ukraine. As we have seen in the past, Russia would sell cheap gas to its middlemen allies while significantly increasing the price after the pro-EU government came into power in early 2014. Diversification of energy sources will thus lead to less leverage from Russia and the possibility of securing cheaper gas (compare to what they are paying right now from Russia). Although Ukraine had the privilege of buying cheap Russian gas ever since its independence, today, the breakdowns in relations with Russia have led to a higher gas price, increasing the need to diversify gas from other sources.

Finally in the long term the government should exploit Ukraine’s human capital in an effort to develop the country’s renewable energy usage. Although Ukraine might not be in a fiscal position to support these people right now this should definitely be in their long term goal. International institutions, NGOs and non-profits should also support R&D in sustainable energy. With the human capital Ukraine is definitely capable to become a key research center for renewable energy. This final initiative will definitely help the country to become energy independent.

What Poroshenko’s government is facing will be no easy task, but what is going on in the energy sector also cannot continue. The oligarchs still have a significant influence in Ukraine, and breaking their powers will be a huge challenge. Moreover, in an effort to reduce the budget deficit and imports, the government has already cut subsidies to gas prices which accounted for over 7% of the country’s GDP, meaning that consumers will be paying for a higher price than before. However all this will be like bitter medicine for Ukrainian society, as nobody likes rising energy prices. With a little sacrifice Ukraine will see an energy sector clean from corruption, while reducing its imports from Russia, improving its balance of trade and potentially becoming a gas exporter. Foreign firms will come in and extract gas, helping the country to be energy independent while providing sufficient tax revenues for the government to stabilize the country.

One of the first, but most controversial steps, that the Ukrainian government has made is to have one gas price, instead of two: for industries and general household. As a result of this, household energy prices go up significantly. However this move prevents individuals from abusing the difference in gas prices. Influential figures would buy gas designated for households at the cheaper price and then selling it to industries and industry price, thus making large amounts of profits. Yes, this increase in energy prices is extremely harsh on consumers, but it is a move to prevent the oligarchs from dominating the energy sector, reaping off government revenue. This problem, though, can be temporarily, if the government does pursue further economic reforms such as increasing domestic production and diversification of energy sources.

Ukraine must essentially change its whole strategy to give cheap gas prices to the consumers. Instead of just buying gas and subsidizing the prices, the government should instead create investment incentives to bring foreign firms to diversify various gas sources (instead of just Russia), and allow gas prices to fall.

The current crisis in Ukraine will force the country to undertake these reforms in an effort to secure aid from the IMF and its Western friends. Ukraine has no choice but to reform the energy sector which has been greatly abused by a few individuals and mismanagement for many years. The country is heading in the right direction, implementing reforms such as floating gas prices and starting to eliminate the use of middlemen, but this is going to be an uphill battle. The oligarchs are still present, some are still increasing their shares and influence in many energy companies. The next step is to now create incentives to attract foreign investors who can extract shale gas and bring in technologies to make energy usage in the country more energy efficient, thus sailing Ukraine to the path of energy independence while continuing the process of deoligarchization.

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Shane Suksangium is a senior (fourth year student) at Tufts University studying International Relations and Economics, specializing in Europe and the Former USSR

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Igor Herbey is an American-educated economist who is a former commodities trader in Ukraine. In addition to being an analyst at the U.S.-Ukraine Foundation, Igor is a political advocacy professional in Washington D.C., and is currently pursuing a Juris Doctor degree at Georgetown Law. He is originally from Izmail, Ukraine.

Edited by: Alya Shandra

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  • W8post

    Nothing about Tymoshenko and her fortune made in the energy sector?!