Ukraine is a country with scarce natural hydrocarbon resources, and domestic production of natural gas and oil covers only 20%-25% and 10%-12% of demand respectively. Average annual oil and gas production amounts to 18 billion cubic metres of natural gas and 4 million tons of crude oil. The highest output of oil (including gas condensate) was achieved in 1972 (14.4 million tons), and the highest output of gas in 1975 (68.7 billion cubic metres).
Three major petroliferous areas in Ukraine are located in the west (the Carpathian region), the east (the Dnipro-Donetsk region) and the south (the Black Sea and the Crimea region). More than 214 oil and gas fields are now under exploitation.
The transportation of oil by trunk pipeline in Ukraine is carried out by Prydnystrovya trunk oil pipelines in the east and the Druzhba trunk oil pipeline in the west. The idea of a Euro-Asian transCaucasian transportation corridor through Ukraine to European countries is viewed as one of the possible ways of diversifying oil supply to Ukraine.
The strategic importance of Ukraine's gas and oil transportation system is determined by its advantageous geographical position between the major gas-producing regions and major gas consumers in Europe, and the connection of Ukraine's transit gas pipelines with the trunk gas pipelines of neighbouring countries. The developed gas pipelines networks include 36,700 kilometres of gas pipelines, 72 compressor plants and 13 underground gasholders, and transport 93% of the Russian gas exported to European countries.
Legislative framework
Under Ukrainian law, oil and natural gas are treated as mineral resources of national importance. Generally, the legislation governing mineral wealth exploitation is equally applicable to oil and natural gas exploration and development. The main laws regulating this area are:
- the Code of Ukraine on Subsurface, dated July 27 1994 (132/94-VR);
- the Law of Ukraine on Oil and Gas, dated July 12 2001 (2665-3);
- the Law of Ukraine on Production Sharing Agreements, dated September 14 1999 (1127-14);
- the Law of Ukraine on Mining in Ukraine, dated October 6 1999 (1127-14);
- the Law of Ukraine on the Exclusive (Maritime) Economic Zone of Ukraine, dated May 16 1995 (162/95-VR);
- the Law of Ukraine on Pipeline Transportation, dated May 15 1996 (192/96-VR); and
- the Law of Ukraine on Protection of the Environment, dated June 25 1991 (1264-12).
Pursuant to the Constitution of Ukraine, subsurface resources are the property of the people of Ukraine. The state and local authorities exercise the right of ownership to subsurface resources on behalf of the people of Ukraine. Foreign citizens and legal entities have the right to use subsurface resources in accordance with applicable Ukrainian law.
Regulatory bodies
The authority to regulate the use of oil and gas natural resources is vested in the following bodies:
- the Cabinet of Ministers of Ukraine;
- local councils;
- the Ministry for Ecology and Natural Resources;
- the Ministry of Labour and Social Policy;
- the National Electricity Regulatory Commission; and
- the Ministry for Fuel and Energy.
Subsurface use permits
Under the Law of Ukraine on Licensing Specific Types of Entrepreneurial Activity, dated June 6 2000 (1775-3), the exploration of natural resources is subject to licence.
Oil and natural gas licences cover, in particular:
- the erection and dismantling of well-drilling units for prospecting for oil or gas;
- the drilling of wells for prospecting for oil or gas; and
- the extraction of oil or gas for exploration purposes.
Any enterprise is eligible to apply to the Ministry for Ecology and Natural Resources for a licence if it meets the requirements set forth by law.
According to Article 13 of the Oil and Gas Law, special permits must be granted for the following types of activities:
- geological survey of oil and gas natural resources, including exploration and industrial development of deposits;
- extraction of oil and gas (industrial development); and
- construction and exploitation of underground facilities unrelated to oil and gas extraction.
Special permits for subsurface use are granted to oil and gas companies, and to properly qualified individuals with the necessary material, technical and economic capabilities to exercise subsurface-use rights. Foreign legal entities and individuals are expressly permitted to obtain subsurface-use rights, and are thus free to apply for a respective permit.
Permits for the use of oil and gas natural resources may be granted for the following terms:
- geological survey of oil and gas natural resources, including development of deposits - up to five years;
- geological exploration of oil and gas natural resources with subsequent industrial development of deposits - up to 20 years;
- extraction of oil and gas (industrial development) - up to 20 years; and
- construction and exploitation of underground facilities unrelated to oil and gas extraction - up to 20 years.
There is a special procedure for issuing a permit to use strategically important natural resources. Mineral deposits that hold a minimum 15 million cubic metres of gas or 15 million tons of oil are considered strategically important to the Ukrainian economy. The Cabinet of Ministers is involved in licensing strategically important natural resources and holds special meetings to review relevant applications.
Under the regular procedure, permits are issued on a competitive basis. The Oil and Gas Law stipulates that special permits for the use of oil and gas natural resources shall be granted according to the procedure established by the Cabinet of Ministers. Under this procedure, permits are awarded through tenders held by the Ministry for Ecology and Natural Resources. Within 30 days of the date on which the winner of the tender is announced, the winner and the authorized governmental authority must enter into an agreement setting forth the conditions for use of the relevant oil or gas resources. The licence must be issued to the winner no later than 60 days from the date on which the tender results were announced. The winner must commence operations within 180 calendar days of the date on which the licence is issued.
Ukrainian law provides a number of incentives for the efficient exploration and development of natural resources. For instance, if a subsurface user discovers a new field, it will have a pre-emptive right to obtain a special permit for the extraction of oil and gas on a relevant land parcel.
A permit for subsurface use is dependent on the local council's approval of the allocation of land to the licence seeker. The Ministry for Ecology and Natural Resources determines the size and boundaries of each land parcel granted for use, and the winner of the tender can commence its activities only upon receipt of the licence. According to Ukrainian land law, the land parcel is granted for use by way of a lease agreement with a local council or local state administration. The term of such lease agreements may not exceed 50 years.
The development of oil and gas deposits is subdivided into (i) exploration and industrial development, and (ii) industrial development. The development of a deposit or a separate field may be commenced only once the Ministry of Fuel and Energy of Ukraine has adopted a decision on such development. Mining allotment permits for the industrial development of oil and gas, or the exploitation of underground facilities unrelated to the extraction of oil and gas, are issued by the Ministry of Labour and Social Policy.
Payments for oil and natural gas production
In addition to general corporate taxes, companies utilizing natural resources must pay special subsurface use charges. These charges comprise:
- payments for the use of natural resources;
- fees for exploration works carried out at the state budget's expense;
- excise tax;
- fees for the issue of special permits; and
- rental duties for extracted oil and gas.
To promote private investment into the development of less accessible deposits (ie, deep-lying oil and gas layers) and depleted fields, the state offers certain tax privileges to exploration companies. According to Presidential Decree 433/96, dated June 17 1996, exploration companies do not pay rental duty for oil and gas extracted from these deposits in excess of a base volume throughout the entire term of the deposits' extraction. They are also exempt for a 10-year term from fees for exploration works carried out at the expense of the state budget. The Cabinet of Ministers updates and approves the list of less accessible deposits from time to time.
For demographic, social and environmental reasons, Ukrainian law may establish extraction quotas for particular types of natural resources, including oil and gas.
State supervision and control
The Ministry of Ecology and Natural Resources and its local divisions exercise state control over the geological exploration of subsurface resources.
The Ministry of Labour and Social Policy and its local divisions supervise and ensure the protection of works on geological exploration.
According to their competence, local councils and state administrations, the Ministry of Ecology and Natural Resources and its local authorities monitor the utilization and preservation of subsurface resources.
Production sharing agreements
Under the Production Sharing Agreement Law (the PSA Law), the state mandates an investor to explore, develop and produce natural resources at a certain subsurface site within a certain timeframe. The investor undertakes to perform this work at its own expense and risk, with subsequent reimbursement of its expenses (cost recovery) and receipt of compensation in the form of a portion of the profitable products.
The PSA may be bilateral or multilateral, if investors assume joint and several responsibility. The Cabinet of Ministers and relevant local authorities act as a party to the PSA on behalf of the state, while the other party may be represented by a group of investors consisting of several Ukrainian or foreign citizens or legal entities.
The PSA Law provides for governmental guarantees with respect to various approvals (eg, licences and permits) in favour of the investors. However, the PSA Law states that these approvals shall be issued in accordance with the requirements set forth by Ukrainian law. In addition, a special permit on implementation of the PSAs must be obtained.
The Cabinet of Ministers approves the list of mineral deposits that may be exploited under the PSA. The investor can apply to the Cabinet of Ministers or to the State Inter-Agency Commission seeking inclusion of any newly discovered mineral deposits in this list.
As a general rule, the PSAs are awarded to the winner of a tender held by the State Inter-Agency Commission. However, if a deposit has inadequate mineral reserves (below the threshold established by the Cabinet of Ministers), an investor may be awarded the PSA without a tender upon a decision of the Cabinet of Ministers and the respective local self-government body.
The PSA's term of validity is determined by the parties, but may not exceed 50 years from the date on which it is signed.
Transfer of title
The state and the investor distribute product extracted under the PSA. To this end, parties to the PSA should:
- specify the total volume of extracted product and its value;
- specify the cost-recovered portion;
- distribute the profit portion between the state and the investor; and
- transfer the relevant part of the profit portion or its monetary equivalent to the state.
The cost-recovered portion may not exceed 70% of total quarterly production, until the investor has recouped his investment.
The state retains ownership of the product until it is distributed among the parties to the PSA. At the time of production sharing, the ownership rights to the cost-recovered portion of the product and the profit portion of the product are vested in the investor.
An investor is free to use and dispose of a portion of extracted natural resources determined by the PSA. Such product is not subject to a licence or quota regime. An investor is obliged to sell its portion of the extracted product within Ukraine only if this is expressly stated in the relevant PSA. Any other limitations of an investor's rights are not permitted, unless expressly set forth in the relevant PSA.
The title to assets created and acquired by the investor in the performance of its obligations under the PSA is passed on to the state if the value of those assets is completely covered by the cost-recovered portion of production. However, the investor enjoys a pre-emptive right to utilize further such assets.
Geological, geophysical, geochemical, technical, economic and other data obtained as a result of work performance belongs to the state.
Investment incentives
For the duration of the PSA, the investor may pay certain taxes in kind rather than making cash payments.
Investors and subcontractors are exempt from licensing and quota regimes when importing equipment necessary to perform work under the PSA, as well as when shipping this equipment back out of Ukraine upon implementation of the PSA. This equipment is not subject to value added tax (VAT) or customs duties (with the exception of customs fees).
The product obtained by the investor is subject to VAT when sold locally, but is not subject to any tax or customs duty (with the exception of customs fees) when exported out of Ukraine.
The PSAs may establish specific depreciation rates other than those envisaged by applicable law.
Profits received under the PSA are exempt from profit repatriation tax when taken out of Ukraine.
Funds received by a foreign investor under the PSA are exempt from any restrictions on conversion into Ukrainian or foreign currency, and may be repatriated abroad under the terms and conditions of the PSA. Any requirements for the mandatory sale of foreign-currency proceeds do not apply to these funds.
Foreign citizens engaged in the PSA's implementation may be employed without any need for special permits.
Forcible withdrawals of funds from bank accounts which an investor has opened in Ukraine in order to finance operations under the PSA are not permitted.
The investor may only assign its rights and obligations under the PSA to any legal entity or natural person with the state's prior consent, and as long as the assignee has sufficient financial and technical resources, as well as experience in managing the activities envisaged by the PSA. If the investor receives no answer within 90 days of the date of its request, the state's consent is deemed to have been granted.
The PSA Law also provides certain tax exemptions for investors, and indemnifies investors against any adverse changes in Ukrainian law. The state may waive its court immunity, preliminary injunction immunity and judgment enforcement immunity.
Pipeline transportation
The pipeline transportation system of Ukraine consists of a trunk pipeline transportation system and an industrial pipeline transportation system.
The state-run trunk pipeline transportation system is of paramount importance to the national economy and security. Privatization of the state-run trunk pipeline transportation enterprises is prohibited. However, trunk pipeline transportation facilities and terminal stations for oil, gas and derivative products constructed at the expense of municipal or private owners after June 15 1996 may be held in municipal or private ownership.
The title to industrial pipeline transportation facilities is transferred in accordance with applicable Ukrainian law.
The following activities are subject to licence:
- oil and oil product transportation by a trunk pipeline;
- natural gas and oil transportation by pipeline, as well as its distribution;
- natural gas supply under a regulated tariff;
- natural gas supply under an unregulated tariff; and
- storage of natural gas in amounts exceeding the thresholds determined by the licensing conditions.
The licensing authority is the National Commission of Ukraine on Energy Regulation.
The transportation and distribution of natural gas may be carried out on the basis of a concession agreement.
Legislative framework
The following laws set forth the Ukrainian energy sector's legal, economic and organizational principles of operation:
- the Law of Ukraine on the Energy Industry, dated October 16 1997 (575/97-VR);
- the Law of Ukraine on Energy Conservation, dated July 1 1994 (74/94 VR);
- the Law of Ukraine on Natural Monopolies, dated April 20 2000 (1682-3);
- the Laws of Ukraine on Permitted Activities in Nuclear Power Utilization Areas, dated September 11 2000 (1370-14) and on Utilization of Nuclear Power and Radiation Safety, dated February 8 1995 (39/95-VR); and
- the Law of Ukraine on Concessions, dated July 16 1999 (997-14).
Energy sector analysis
The Energy Industry Law governs the generation, transmission, supply and utilization of energy.
The regulation of the Ukrainian energy industry has certain peculiarities due to the following operational conditions and requirements:
- the need to maintain a continuous balance between the generation and consumption of electric energy;
- Ukraine's unified energy system, in which consumers are supplied by thermal power plants and boiler houses through a centralized heat supply; and
- the existence of natural monopolies.
The Energy Industry Law defines the 'unified energy system' as Ukraine's power stations, electric and thermal networks and other energy industry facilities, which are unified by a joint regime of generation, transmission and distribution of electric and thermal energy under a centralized administration.
Regulatory bodies
The authority to regulate the generation, transmission, supply and utilization of energy is vested in the following bodies:
- the Cabinet of Ministers;
- the Ministry for Fuel and Energy;
- the National Electricity Regulatory Commission (NCER);
- the State Committee of Nuclear Regulation of Ukraine;
- the State Inspectorate for Exploitation of Power Stations and Electric Networks; and
- the State Inspectorate for Supervision of the Consumption of Electric and Thermal Energy.
Division of authority
The Ministry of Fuel and Energy is the key regulatory authority in the energy industry. Its responsibilities include the following:
- regulating the fuel and energy sector;
- pursuing government policies in the sector;
- ensuring energy safety at national level;
- proposing economic incentives for promoting the development of the fuel and energy sector; and
- participating in the formation, regulation and improvement of the fuel and energy market.
Governmental control in the energy industry is exercised by the State Inspectorate for Exploitation of Power Stations and Electric Networks and the State Inspectorate for Supervision of the Consumption of Electric and Thermal Energy, as well as by other authorities specified by Ukrainian law.
The NCER is the highest regulatory authority, which is responsible for:
- granting licences to perform different types of activities in the energy industry;
- formulating the tariff policy;
- establishing a procedure for controlling operations on the wholesale electric energy market; and
- imposing sanctions for violation of the rules and conditions for the performance of activities in the wholesale electric energy market.
The NCER regulates natural monopolies in the energy industry and businesses operating in related markets.
Among others, the following spheres are identified as natural monopolies: (i) the transmission and distribution of electric energy, and (ii) the centralized supply of thermal energy.
'Related markets' include the generation of electric and thermal energy in excess of the set thresholds, and the supply of electric energy.
Regional energy suppliers may not refuse to enter into an agreement for electric energy supply with customers located within their territory of operation.
Facilities
Under the Energy Industry Law, the following are treated as energy industry facilities:
- power stations (other than the nuclear sections of nuclear power plants);
- power substations;
- electric networks connected to the unified energy system;
- boiler houses connected to the centralized heating system; and
- the centralized heating system.
Energy industry facilities may be both state and privately owned. However, the Energy Industry Law provides that the following assets may not be subject to privatization:
- property securing the integrity of the unified energy system and the centralized supply administration;
- trunk and interstate transmission lines; and
- the property of nationally important research institutions.
The State Privatization Programme for 2000-2002 included certain provisions which relate to the privatization of fuel and energy companies. For example, only majority shareholdings (exceeding 50%) in an open joint stock company are offered for sale, and only 'industrial investors' are eligible for the acquisition of these majority shareholdings. In order for an interested party to qualify as an industrial investor, one of two conditions must be met. The first is that, for at least three years, it must have:
- been engaged in the production of commodities (or performance of works, or provision of services) which are similar to the principal commodities (works, services) produced by the target company;
- utilized the commodities (works, services) of that company in its main production; or
- used the produce of that company as raw materials.
No offshore company may act as an industrial investor.
Pursuant to the Presidential Decree on Some Issues of the Privatization of Companies within the Power Industry, dated August 2 1999, the Regulation on the Procedure for Holding Tenders for the Sale of Shares in Energy Companies was approved. Under this procedure six regional energy suppliers were successfully privatized in 2001.
The Law on Concessions determines that the right to use state or municipal property for the production and/or transportation of electric energy, or for the provision of services related to the supply of thermal energy, may be awarded by concession. Under a concession agreement, an authorized executive agency or local government body grants the concessioner the right to create or significantly improve a specific facility, and to manage it for purposes aimed at serving public needs. A foreign investor may also act as a concessioner.
Licences
Special licences to generate, transmit and supply electricity are granted pursuant to the instruction and relevant rules of the NCER.
The NCER grants a separate licence for each of the following types of activities:
- electric energy generation (where the facility's installed capacity is equal to or over 5 megawatts (MW), and for wind power stations, regardless of their installed capacity or energy output);
- electric energy transmission by trunk and interstate transmission lines;
- electric energy transmission by local electric networks;
- electric energy supply under a regulated tariff;
- electric energy supply under an unregulated tariff; and
- wholesale electric energy supply.
The term of the licence is established by the NCER, but may not be less than three years.
Activities in the area of nuclear power utilization are covered by the Law on Permitted Activities in Nuclear Power Utilization Areas and the Law on Utilization of Nuclear Power and Radiation Safety.
Administration of the unified energy system
In Ukraine, a centralized administration for the generation, transmission and supply of electric energy is in place. Administration is carried out by the State Enterprise 'Energorynok'. All business entities operating within the unified energy system of Ukraine are subject to the centralized administration.
Wholesale electric energy market
The sale of all electric energy generated by power stations with installed capacity or output exceeding the threshold indicators, and all wholesale trade in electric energy, must be carried out on the wholesale electric energy market.
Electric energy is not subject to obligatory sale on this market if it is:
- consumed by a power stations for its own needs;
- generated by power stations with an installed capacity of less than 20 MW;
- generated by power stations whose aggregate electric energy output into the unified energy system in the last year was less than 100 million kilowatts per hour; or
- generated by thermal power plants which belong to energy suppliers and which are designated for consumption within a specific territory.
The wholesale electric energy market operates on the basis of a general agreement between:
- the power generation companies (four thermal power stations, two hydro-power stations and the State Enterprise 'Energoatom', which includes five nuclear power stations);
- the wholesale electric energy supplier, Energorynok; and
- regional electric energy suppliers (27 Oblenergos).
The market's operation, the methods for load sharing between energy generation facilities and the bases for the calculation of tariffs are established by the rules of the wholesale electric energy market, which form an integral part of the general agreement.
The wholesale electric energy market operates under the following principles:
- All business entities engaged in the generation and supply of electric energy will have equal access to the market and to electric network services, as long as a relevant licence is available;
- Electric energy is sold and purchased according to the rules of the wholesale electric energy market;
- Tariffs for electric energy produced by power generation companies and wholesale tariffs are calculated in accordance with the rules of the wholesale electric energy market; and
- All operators on the wholesale electric energy market must enter into agreements for the sale and purchase of electric energy with Energorynok, based on the provisions of the general agreement.
No other wholesale electric energy markets are permitted.
Cash settlements on the wholesale electric energy market
Both wholesale and regional electric energy suppliers must open special settlement accounts to handle transactions for electric energy traded on the wholesale electric energy market. These accounts are designated exclusively for the accumulation of funds received for electric energy, and their further transfer to the seller's current account and to the accounts of any other wholesale electric energy market participants involved. The special settlement accounts may not be subject to forcible withdrawals or suspension of banking activities. At present, Prominvestbank is the financial institution authorized to provide these special settlement accounts.
An NCER formula is applied to transfers by Prominvestbank of funds received from electric energy consumers without payment orders. Under this formula, funds from the special settlement accounts of Oblenergos will be transferred to Energorynok's special settlement account, except for a certain percentage owed to the Oblenergos. Funds paid for electric energy purchased by Oblenergos on the wholesale electric energy market are directly transferred to Energorynok's special settlement account.
Funds from the special settlement account of Energorynok are then forwarded to the current accounts of power generation companies and other business entities involved in energy production and transmission. Energorynok prepares daily reports on financial settlements for all participants on the wholesale electric energy market.
The terms for opening a special settlement account and for fund transfers are included in the mandatory terms of agreements for the sale and purchase of electric energy.
Outlook
Some positive changes have occurred in Ukraine's energy industry in recent years. The rate of cash payments for the consumption of electric energy has increased significantly. However, the profitability of regional suppliers still remains low; this may be partially due to electricity losses during transmission through local electric networks. At the same time, a more competitive model for the wholesale electric energy market has been developed and is under discussion. The liberalization of the energy industry is expected to gain momentum after the Spring 2002 parliamentary elections.
In the meantime, the upcoming second stage of privatizations will offer new investment opportunities for foreign investors. Utilizing state or municipal property by concession may be another attractive way to invest in the energy industry of Ukraine.
For further information on this topic please contact Igor Svechkar or Gennady Molchanov at Shevchenko, Didkovskiy & Partners by telephone (+380 44 230 6000) or by fax (+380 44 230 6001) or by email ([email protected]).