Crux (#10 October 2014)

Sensitive Energy

The policy of improving energy security is still being worked on. The Ukrainian government is once again facing the problem of energy dependence on the eve of the growing cold and coming heating season. The scale of problems appeared to be enormous and sector reforms Ч absolutely critical. Essentially, energy is considered engine behind its integration with the EU. This monthТs expert panel offers an opportunity to get a legal review on selected sensitive energy matters.

On 27 August 2014, the President of Ukraine Petro Poroshenko terminated the National Commission in charge of the state regulation of public utilities, and the National Commission in charge of the state regulation in the energy sector, instead he established the National Commission on the state regulation of energy and public utilities. How would this new regulator influence the energy sector in Ukraine?


Yaroslav Petrov counsel, Asters

From my prospective, generally, establishment of a united regulator, the National Commission in charge of the state regulation of public utilities is a positive step. Especially, establishment of the Commission will be well accepted by companies involved into cogeneration, i.e. combined production of electricity and heat. In the past under certain circumstances due to defects in the Ukrainian legislation such companies had to get licenses for production of electricity at NERC and licenses for production of heat at the National Utility Services Commission. Now such companies will be able to get both licenses in one regulatory body, i.e. the Commission. As regards compliance with the obligations of the European Energy Community (further Ч Community), it is not likely that the Secretariat of the Community will be satisfied with the Regulation on the Commission. One of the main requirements of the Community is an independent regulatory body, i.e. where neither state agencies, nor private business are able to influence the decision making powers of the Commission. The Regulation on the Commission says that its Chairman and members are selected by the President of Ukraine, which is similar how it was at NERC. I would assume that such approach contradicts the point of view of the Community Secretariat on the independence of the regulator. The recent draft acts on the functioning of electricity and natural gas markets developed by the Community Secretariat demonstrate that the Secretariat believes that in order to achieve independence of the Commission its members should be elected by the Parliament of Ukraine.

What measures should be taken to properly regulate monopolies of the electricity market to prevent their monopoly abuse?


Oleksandr Voznyuk, counsel, Asters

Fair pricing in the electricity market cannot be driven by the supply-demand equilibrium, where any deviation is indicative of abusive conduct. Objectively, we have a significant difference in production costs associated with using various energy sources: the cost of nuclear power is well below that of the heat energy, while renewable energy, such as wind, is incomparably more expensive. Thus pure competition law tools are hardly instrumental to ensure the desired fairness there. And neither straightforward price regulation is. One of the solutions that I would think of may be letting alternative (to the state-owned Energorynok) suppliers in to the market Ч this will automatically go down on the core problem and create conditions for competitive price formation. This calls for energy generating companies to make direct sales to a variety of suppliers possible. I would imagine that there are lots of issues to be considered Ч for instance dealing with forward-looking planning, overcoming technological complications, etc. A good first step at the legislative level would perhaps be prohibiting combining energy supply and transportation activities within one undertaking Ч hopefully, this will lift the main market entry barrier.

What issues of the municipal energy sector in Ukraine would you point out? What main changes should be made in the regulatory framework to address such issues?


Alexander Burtovoy, partner, Antika Law Firm

Unfortunately, today the Ukrainian municipal energy sector is going through a number of unsettled problems. First and foremost, the problem resides in the low level of energy efficiency and worn-out condition of durable equipment, lack of investments, as well as lack of effective monitoring and control systems over primary energy resources supply and consumption; complex and shadow rates settings system and others. These problems relate to consumers as well as to energy producers and suppliers.

There is a number of legislative, public and other initiatives aimed at municipal energy sector reforming, including energy efficiency improvement. Such initiatives are supported and financed by international financial organizations and donors. The government defines energy efficiency and reforms in the municipal energy sector as strategic objectives.

It should be mentioned that taking into account the demand of the market and its current state it is impossible to solve all problems existing in municipal energy sector at budget fundsТ sole expense. Nevertheless, today there is practically no effective system that would attract private funds. The main reason to explain such a situation is that there are no respective mechanisms, or guarantees, or the procedures to implement such projects are too complicated and probably corrupt.

Among legislative initiatives, it is necessary to mention a number of legislative drafts aimed at establishing private funds market in the municipal energy sector, raising the level of estimation and effectiveness of energy resources usage, establishing ESCO market in the public sector as well as in the housing and utility sectors. For instance, accepting and due performance of the act on establishing the Unified state system for monitoring the production, supply, transportation, consumption and payment for fuel and energy resources and utilities shall enable to create an effective monitoring system over energy resources consumption, to form energy balance based on accurate figures, to define the sections that require to be modernized and/or reformed first and foremost. The positive initiative also includes the On Energy Efficiency of the Buildings Act that despite its УnationalФ peculiarities shall take Ukraine closer to euro standards through the introduction of energy efficiency certification of buildings or its units. It is necessary to particularly note a number of drafts acts on amendments to the Budget Code of Ukraine, the On Energy Saving Act of Ukraine, the On Public Procurement Act of Ukraine aimed at establishing ESCO services market, including the public sector. The main objective is to create the ESCO market in Ukraine and to remove the barriers to implement long-term projects in public and municipal sectors relate to failure to conclude agreements with public organizations for more than a period of one year.

Pursuant to the Energy Strategy of Ukraine complex programs to improve energy efficiency are planned to be implemented by 2030 in order to decrease the specific consumption of energy resources by 30-35% that should significantly reduce its burden on economy, increase the energy independence of the country and competitiveness of its GDP.

What does the concept of an energy service contract imply? What provisions should it include?


Yuriy Draganchuk, managing associate, Sayenko Kharenko

Decreasing the level of consumption of fuel and energy resources as well as costs for utility services in public buildings has been the main principle in Ukrainian energy policy for a long time. However, given the absence of funds in the state and local budgets for such purpose, energy efficiency remains only declarative principle of our countryТs development.

In such circumstances it is highly important to implement the concept of energy performance contracts (EnPC) in Ukraine. Under the EnPC concept energy efficiency measures in public or municipal building (as well as private) are implemented by energy service company (ESCO) on its own (or borrowed) funds. Payments to ESCO for such energy efficiency services depend on the level of achieved savings (level of reduction in consumption of fuel and energy resources and/or costs for utility services). Hence, ESCO is only entitled to payments for its services in case actual savings are attained and most importantly in the amount and out of the funds released as a result of such savings. Consequently, the EnPC concept in its essence provides for the implementation of energy efficiency measures free of charge (on ESCO funds) at the initial stage, but the result of such measures becomes fully beneficial (in terms of financial savings) to the building manager after the term of the contract (during the term of EnPC the authority managing budgetary funds (in public sector) or building owner (in private sector) will make payments to ESCO for its services out of the funds received as a result of savings).

Currently, EnPC concept may not be implemented in Ukraine due to the existence of legal barriers. For this reason our team takes part in the EBRD project on development of legal mechanism for the EnPC implementation. With the cooperation of EBRD and other international advisors we have prepared draft acts amending Ukrainian Budget Code, procurement and energy savings legislation. In particular, the draft acts establish the main terms and principles of EnPC, provide for a clear procurement procedure and secure that funds released as a result of implementation of energy efficiency measures are kept at the local budgetary level. We believe that the latest one gives strong motivation for local budgets and goes in line with the decentralisation policy declared in our country.

What key elements should be taken into account for tax audits of energy industries?


Larysa Vrublevska, auditor, associate partner, International Legal Center EUCON

Development of the energy sector in Ukraine is taking place within the current trends of creating incentives for energy conservation in production and consumption of energy from alternative sources. To encourage the industry and to accelerate development of alternative energy production, the government provides a number of tax benefits. The benefits include a partial exemption from taxation for the companies in the energy sector, exemption from import duty and value added tax on imports of equipment and materials, and reduced land tax.

During tax audits of the taxpayers, who enjoy the benefits, they will examine if the companies qualify for the benefits in the first place and if they comply with additional conditions. For example, the additional condition of the income tax exemption is the specific use of funds that are saved by such benefits. The saved money can only be used to increase production. If the tax audit reveals violations related to the specific use of such funds, a taxpayer will have to adjust the tax payment in the current period and to pay a penalty for the period of underpayment. During audits of VAT benefits, the supervisory agency would check if the exempted goods are used for own production and if identical goods or goods of similar quality are not manufactured in Ukraine.

According to the Third energy package of the EU, companies are prohibited from simultaneously selling, transporting gas and electricity. What changes in the energy sector of Ukraine should be introduced to implement the package?


Anton Babak, associate, Lavrynovych & Partners

According to the Annual Implementation Report 2014 by the Energy Community Secretariat the unbundling of distribution network operation and deregulation of generation are absolute priorities for UkraineТs electricity market. The same is true for the Ukrainian natural gas market.

Unbundling consists of separation of generation/production of electricity/natural gas from its supply and transmission system operators.

In the field of electricity, transmission system operator Ukrenergo is legally and functionally unbundled. However, distribution and supply are still subject to legal and functional unbundling. These activities are currently concentrated with the Oblenergos (regional energy supply companies). During the process of further implementation of the Third energy package, Oblenergos are to be divided into independent legal entities in charge of either distribution or supply of electricity.

In the field of natural gas, Ukrtransgaz (as a transmission system operator) is a subsidiary legally unbundled from Naftogaz and is not engaged in production or supply. However, functional unbundling between Ukrtransgaz and Naftogaz has not yet been implemented. Further unbundling is called to ensure managerial and decision-making independence of Ukrtransgaz from Naftogaz. Recently, the Cabinet of Ministers of Ukraine adopted new amendments to the Action Plan for the Implementation of the Obligations under the Treaty Establishing the Energy Community (Resolution No.864-р of 17 September 2014). The amendments, among other things, impose obligations on the respective government bodies to provide draft acts on the implementation of EU directives on further unbundling in the fields of gas (2009/73/EC) and electricity (2009/72/EC).

What are features of commercial disputes involving energy market players?


Taras Poshyvanyuk, partner, FCLEX Law Firm

Running a business in a market economy gives rise to a large number of disputes between the participants of such relationships. Many such disputes are resolved beyond the court room. However, there is a widespread practice of УshowdownsФ in court.

At the same time, especially interesting are disputes arising between the parties within the energy market. It should be noted that proceedings within the energy sector are usually characterized by claims running into millions and often contain a political component, as an active participant in this segment of economy is the state plays through her company with the Companies it controls, such as SJSC Naftogaz Ukraine Ч in oil and gas industry, SE Energorynok Ч in the electricity supply sector.

Economic disputes involving the business energy market can be divided into three layers: the first one includes disputes relating to the privatization of state owned enterprises, the second layer consists of the disputes related to the collection of debts under agreements concluded, and the third one includes disputes related to access to energy sources (gas and oil fields) and to sale of energy carriers in Ukraine, as well as export beyond Ukraine.

Besides, the number of litigations with participation of the companies in the energy sector tends to rise. This trend is caused primarily by the unstable economic situation in the state and change of power, resulting in redistribution of influence spheres, including in the energy market.

Reverse gas supplies from Europe to Ukraine may be challenged by the Russian Federation in international arbitration. What arguments might Russian gas monopoly Gazprom and European companies have in this regard?


Markian Malskyy, partner, head of West-Ukrainian Branch, Arzinger

As far as we know, the European agreements with Gazprom do not contain any provisions on the prohibition of re-export of Russian gas (unlike the Ukrainian agreement). Consequently, after being injected in the cross-border gas metering station, the ownership rights for such gas are being transmitted to a European company. The owner disposes of such gas at its sole discretion. It has the right to re-export it to Ukraine by means of reverse supply.

From a legal point of view it is crucial that the reverse itself is not virtual, but actual. Provided that the Russian gas, in fact, does not reach the border of Ukraine and Europe, and the offset takes place only on paper Ч it turns out that Gazprom is paying for the transportation of the gas, which eventually remains in Ukraine. Such a case may theoretically give some arguments for the Russian supplier to raise a claim against European countries and Ukraine, but in each case the specific provisions of gas supply contracts shall be studied.

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