On 9 April 2015 the Parliament of Ukraine adopted Draft Law No. 2250 “On the Natural Gas Market” (the “Law”), which the President is expected to sign in the coming days. The Law transposes Ukraine’s commitments under the Energy Community Treaty and the so-called “3rd Energy Package” of the European Union (namely – Directive 2009/73/EC concerning common rules for the internal market in natural gas and Regulation No. 715/2009 on conditions for access to natural gas transmission networks) and with Directive No. 2004/67/EC concerning measures to safeguard security of natural gas supply into Ukrainian legislation.

The Law was drafted in close cooperation with the Ukrainian government, state-owned oil and gas company Naftogaz, and the Energy Community Secretariat. The adoption of the Law proves Ukraine’s commitment to further reform of the gas market and its approximation to EU rules. In turn, the success of the gas market reform in Ukraine is crucial for the security of gas supplies in the CEE region and is expected to have a strong impact on EU energy policy.

Below we outline the main changes introduced by the new Law and describe how it will benefit the industry.

1. Gas Market Administration. The Law establishes a number of basic principles for administration of the gas market – any decisions taken by the public authorities must comply with fundamental principles of proportionality, transparency and non-discrimination. The Law (Article 2(3)) contains a detailed explanation of these principles. Another important change is that the Ukrainian public authorities and courts will be obliged to take into account legal precedents, case law and other practices of the Energy Community Secretariat, the European Court of Justice and the European Commission in applying provisions of the Law (Article 2(2)).

2. Gas Market Regulation and Supervision (Article 4). These functions will be mostly performed by the Regulator (i.e. the National Commission for State Energy and Public Utilities Regulation). The Law only lists the main competences, rights and obligations of the Regulator, as Parliament is expected to adopt a separate Law on the Regulator’s legal status within a few months.

3. Naftogaz Unbundling. The most important and anticipated part of Ukraine’s gas sector reform is unbundling of the state oil and gas monopoly Naftogaz, which, together with its subsidiaries, currently carries out gas production, transmission and supply functions at the same time. The Law creates a proper legal basis for such restructuring.

4. Unbundling Options: The 3rd Energy Package provides for three basic models for unbundling: Ownership Unbundling (OU), the Independent System Operator (ISO) and the Independent Transmission Operator (ITO). When implementing the unbundling rules member states have to make a choice between these models. The Law provides for the implementation of two different models in Ukraine (OU and ISO). The government has to decide on which option by the end of 2015.

a. OU model (Article 23): This option is intended to effectively separate the production of gas from its transmission. Supply and production companies are not allowed to hold a majority stake in a transmission system operator (TSO), exercise voting rights or appoint its board members.

The Law provides that this option becomes applicable in Ukraine by default. The so-called “certification” procedure provides that the Regulator must verify and monitor that the TSO fulfils all the requirements laid down in the OU option.

b. ISO model (Article 27): Under this option, the transmission pipelines may remain under the ownership of a vertically integrated undertaking; however, operation and control of the day-to-day business must be transferred to an independent system operator (ISO).

The Law provides for some conditions that are necessary for the ISO model to be implemented. The Law also contains a list of guarantees and requirements that must be performed by the designated gas network operators.

However, the above-mentioned provisions and requirements (namely Articles 23-31) become applicable from 1 April 2016. Between 1 October 2015 and 1 April 2016 a special “transitional” legal regime is applicable to TSOs. In particular: 1) a TSO may not be engaged in gas production and/or gas supply; 2) if a TSO is a part of a vertically integrated undertaking (VIU), the TSO must be legally and functionally independent of the VIU’s other activities that are not related to gas transportation; 3) a TSO’s managers may not hold concurrent positions; 4) the TSO must be independent in its decisions and current business operations.

5. Independence of the Operator of the Gas Storage Facilities (GSFs) (Article 47). A GSF Operator may not be involved in natural gas production or supply. It should be legally and functionally independent from other types of activities not related to natural gas transportation and storage. Access to GSFs must be granted either on a regulated basis (tariffs to be established by the Regulator) or on the basis of bilateral contracts (Article 48).

6. Independence of the Distribution System Operators (DSOs) (Article 39). According to EU unbundling requirements DSOs may not be involved in activities related to natural gas production or supply. Currently, Ukrainian DSOs also perform supply functions, which they will have to unbundle, as the Law provides that DSOs should be legally and functionally independent from other types of activities which are not related to natural gas distribution. The Law provides that only small gas distribution companies (i.e. companies with less than 100,000 customers) can be exempt of this requirement, subject to the Regulator’s approval.

These independence requirements become applicable from 1 January 2016. Between 1 October 2015 and 1 January 2016 a special “transitional” legal regime is applicable to DSOs. In particular: 1) if a DSO is a part of a VIU, the DSO must be legally and functionally independent from other activities of the VIU, not related to gas distribution; 2) a DSO’s managers may not hold concurrent positions; 3) a DSO must be independent in its decisions and current business operations.

7. Third Party Access (Article 19). The Law provides for non-discriminatory access to gas transportation infrastructure. Access may be denied only if: (1) there is no free transportation capacity; (2) granting access may hinder the operator from the performance of its special obligations on the protection of public interests; and (3) the operator’s refusal is substantiated by the Regulator’s decision in terms of ‘take-or-pay’ obligations (i.e. Article 55 of the Law provides that in the event of severe economic and financial difficulties due to non-fulfilment of the ‘take-or-pay’ obligations the Regulator may allow the relevant market player not to comply with the rules on equal access to the gas transportation infrastructure).

8. Security on the gas market (Articles 5 and 6). The Ministry of Energy and Coal Industry must develop and adopt Rules on Security of Gas Supply and the National (Emergency) Action Plan. These regulations (mandatory for all gas market players) will cover measures and actions to be applied on the gas market in order to safeguard security of gas supply and to mitigate or offset the potential impact of a gas supply disruption.

9. Public Service Obligations (PSOs) (Article 11).  PSOs are obligations that the government may impose on any gas market players in exceptional cases and on a temporary basis in order to ensure that certain public interest objectives are met. The Law provides that such “public interest objectives” may include 1) national security and security of gas supply, 2) stability, necessary quality and accessibility of energy resources, 3) environmental protection (including energy efficiency and energy produced from renewable sources), 4) protection of individuals’ health, lives and property.

The government’s decision to impose PSOs must determine (i) a specific public interest objective, (ii) scope of the PSOs, (iii) the group of gas market players and the scope of their rights, (iv) the group of consumers, (v) regions and time periods for the gas market players’ performance of the PSOs, (vi) sources of funding and compensation for expenses to be paid to the gas market players (with due account of the allowed profit level). The selection of gas market players must be made by the government in a transparent and non-discriminatory way, based on the relevant criteria for such selection as approved by the government.

The Law (Article 11(6)) provides that financial settlements between gas market players and consumers may be performed exclusively through so-called “accounts with the special regime of use” in compliance with the Algorithm of Settlements to be approved by the Regulator. However, these provisions will expire on 1 April 2017, the date from which all relations on Ukraine’s natural gas market will become market-based, as the final step towards liberalisation of the gas market under the new Law.

10. Market Gas Pricing. The Law puts an end to the government’s practices of cross-subsidisation and non-cost reflective prices. Once the Law comes into force, in theory neither wholesale nor retail prices will be regulated. However, it is likely that the government will impose PSOs for a period until the retail prices for some categories of consumers can reach average market levels. The Law also tries to find a balance between protection of gas consumers, especially “vulnerable consumers”, which are households that are eligible for subsidies, and their right to freely select and change gas suppliers.

11. Coming into force. The Law becomes effective once signed by the President and officially published. However, most of its articles and provisions (except for a number of the above-mentioned provisions relating to the independence of TSOs and DSOs) will come into effect on 1 October 2015. On the same date, the current Law of Ukraine “On the Fundamental Principles of the Natural Gas Market” will expire.

12. Secondary Legislation. The Law not only requires Ukraine to adjust existing laws and practices in line with the Law itself, but also requires the adoption of a significant amount of new secondary legislation by the Regulator, Ministry of Energy and the Coal Industry and system operators (including the Transmission and Distribution Network Codes, Storage Code, model contracts and agreements, National (Emergency) Action Plan, certification procedures etc.). Most of these documents must be adopted before 1 October 2015, when the main provisions of the Law will kick in.