The move was not unexpected. Following a confrontation with the government in early April 2017, the chairman of Naftogaz’s supervisory board, Yulia Kovaliv, had stepped down in favor of Mr. Warwick. A third British national, Charles Proctor, resigned in protest in early September.
The significance of these changes goes far beyond a typical boardroom reshuffle. Reforming Naftogaz’s corporate governance is central to Ukraine’s March 2015 agreement with the International Monetary Fund (IMF), which unlocked a four-year Extended Fund Facility (EFF) worth $17.5 billion. This loan amounts to a life support system, without which Ukraine’s economy would likely go into a tailspin.
Well into the third year since that agreement was signed, Ukraine’s credibility is on the brink of a collapse. Trouble at Naftogaz is not the only concern. Other key elements of the IMF agreement, such as the fight against corruption and overhauls of the banking and pension systems, are also under increasing doubt. Powerful vested interests are pushing back hard against measures that threaten their revenue streams. The reforms could still be allowed to proceed, but the odds are not good.
Naftogaz is particularly important, for two reasons. One is the company’s sheer size. With 175,000 employees, it is the country’s largest taxpayer. It supplies most of Ukraine’s household heating and manages the transit pipelines shipping Russian gas to Europe.
If entrenched corruption cannot be eradicated, there is little reason
to believe Ukraine will deliver on its reform pledges
An even more important reason is that Naftogaz has long been notorious for corruption. If these deeply entrenched networks cannot be eradicated, there is little reason to believe the government will deliver on any of its other reform pledges. In this sense, Naftogaz can be regarded as the keystone of reform in Ukraine – if it crumbles, the whole edifice could come crashing down.
Outside supporters of Ukrainian reform reacted predictably harshly to the resignation of the expat experts from Naftogaz’s board. The American and British embassies in Kiev expressed concern. The regional managing director of the European Bank for Reconstruction and Development (EBRD), Francis Malige, called the situation “a crisis,” while the IMF is clearly worried that its involvement in Ukraine may be about to unravel.
Naftogaz offers important lessons for those who believe that successful economic “transition” hinges on installing young technocrats with superb academic credentials, then providing them with powerful outside support from foreign governments and multilaterals like the IMF and EBRD. While the first part of this reform recipe has merit, the second betrays a good deal of wishful thinking.
It is certainly true that the Naftogaz story demonstrates how much can be achieved with brains and dedication. Part of Ukrainian President Petro Poroshenko’s deal with the IMF was to appoint a new management team, consisting of young professionals with experience in the oil and gas industry and investment banking. The company’s 39-year-old CEO, Andriy Kobolyev, has worked wonders, turning a $1 billion net loss for 2015 into a $1 billion net profit for 2016.
The restructuring under Mr. Kobolyev has proceeded via price increases, cutting out murky intermediaries and a bold wager on transparency. The latter included the introduction, in March 2016, of the Independent Supervisory Board. The new management team also committed to the demands of the European Union’s Third Energy Package, and most importantly to “unbundling” – in this case, spinning off the company’s gas transport division, Ukrtransgaz.
Ukraine's politically vital goal of gas independence may be in reach if Naftogaz can keep expanding output
Another promising sign for Naftogaz are improvements at Ukrgazvydobuvannya, the company's upstream subsidiary. Oleg Prokhorenko, the CEO of the natural gas production company, has achieved a turnaround to profitability and, for the first time since independence in 1991, an increase in gas output. The key has been a thorough refurbishing of the company’s drilling equipment, with an emphasis on hydraulic fracking.
Thanks to these efforts, the business outlook for Naftogaz could be favorable. If the company can meet its goal of expanding production from 14.5 billion cubic meters (bcm) in 2015 to around 20 bcm (the Soviet-era high was 68 bcm), the politically vital goal of gas independence for Ukraine would be in reach. Adjusting prices toward market levels has already caused a drop in domestic consumption from 42.8 bcm in 2014 to 33.2 bcm in 2016 (less than half the 75 bcm level in 2006, when Ukraine’s manufacturing industry was still doing well). It is hoped that investments in energy efficiency will further trim demand to 26 bcm by 2020.
The improvements at Naftogaz mirror the broader achievements in Ukraine’s macroeconomic policy. The currency has stabilized, foreign reserves have been replenished and economic growth has returned. According to the World Bank, gross domestic product expanded by 2.3 percent in 2016, and growth of around 2 percent is expected for the current year. This stands in stark contrast to 2014-2015, when the Ukrainian economy contracted by 17 percent, the currency was in free fall and foreign reserves had run dry.
A powerful vote of confidence from international capital markets was the success of Ukraine’s $3 billion Eurobond in September 2017, which was placed with a 15-year maturity and a 7.375 percent yield. The sale was reported to have attracted about 400 investors and an estimated $10 billion in bids. This cash infusion will be used to clear the books of debt maturing before the 2019 presidential elections, including $1.7 billion in short-term paper. The government has also begun redeeming $1.5 billion of bonds maturing in 2019 and 2020.
Other achievements include setting up the National Anti-Corruption Bureau and embarking on a cleanup of the banking system. In December 2016, the National Bank of Ukraine declared PrivatBank – the country’s largest commercial lender – insolvent and nationalized the bank to protect its 20 million customers. The reality behind allegations of an “imprudent lending policy” was that some 97 percent of PrivatBank’s corporate loans had gone to companies linked to its shareholders.
All this explains why there is no shortage of outside observers who are upbeat about Ukraine. They feel vindicated in the belief that young technocrats can work wonders if they are given sufficient support. As recent developments have demonstrated, however, the second part of that argument is a weak link. While the reformers have shown their skills, even strong outside support has not allowed them to overcome powerful vested interests.
The empire strikes back
The magnitude of this challenge is illustrated by Naftogaz, which has a long history of predatory corporate governance. The company’s role in the Russian gas trade entailed outsourcing to murky intermediaries that used transfer-pricing schemes to siphon off massive profits. Selling gas to households at heavily subsidized prices deprived Naftogaz of the resources needed to invest in exploration and production and maintain its energy infrastructure. It also removed all incentives for energy conservation. Instead, oligarchs exploited the opportunity to devise multibillion-dollar schemes diverting cheap gas for residential use to energy-guzzling industries like steelmaking.
Young reformers with brains and commitment are facing an old guard
using political pressure and backroom deals
After the young reformers at Naftogaz showed what can be accomplished with brains and commitment, the old guard is now demonstrating the effectiveness of political pressure and backroom deals. It is being made clear that when powerful vested interests are challenged, even the most enthusiastic support from outside actors will come up short.
The IMF agreement stipulated that full liberalization of gas prices to households should have been achieved no later than April 1, 2017. As that deadline approached, the IMF called for an additional price increase of 17.6 percent. The government found this recommendation to be politically unacceptable, causing negotiations to stall.
Prices charged for household gas had risen from 725 Ukrainian hryvnia (UAH) per 1,000 cubic meters (tcm) in early 2014 to 6,879 UAH in May 2016. Even on an inflation-adjusted basis, that amounted to more than a fivefold increase in consumer prices. Close to one-third of Ukraine’s population is already living below the poverty line (defined as earning below the minimum wage) and nearly 10 million households qualify for special government support to pay their gas bills.
But the lack of political will to fully liberalize gas prices only partly explains the resignations from Naftogaz’s supervisory board. Another key failure was the divestment of Ukrtransgaz, which was effectively blocked by legal obstruction. This must be viewed in the context of recent amendments to Ukraine’s commercial and administrative codes, all of which appear aimed at making it harder to prosecute economic crimes.
Head in a coffin
This legislative backlash is part of a broader collapse of judiciary reform in Ukraine. When the government announced the new composition of the Supreme Court on September 29, it turned out that of 111 nominated judges, 85 had been negatively assessed by the Public Integrity Council (a civil society watchdog created to advise on judicial appointments), including 25 who had been rejected outright for lacking the integrity to hold public office.
The laudable ambition to clean up the banking system provides another clear illustration of pushback in practice. According to Valeriya Gontareva, who was then governor of Ukraine’s central bank, on the evening before the government nationalized PrivatBank, some 16 billion UAH ($598 million) was suddenly withdrawn, leaving the lender in serious need of recapitalization. This came at a time when the country had $13 billion of external debt to service.
The Naftogaz resignations nearly complete the exodus of the young reformers
appointed by President Poroshenko
Ms. Gontareva, who had been regarded as one of the main guarantors of economic reform, was then subjected to a brutal campaign of harassment – including placing at her door a coffin containing a model of her severed head. On April 12, 2017, she resigned. Her departure coincided with public warnings from the IMF that Ukraine’s domestic politics could derail crucial reforms and with the first defections from Naftogaz’s supervisory board.
Those resignations nearly complete the exodus of the young reformers – most of them English-speaking investment bankers – who were appointed to senior posts after President Poroshenko assumed power. The most prominent of them was Economy Minister Aivaras Abromavicius, who resigned with his entire team in February 2016, protesting that corrupt officials had blocked systemic reform and were trying to regain influence over state enterprises such as Naftogaz.
It remains possible that the government will make a renewed commitment to give Naftogaz’s management team enough political cover to keep pushing toward transparency and a sustainable business model. This would be important not just in economic terms, since it would go a long way toward rooting out the corruption that is stifling Ukraine’s energy sector. It would also send a powerful signal to investors, foreign and domestic, that vested interests are being tackled in earnest.
But the likelihood of this happening is shrinking fast. If Naftogaz’s young managers are thrown to the wolves, it will become increasingly difficult for the IMF to justify maintaining its support. It will also drive home that there is only one way of doing business in Ukraine – the old, crooked way. That is a message with severe implications.
Technocratic skills may indeed be necessary to implement radical reform, but the real challenge is breaking up the crony networks that are characteristic of the post-Soviet system. There is an important precedent here. During the 1990s, we saw the same foreign enthusiasm for young reformers in Russia – and that ended with Vladimir Putin’s “authoritarian restoration.”
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