Photo: Oleksandr Gimanov/AFP/Getty Images
Brief by Ben Cahill and Leslie Palti-Guzman
The aim of the bipartisan and internationalCSIS Ukraine Economic Reconstruction Commissionis to produce a policy framework that will help attract private sector investments to support Ukraine''s future economic reconstruction. To support the commission, CSIS will convene a series of working groups to examine a range of issue-specific areas that are critical for reconstructing and modernization of the Ukrainian economy, including in agriculture, energy, and transportation and logistics, as well as addressing the impact of corruption on private sector investment.
In a postwar period, Ukraine will gravitate toward the European Union and its energy system. As Ukraine rebuilds and adapts to a new geopolitical reality, achieving energy security will be instrumental to put the country back on its feet, and Ukraine will require assistance from international donors. To facilitate the financing of new energy infrastructure, Kyiv will position its gas resources and infrastructure as a potential asset for Europe''s energy security and energy transition.
This brief examines the role of natural gas in Ukraine''s energy future. It begins with an overview of gas in the country''s energy system and economy. The brief then outlines the importance of natural gas infrastructure among other reconstruction priorities and examines the role of Ukraine''s gas resources and infrastructure in a lower-carbon Europe.
Ukraine has a diverse set of energy sources, with nuclear energy playing a prominent role (see Figure 1). Fossil fuels remain Ukraine''s largest source of primary energy, with coal and natural gas accounting for the largest shares. Due to its substantial hydrocarbon resources and its nuclear energy industry, Ukraine was able to meet about two-thirds of its energy needs through domestic production before Russia began its unprovoked war in February 2022.
Before the war, nuclear energy typically provided more than half of Ukraine''s electricity generation. The generation mix has fluctuated as Ukraine copes with extensive, targeted Russian attacks on its energy infrastructure that have knocked out some 50 percent of the country''s generation capacity. Ukraine''s Zaporizhzhia nuclear power plant is now offline, with all six of its reactors in shutdown mode, as the facility remains occupied by Russian troops and at risk of shelling and damage.
Renewable energy (including wind, solar, hydro, and biomass) grew from under 2 percent of Ukraine''s generation capacity to around 11 percent by 2020. In 2021, Ukraine set a target to expand the share of renewables to 25 percent of total generation capacity by 2035. Various factors will make it hard to reach these targets, but renewable energy deployment will be a key priority in postwar reconstruction efforts.
Natural gas plays a relatively small role in power generation. Natural gas makes up only 7 percent of Ukraine''s electricity generation, but this share could grow after 2030 to back up intermittent renewable energy and offset the shrinking share of coal generation. Energy efficiency will be a key area of focus postwar to reduce gas consumption in residential use.
By contrast, gas plays a critical role in household and district heating. About 80 percent of Ukrainian households rely on centralized gas supply and more than half use centralized water supplies that are heated by gas. Households, district heating for household and non-household use, and industry account for roughly equal shares of Ukraine''s gas consumption (see Figure 4). This widespread reliance on gas for heating creates vulnerabilities. Attacks on natural gas infrastructure such as pipelines could create a humanitarian risk in the cold winter months.
Ukraine is one of the largest gas resource holders in Europe, with 38.5 trillion cubic feet (tcf) in proven reserves as of the end of 2020. Its gas reserves, according to BP''s Statistical Review of World Energy, grew by an annual average of 3.9 percent between 2009 and 2019, compared with reserve declines in most of Europe. Domestic gas resources have been sufficient to meet about 70 percent of Ukraine''s gas demand in recent years.
State-owned gas company Naftogaz has historically dominated the domestic gas sector. Since 2016, it has typically accounted for about 70 percent of Ukraine''s gas production. In 2022 its subsidiary UkrGasVydobuvannya produced 13.7 billion cubic meters (bcm), alongside 5 bcm from private companies and 1.1 bcm from Ukrnafta. Naftogaz is Ukraine''s largest company and employs more than 50,000 people. In the first half of 2022, it provided 53.5 billion hryvnia (US$1.8 billion) to the state budget in royalties, income tax, and other taxes—equivalent to 20 percent of the state budget.
The natural gas sector in Ukraine benefits from extensive infrastructure, but the war has placed energy assets at risk. The country''s gas transportation network is one of the most extensive in the world, with 38,600 km (nearly 24,000 miles) of pipelines (transmission and distribution). But sustained attacks on the country''s gas production will impact its ability to remain self-sufficient. Strikes on Ukraine''s energy infrastructure have targeted the electricity transmission grid, leading to increased dependence on gas for power generation. Above-ground gas extraction facilities are more vulnerable to attacks, while 90 percent of gas pipelines are underground.
Ukraine traditionally served as a key transit route for Russian gas exports to Europe, but over the past decade its gas trade relationships have evolved. After the breakup of the Soviet Union, Ukraine was heavily dependent on Russian gas imports. Its extensive gas infrastructure and status as a gas transit route from Russia to Europe were some of the main strategic assets for the newly independent country. But its sovereignty created an uncomfortable mutual dependence between Ukraine and Russia.
Long-standing disputes between Russia and Ukraine over contract terms for gas transit volumes culminated in Ukraine''s 2015 decision to stop importing gas from Russia. The two countries had argued for years over prices, contract length, and the use of take-or-pay contracts. Ukraine''s outstanding debts had climbed as the country rejected price adjustments by Gazprom. Between 2005 and 2020, Ukraine''s gas transit volumes dropped from 136 bcm per year to 42 bcm per year.Today''s transit is governed by the 40 bcm per year deal signed by Russia and Ukraine in December 2019 to cover the 2021–2024 period. However, Ukraine transit volumes reached just 18.7 bcm in 2022.
Ukraine may need to rely more on gas imports from its Western European neighbors this winter and next as Russia targets the country''s critical energy infrastructure. But actual imports will depend on further military activities, levels of domestic gas production, import gas prices, supply availability, and demand destruction due to the war.
Ukraine can secure additional gas volumes from its neighbors, but at a high cost. Last year, Ukraine covered approximately one-third of its 33 bcm gas needs through imports from the rest of Europe; the remainder came from domestic production. Ukraine has a firm import capacity of 54 million cubic meters per day (mcm/d) from Poland, Slovakia, and Hungary. These countries will continue to send small volumes of gas to Ukraine throughout the war.
Securing financing for gas imports could become a winter priority. Some gas or liquefied natural gas (LNG) suppliers will not sell gas directly to Ukraine under long-term contracts due to Naftogaz''s credit risk and high political risk. Lenders including the European Bank for Reconstruction and Development (EBRD) and the Export-Import Bank of the United States have facilitated Ukraine''s winter gas purchases.
Despite the vulnerability of Ukraine''s transit volumes from Russia, Europe''s gas infrastructure partnerships are providing new options. Ten years ago, Ukraine began to plan for Black Sea LNG import terminals, despite Turkey''s opposition to any LNG tankers entering the Bosporus, but these plans have since stalled. However, another proposal along these lines resurfaced this year. Turkey''s company Karpowership is also attempting to supply electricity to Ukraine through its LNG-to-power floating power plants, which would be located offshore Romania.
Ukraine and Europe remain on high alert for preparing for the winter of 2023–2024 as the continent will need to refill gas inventories this summer with very limited Russian supplies. The International Energy Agency estimates that Ukraine will need to import more from its neighbors, possibly 5 bcm, to refill its storage levels to 14 bcm ahead of the next cold season.
Ukraine''s energy resources should be a pillar of postwar economic recovery, but the future role of natural gas in Ukraine depends on a few critical uncertainties. Key factors include the status of Russian gas transit, the ability to invest in domestic production and attract foreign investment, and the scale of international financial support to rebuild and redesign Ukraine''s future energy system.
The future of Russian gas flows to Europe via Ukraine remains a wildcard that will impact Ukraine''s revenue after the war and the sense of usefulness of its large transmission network. There are several possibilities.
First, Russian gas could keep flowing via Ukraine''s gas grid into 2024 and beyond. Ukraine''s current take-or-pay contract for Russian volumes expires in 2024. The parties could continue the transit agreement beyond 2024, providing Ukraine with much-needed income.Ukraine''s transit revenues reached roughly US$2.06 billion in 2020 and were set to amount to US$1.27 billion per year in 2021–2024 following a deal between Gazprom and Naftogaz. However, over the past decade, Russia has worked on bypassing Ukraine with Nord Stream 1 and Nord Stream 2. In the unlikely scenario that one of those pipelines begins to ship gas, the future of Ukraine''s gas transit utilization could be threatened again.
It is also quite possible that Russian gas will stop flowing via Ukraine before or after 2024, and as a result Ukraine''s gas network would be used mainly to transport Ukrainian gas. The pipeline system will then be optimized for the domestic market and regional trade, providing that Ukraine can technically guarantee sufficient pressure in the pipeline in the absence of Russian gas.
Ukraine is an established natural gas producer with significant resources, but it will be challenging to attract investment for reasons ranging from security risks to regulatory and policy uncertainty.Ukraine''s most prospective areas for conventional and unconventional gas exploration are in the eastern region, including some active conflict zones. And sustaining and increasing production will be difficult without a predictable regulatory framework that can attract foreign investment. To realize its potential, Ukraine will have to resume some of the gas market reforms it initiated in the latter half of the 2010s but abandoned several years ago. This will mean grappling with the dominant role of Naftogaz and the limited space currently available to private investors.
Ukraine''s market structure and pricing regime are clearly important concerns for potential investors. If Ukraine hopes to attract more foreign investment for gas exploration and development, important reforms would include new legislation to enhance rule of law and create a stable investment regime. Transparent, predictable policies for exploration and development licenses will also be essential.
Preferences for state rather than private investment in the energy sector could also be a challenge. The energy sector in Ukraine has historically been dominated by the state, and private producers currently produce only about 5 bcm per year. A monopoly over gas transit and extensive control of the gas industry left the fully integrated Naftogaz in a privileged position. In the company''s latest annual report, the Naftogaz chief executive officer states that until recently "the gas transit business made the company look more successful than it really was" and "governance bodies became too complacent over what was essentially parasitic behavior."
Private companies would prefer to see structural reforms to limit Naftogaz''s control. But to date there is no clear indication that postwar economic reforms will include a renewed effort to create a more level playing field and force Naftogaz into more of a commercial role. Indeed, the rollback of liberalized pricing will likely benefit the state gas company, and it is likely that Ukraine''s government will view state companies as central players in reconstruction and economic development.
A number of regulatory reforms could help Ukraine enhance its appeal to investors. A few action items include:
The longer the war lasts, the costlier Ukraine''s reconstruction will be. It is difficult to estimate a sum as the war continues, but in September 2022, Ukraine, the European Union, and the World Bank pegged the cost of reconstruction and recovery at US$349 billion. Since the war started, the United States has provided approximately US$32 billion in assistance to Ukraine, including nearly US$200 million in emergency energy sector support and acquisition of critical grid equipment.
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