‘DNR’/‘LNR’: creative destruction

The ‘DNR’ and ‘LNR,’ which were declared to be terrorist organizations by the Ukrainian Office of the Prosecutor General, are causing economic collapse on the occupied territories. According to the State Statistics Service, industrial production in these districts has decreased by 55-80% within the past months, compared to what it was before the war. Many of the mines, factories and much of the infrastructure suffered serious damage, some objects cannot be restored. The overall cost of restoring Donbas, occupied by ‘DNR’/‘LNR’, may reach several dozen billion dollars. The government claims losses of 16 billion USD. Nonetheless, there is a ray of hope: this destruction may help Ukraine. Donbas was the ‘capital of coal mining’ in Russian and Soviet empires. However, Donbas’ ‘Golden Age’ is long gone. Productivity peaked in the 1970’s, and since then coal extraction has been going down. Cheaper replacements emerged, and the reserves of comparatively easily extractable coal were being gradually exhausted. Many of the mines are fighting for survival. Why did large-scale coal extraction last? Huge subsidies were issued for this purpose. In 2013 the government spent 13,3 billion UAH to subsidize coal extraction at state-owned mines. This amount of money is close to the budget of the Defense Ministry or the MIA. The government has been trying to shut down the unprofitable mines for a long time, however this step was a minefield for the politicians. One Ukrainian government did not even survive a miners’ strike. The coal industry had powerful protection of several of Ukraine’s richest people, and they expressed huge will to continue subsidizing the mines using state funds. The experience of other countries shows that the closure of the cola industry is detrimental both from the economic and political perspectives. For example, in Great Britain. Besides, subsidizing coal extraction in Ukraine was not only expensive but also distorted the economy. In particular, every state-owned mine received subsidies which were supposed to cover the difference between predicted expenditures and sales. Nonetheless, the calculation of the subsidies was tied to extraction, so they amount on non-enriched coal which was extracted, and not the sales, so-called trading coal. As such, the mines were interested in extracting low-quality coal which had no export market, and mixed in coal from illegal mines to receive full subsidies. Such illegal mines flourished – they did not pay taxes and did not bother with safety measures. As a result, there was too much supply of coal. The surplus went to export: 740 million USD in 2013. So, Ukraine not only subsidized its own electricity production, but also that in other countries. The project of the 2013 state budget gave 13,3 billion UAH to subsidies, however, the sector ‘won the right’ to demand 15,2 billion. This scheme led to inefficient use of resources and weakened the region’s further development. What will happen if Ukraine buys coal from other sources? As the exchange rate is fluctuating dramatically, and the information on coal extraction on territories controlled by the ‘DNR’ and ‘LNR’ is clearly incomplete, we are using 2013 measures, which may be considered a typical peacetime year. In 2013 a ton of coal in Ukraine cost about 600 UAH, meanwhile the price of Ukrainian coal from a state-owned mine, a subsidy receiver, was about 1600 UAH per ton. As such, every ton of Ukrainian coal from state mines costs about 1 thousand UAH of subsidies or 120 dollars at the exchange rate of 8 UAH per USD. Devaluation possibly improved the situation in a way, however both prices and expenditures are changing. Which is why subsidies per ton of coal could have also grown. The price of South-African or Australian Coal constitutes about 95-100 USD per ton: 75-89 USD per ton FOB Richards Bay plus 20 USD for delivery to Ukraine. The Ukrainian government bought South-African coal at a price of 86 USD per ton, however, after the inclusion of delivery to thermal power plants and other expenses, the price constituted 110 USD per ton. Russian coal is even cheaper. Even after significant devaluation of the Hryvnia, the cost of imported coal is 20% lower than the coal which is extracted from domestic mines. Besides, imported coal could be higher in quality. It has a lower ash content, and higher thermal productivity, so less of it is needed. Let us return to calculating the expenses. State-owned mines in Ukraine in 2013 extracted about 10 million tons of coal, the ‘waste’ constituted at least 20 USD per ton. So, we can draw a conclusion. The replacement of coal extraction from state-owned mines with imported coal will help us save 200 million USD at least each year. Coal subsidies are a huge hole in Ukraine’s budget, which would cost hundreds of millions. However, the war in the East of Ukraine ‘solved’ this problem differently. The Ministry of Energy and Coal reported that 12 mines had been destroyed, 55 out of 93 mines do not work, extraction had gone down from 70 to 30 thousand tons per day. On the territory Ukraine controls, only five state-owned mining companies work with 37 mines. Only 20% of labor force is involved – about 14 thousand workers. It seems that these extraction companies continue to receive subsidies from the Ukrainian government. Another 14 state-owned mining companies with about 60 thousand workers are on the territory controlled by the ‘DNR/LNR.’ It is obvious that these territories have no resources to pay subsidies. It is unlikely that the Russian sponsors of ‘DNR’/‘LNR’ will agree to pay. Even in better times, the Russian government decided to close down the mines in Rostov oblast, where the coal mining industry was in a better state than the coal industry of Ukraine. With increasing sanctions, the resources of the Russian government are quickly depleting, and expenditures on subsidies of coal extraction are beyond the capabilities of even the most ardent ‘Novorossiya’ supporters. As such, the coal industry on the territories controlled by the ‘DNR’/‘LNR’ is on the brink of bankruptcy. The consequences of this collapse are most likely to be long-term. If a mine does not work for a long time and is not maintained appropriately, the expenses of restoring it may be too steep for its launch. Ukraine had a huge problem: high cost of coal from state mines and a powerful political lobby to retain subsidies for the coal industry. Some of these subsidies stayed in the pockets of the lobbyists. Money wasting was ubiquitous. War with Russian terrorists cost us many lives and the destruction of the industry. However, some destruction may be useful. This will increase the speed of redistributing resources towards more productive goals, heighten the efficacy of use of limited human and financial resources and may lead to a significant technological jump in Donbas. Besides, this may bring indirect benefits. For example, destruction may increase energy efficiency and decrease CO2 emissions. Of course, it is not easy to find jobs for unqualified workers. The experience of the UK and Germany with closing inefficient mines shows that a significant number of miners were unable to find jobs where their salaries would be close or higher to those they received at the mines. Can this problem be solved? The government can ‘materially encourage’ the workers of state mines to seek employment in other places. For example, we can promise to pay them part of the salaries they earned before, allow them to find another job and earn additional pay as a supplement to these payments. In 2013 the average salary of a miner was 6 thousand UAH, in other industries – 3265 UAH, and the minimum wage was 1147 UAH. If the government pays minimum wage to the miners, and they are able to additionally earn money somewhere else in the economy, their overall income will constitute 4,5 thousand UAH. This additional pay to the miners will cost the Ukrainian budget 1 billion UAH a year. Importing 10 million tons of coal to produce electricity – the volume of crude coal from state-owned mines taking into account the higher quality of imported coal will cost 800 million USD or 6,4 billion UAH with the 2013 exchange rate. So the overall cost will constitute 6,4 billion UAH. This amount is smaller than then 13,2 billion UAH of subsidies the government paid in 2013, and smaller than the 15,2 billion UAH ‘earned’ by the state-owned mines. As such, it is best for Ukraine to import coal and pay minimum wage to the workers of state-owned mines. In the short-term perspective, the subsidy decrease will save additional money for the state budget. The volume of coal extracted from state mines on the territories controlled by the ‘DNR’/‘LNR’ constitutes 8 million UAH. If we do not pay subsidies, 1 thousand UAH per ton, we can save 8 billion UAH in 2013 prices. Obviously, this ‘creative destruction’ will not solve all the problems. For example, someone has to control the ecological safety of the closed mines. The government will have to help the people who will have lost their jobs through re-qualification programs and monetary assistance. These programs can be costly, but they will be cheaper than subsidizing the coal industry. Most importantly, they will invest money in the region’s future success, and not the wasteful support of a dying industry.