Gas sales to industrial consumers and budget …Gas sales to industrial consumers and budget organizations (non-regulated prices) 2.7 1.5 1.3 1.2 0.4 0.3 0.2 1.5 Naftogaz Ukrnafta

Gas sales to industrial consumers and budget organizations

(non-regulated prices)

Market share

(in bcm, 2015)

Preliminary segment results for Naftogaz

(in UAH bn, 2015)

7.4

29.8

Gross profit

Revenues

Naftogaz24%

Other76%

1

Gas sales to industrial consumers and budget organizations

(non-regulated prices)

2.7

1.5

1.3

1.2

0.4

0.3

0.2

1.5

Naftogaz

Ukrnafta

DTEK

Burisma Holdings

Ukrnaftoburinnya

Geo-Aliance

JKX

Other private producers

Gas sales to non-regulated segment, bcm Gas production, bcm

2

2015

Roadmap to efficient gas market in Ukraine

3

New Law

on the Regulator

New Regulator: insulated from political meddling

+ not influenced by oligarchs + competent

= trusted by market participants

1

Roadmap to efficient gas market in Ukraine (cont’d)

4

Amend Secondary Legislation to

Implement EU Network Codes etc.

Liquid daily market:

OTC/Exchange

Counterparty

risk

management

Access to forex

+ capital

2

Is secondary legislation 100 % compliant with 3EP?

Developed by the European Commission

DIRECTIVE 2009/73/ECby Energy Community

REGULATION (EC) No 715/2009

by Energy Community

Transposed by the Energy Community

• COMMISSION REGULATION (EU) No 312/2014

Network Code on Gas Balancing of GTS

• COMMISSION REGULATION (EU) No 984/2013

Network Code on Capacity Allocation Mechanisms

• COMMISSION DECISIONS (EU) 2015/715

amending Annex I to Regulation (EC) No 715/2009

on conditions for access to the natural GTS

• COMMISSION REGULATION (EU) 2015/703

Network Code on interoperability and data

exchange

DIRECTIVE 2009/73/EC

Concerning common rules

for the internal market in

natural gas

REGULATION (EC) No

715/2009

on conditions for access to

the natural gas transmission

networks

3EP

Secondary

Legislation

5


6

Amend Transit Contract with Gazprom

to comply with EU Rules

Shipping code

pairs

Interconnection

agreements

Unrestricted

entry/exit to

Ukrainian GTS,

inc. VRFs*

Non-

discriminatory

application of

new entry/exit

tariffs

Unbundling of

the TSO

Western Partner

for the TSO

Western

partners for

UGSs

* – Virtual Reverse Flows

3

Backhaul will enable additional West-to-East capacity

EU neighbouring countryAvailable for backhaul

as of July 2014

Expected in

July 2017*

Poland 0 4

Hungary 0 6

Slovakia 0 38

Romania 0 19

Total 0 67

Notes: * estimates based on actual physical gas flows from Ukraine to Poland, Hungary, Slovakia and Romania in 2015

Interconnection

Agreements signed

between UA and TSOs

of all neighboring

countries

No Interconnection

Agreements

bcm / year

Improves energy security of Eastern and Southeastern Europe

Leads to fair market pricing for regional buyers

Opens access for EU companies to Ukraine’s vast underground storages

Interconnection Agreement (already signed between UA and HU TSO) improved

cooperation and expanded opportunity for security gas supply of EU countries (firstly SK,

PL, HU, BG)

Backhaul:

7


8

Amend Supply Contract with

Gazprom to comply with EU rules

“Hub minus Transportation” prices

for Russian gas in UA

Non-regulated

household prices

Competition in retail

4

Source: Bloomberg. Energy conversion for NCG and CEGH prices as 1 tcm = 10,41 MWh (GCV) – for calorific parity with Gazprom's price for Naftogaz

* – Future prices are based on estimated cost of transportation as of Mar-2016

Cost of transportation from NCG to Ukrainian border is calculated for average private importer for booked capacities for 1 month.

USD / ’000 m3

Russian gas price for Naftogaz and market prices

9

0

100

200

300

400

500

600

Ja

n'1

0

Ma

y'1

0

Sep'1

0

Ja

n'1

1

Ma

y'1

1

Se

p'1

1

Ja

n'1

2

Ma

y'1

2

Se

p'1

2

Jan'1

3

Ma

y'1

3

Se

p'1

3

Ja

n'1

4

Ma

y'1

4

Se

p'1

4

Ja

n'1

5

May'1

5

Se

p'1

5

Ja

n'1

6

Ma

y'1

6

Se

p'1

6

Ja

n'1

7

Ma

y'1

7

Se

p'1

7

Ja

n'1

8

Ma

y'1

8

Se

p'1

8

Russian gas price for Ukraine (according to the contract with Gazprom)Russian gas price for Ukraine with agreed discounts (including "winter packages")NCG price netted back to Eastern Ukrainian border*NCG price plus cost of transportation to Western Ukrainian border

Expected costs of transportation from UA/RU border to NCG in Mar-2016 is about 82-85 USD/’000 m3

Expected costs of transportation from NCG to UA/SK border in Mar-2016 is about 40-45 USD/’000 m3


10


Non-regulated household prices

Privatization of gas production

Corporate Governance

reform of Naftogaz

0% Royalty Tax + Fair Auctions

for new gas production licenses

Supervisory Board: insulation

from political meddling and

graft

Increase in Production

5


11

New Regulator:

insulated from political

meddling + not influenced by oligarchs + competent

Counterparty risk

management

Access to forex + capital

Unrestricted entry/exit to

UA GTS, incl. VRFs

Non-discriminatory application of new entry/exit

tariffsWestern

Partner for the TSO

Western partners for

UGSs


Privatization of gas

production

Increase in Production

Development of a hub

EU off-takers of Gazprom have economic incentives to change

delivery points to UA/RU border

6

12

Gas Market Law is a framework

Implemented through the secondary

legislation:

Network Codes, Rules of Supply,

Tariffs, Rules of Security of Supply,

National Prevention Plan, etc.

Gas Market Law impact on local gas market liberalization

New Market, Old Regulator?

13

• Fair Regulator: competent, independent from other

market participants and from political meddling

• Efficient market needs a Fair Regulator

• The Law on Regulator was supposed to be adopted

simultaneously with Gas Market Law. And?

Case study: Gas Market Law vs Secondary Legislation

Gas Market Law Secondary Legislation

Completely new law drafted by the Energy

Community Secretariat (ECS)

Key concepts developed by World Bank

consultants

Regulator, regional distribution companies

(DSO):

a) claimed that the Law wouldn’t work due

to local specifics;

b) suggested to amend existing legislation

Regulator, DSOs:

a) claimed that it wouldn’t work due to local

specifics;

b) Insisted on using their drafts

Minister of Energy Y.Prodan made political

decision to use the ECS draft

Energy Minister V.Demchyshyn made

political decision to take the Regulator’s side

Amendments to the ECS draft were possible

only if proved that provisions wouldn’t work

otherwise, as required by the Deputy

Minister of Energy I.Didenko, head the

working group

No consensus was reached between the

World Bank consultants and Naftogaz on

one side and the Regulator and DSOs on

the other side. Minister V.Demchyshyn

chaired the working group

Naftogaz role: show viability of the ECS draft Naftogaz role: scream about problems

Amendments subject to ECS confirmation ECS could raise their objections ex-post

Result: Success Result: ?

14

The ultimate goals of restructuring at this stage are reaching compliance with the Law in respect of the TSO separation, establishing framework for foreign partnership in the

TSO, employment of the best practices of the natural monopolies regulation.

All other forms of restructuring of Naftogaz lie within the competence of the Naftogaz supervisory board

Separation of transmission activities or full Naftogazrestructuring?

The Third Energy Package (3EP), i.e. Directive 2009/73/EC

sets a clear mechanism to eliminate discrimination regarding

access to the GTS – it requires effective separation of

transmission from production and supply activities

EU

The Gas Market Law introduces EU requirements regarding

separation and independence of the TSO into the Ukrainian

legislation

Gas Sector Reform Plan, adopted CMU and approved by the

World Bank, provides for Naftogaz restructuring aimed at

separation of transmission activities in compliance with the Law

15

• Naftogaz should get a right to assign the transit contract

with Gazprom to the unbundled TSO

• The TSO should get a new state owner with sufficient

independence from the CMU

• If somebody wants to consider finding a private owner for

the TSO, he should look at legislative limitations for

private control over GTS

Critically important factors to be considered selecting the model

Naftogaz pointed out three legal problems, that should be

addressed when deciding on the model (FOU, ISO or ITO) or

timing of the unbundling:

16

Why a foreign partner is needed for the TSO?

bring the necessary commercial and technical know-

how to enhance cost efficiency

defend Ukraine’s interests as a transit country, incl. in

debates over Nord Stream-2

facilitate raising capital for GTS modernization

fight potential corruption and fraud

TSO is unbundled not to “imitate reforms”, but to:

• help developing an efficient gas market;

• increase the value of the Ukrainian GTS as an asset to the people

of Ukraine.

Engaging a western partner in the operating GTS will:

17

Source: McKinsey & Company, EY

NO technical hurdles for separation

Technical perspective

No cross-subsidization stimulates

efficiency improvement

Transparency of TSO and SSO

Market-based relations between TSO

and SSO mitigate potential

corruption and fraud

TSO and SSO should be separate entities

UGS in Ukraine vscountries where TSO and SSO are one entityin bcm

No effect. Ministry of Energy enforces

security of supply via the Rules and the

National Preventive Plan

Security of Supply

• Almost 140 UGSFs in Europe

• 2/3 of SSOs are separated, only in 4 states

SSOs are together with TSOs

Transmission business is more

attractive

Investment attractiveness

Capital needed to “enter” the market will

be much smaller for TSO partner

Unbundling of Storage System Operator

RO

UK

ES

BG

EL

IT

FR

NLDE

DK

PL

CZ

AT HU

IE

PT

BE

SK

LT

LV

EE

FIN

SE

UA

Total EU-28,

108

UA, 31

LV, 2.3

BE, 0.7BG, 0.6

SE, 0.01

n/aTSO and SSO single entity Separated Both

18

Has the consensus on the future unbundling been reached?

• The “Trust Fund” project led by the World Bank but financed by

the EU was supposed to find solutions to key problems

• The project started in May’14

• Our concern was that the selected consultants did not have

experience in unbundling under the EU legislation

• Ministry of Energy insisted that these consultants should advise

the government on unbundling

• EC provided a consultant with a relevant practical experience but

as we understand this consultant had a very limited role, if any

• WB consultants presented their final report on February 9

• The report contains no answers on how to deal with the

mentioned legal problems

19


• Ministry of Energy, instead of working on the core problems

of unbundling (incl. legal ones), focused on taking as many

as possible of Naftogaz subsidiaries from its control.

• Ministry of Energy was to develop and agree with the ECS

the concept of unbundling by November 2015 and submit a

plan to CMU till February 2016.

• It is only in February that the Ministry presented a

misfocused concept

• EC already raised valid concerns about the submitted

concept

No consensus on the future unbundling, structure and composition

of Naftogaz of Ukraine has been reached. Is splitting up of

transportation and production and storage the most effective

approach?

20

3EP has neither requirements nor recommendations regarding

separation of upstream from trading activities

• absence of the gas sales function in UGV

• PSO mechanism whereby UGV sells all its gas to Naftogaz

• sales price is regulated by PSO Act until April 2017

• significant tax liabilities for Naftogaz if UGV is unbundled.

Separation of UGV from Naftogaz lacks commercial rationale due to:

This “idea” of separation ignores obvious benefits of vertical integration

McKinsey working for the National Reform Council advised to increase

the role of the corporate center (next slide).

Why Ukrgazvydobuvannya (UGV) may not be currently separated?

21

Level of operational control for corporate center

Strategic Architect

Portfolio Manager

Focused Operator

▪ CC focuses on maintaining financial control and result

▪ CC issues guidelines and enables linkages across BUs

▪ CC enforces standard processes and ensures synergies

▪ CC drives integration, leverages common skills and executes

▪ NG lacks control over subsidiaries and effective centralization of relevant activities

▪ NG needs to tighter control to overcome transition challenges and improve efficiency

▪ More decentralized model may be built as NG would consider exiting from some assets

Today

Transition

period

Long-

term

Low High

Strategic Controller

Impli-

cations

▪ Key subsidiaries have

independent Boards

▪ NG performs strategic oversight

of subsidiaries via boards, no

interference in day-to-day

operations

▪ No separate Supervisory

Boards: subsidiaries act as

business units of NG

▪ NG is actively engaged in day-

to-day operations of subsidiaries


22

Corporate governance reform of the TSO and priority actions

Progress of the reform of the management structure of the

Ukrainian gas transmission system and priority actions

• CGAP for the TSO was developed by EBRD but put on hold at the

request of the WB – it should provide for professional management

insulated from political meddling and graft

• Technical assistance from western partners is being discussed

Priority actions

• Set up new “bankable” TSO

• Start developing efficient operating model

• Corporate governance compliant with OECD guidelines

• Amend transit contract with Gazprom

• Complete the unbundling

• Attract reputable western partner to operate GTS

23

Modernization of the Gas Storage and the GTS as a key condition to create regional gas hub

Secured by the EBRD and EIB loans

Key conditions:

• Economics: Russian gas in Ukraine priced at hub – transport, not hub +

transport (100 vs 200 USD tcm)

• Rule of law: EU Regulation, Independent Regulator and TSO with a

Western partner, trusted courts and law enforcement

• Market integrity: currency controls, credit risk etc.

But it is a misconception that modernization of infrastructure is a

key condition

24

Is vertically integrated national oil company a workable concept?

Is the proposed vertically integrated national oil company (on the basis of government stakes in Ukrnafta, Ukrtransnafta and Ukrtatnafta) a

workable model and could it raise efficiency, output and create value for public purse?

• Arguably makes economic sense

• Unlikely agreement between Kolomoyskiy and the government

• We are not working on this proposal

• Would rather suggest privatization of Ukrnafta

25

Old transit tariff vs New entry/exit plus RAB tariff

Effect from implementation of new entry/exit tariffs on cost of transit via Ukraine

(for Gazprom) in 2016 when current non-regulated contract between Gazprom

and Naftogaz for transit of 110 bcm is converted (from 01.01.16) into a regulated

contract for capacity booking of 110 bcm pa till 2019, and Gazprom utilizes 110

bcm of the booked capacities in 2016.

Notes: own preliminary estimates as of Mar-2016 (including fuel component).

* – until Jan’2016 gas transit services were exempt from VAT. According to December 2015 changes in Tax Code of Ukraine, these

services are already taxed by VAT.

“Transit assets” are fully

depreciated by the date of the

transit contract expiration, given

little reasons to expect material

volumes of Russian gas transit

through Ukraine beyond 2020

USD bn.

26

3.17

6.35

0.40

0.72

2.06

Costs based on old tariff

Switch to RAB

VAT*

Use of accelerated depreciation

Costs based on new tariffs

+12,7%

+20%

+48,0%

Notes: own preliminary estimates as of Mar-2016 (including fuel component)

* – Calculations assume that in 2020 under the ship-or-pay clause Gazprom will pay for capacity booked with SK and CZ TSOs. This is the opportunity cost of the Nord Stream-2

** – Though Gazprom pays app. 0 for transit through Belarus, these costs are estimated given "hidden subsidy" for Russian gas (i.e. import price for Belarus is much lower)

*** – Costs of fuel gas used for Portovaya Compressor Station (pumps gas through Nord Stream -1) are artificially allocated to Russian consumers thus decreasing transit costs

278

146

73

74

103

58

66

54

48

0 50 100 150 200 250 300

Nord Stream-2 (exp. in 2018 - 2% utilization)

Nord Stream-2 (2019 - 20% utilization)

Nord Stream-2 (2020 - 90% utilization)

Ukrainian route (old tariff)

Ukrainian route (new tariffs, 2016)

Ukrainian route (new tariffs, 2020)

Yamal-Europe**

Nord Stream-1 *** (2015 - 71% utilization)

Nord Stream-1 *** (90% utilization)

Transportation through Russian territory

Transportation via other pipelines controlled byGazpromTransportation through Ukraine (pipelines notcontrolled by Gazprom)Transportation from UA/SK border to Germanborder

Transportation costs for Gazprom of Russian gas delivered to Germany via different routes

Ukrainian route vs Nord Stream-2: economics should come first

Doubling of Gazprom's Nord Stream pipe is a politically motivated concept.

Calculations show that by the time the Nord Stream-2 becomes fully operational,

taking gas to Germany through Ukraine will cost 20% less. Route through Ukraine

remains the only one fully operational and not controlled by Gazprom

USD/'000 m3

In 2020 the cost of transportation

through Ukraine will be lower

27

Cost of gas transportation via different routes

10.00

20.80

2.49

3.60

2.55

5.12

3.50

2.57

Expected cost of transit via Nord Stream-2 (2019, 20% utilizationof 55 bcm capacity)

Expected cost of transit via Nord Stream-2 (2018, 2% utilization of27,5 bcm capacity)

Nord Stream-1 (expected average cost in 2015)

Nord Stream-1 (average cost in 2014)

Slovakia (2016) *

Ukraine - average expected cost in 2016 based on approved tariffs(RAB, accelerated amortization) and 116,6 bcm of actual transit

(incl. fuel component)

Ukraine - average expected cost in 2016 based on RAB, normalamortization and 116,6 bcm of actual transit (incl. fuel component)

Ukraine - old tariff for Q1'16 (incl. fuel component)

Average cost of transit

USD/’000m3/100km

Notes: own preliminary estimates as of Mar-2016.

* – transmission cost is calculated for 5 years contract from 01/01/16 till 31/12/20 in the amount of 214 GWh / day (20 mcm/day), input data is taken from the website

of the Slovakian TSO, forecasted prices for fuel gas as of 14/01/16; forecasted Bloomberg currency exchange rates for 2016-2020; forecasted indicator of GCV at

10.7 MWh/kcm and forecasted adjustment of tariff for inflation.

28

Booked

capacities,

bcm/year

Entry tariff after 2019,

USD/'000m3 of

booked capacity (incl.

VAT)

Average exit tariff

after 2019,

USD/'000m3 of

booked capacity

(incl. VAT)

30 3.3 10.4

50 2.5 7.2

70 2.0 5.6

90 1.7 4.6

110 1.4 3.8

120 1.4 3.6

150 1.1 2.9

Expected transit tariffs after 2019

Notes: own preliminary estimates as of Feb-2016.

Change in depreciated cost of transit gas transmission assets (V), used for

calculation of gas transportation tariffs

2014 2020 2035-2045

V After Gazprom

statements

Before Gazprom

statements

~10 times lower than

current approved tariffs

“Gas transit assets” will be fully depreciated by 2020, values of the “regulated return on assets” and “depreciation” components in the

structure of tariffs are expected to become low. Tariffs will be reset at a much lower level starting from January 2020.

29

Evolution of market conditions from 2016 to 2020 +

NON-COMPETITIVE price of gas

imported from Russia

2009 Contract terms with Gazprom

COMPETITIVE price from the EU

EU oriented gas imports

Supply from EU dominates, can fully

substitute supplies from Russia in

2016

LOW flexibility for flows across the

borders

Contractual bottlenecks at all but

one IPs at the border with EU;

Backhaul is not possible under

existing contracts structure

COMPETITIVE Price of gas imported

from Russia

Hub-minus-transportation

NON-COMPETITIVE price from EU

HIGHER import from Russia due to

attractive pricing

+ Possibility to re-export surplus of

imported Russian natural gas

DEBOTTLENECKING at all

interconnection points

Backhaul operations are introduced;

Bidirectional gas flows at all IPs

NO RUSSIAN GAS

Under conservative scenario

Imports from EU to cover peak

consumption

FREE flows of gas across the borders

Full infrastructural, legal and

contractual integration with the EU

transmission system

2016 2017-2019 2020

+

GTS and UGS are not attractive for

investments

Infrastructure is used inefficiently due

to uncompetitive practices by

Gazprom => future cash flows are

uncertain;

GTS and UGS are attractive for investments

Given predictable cash flows, TSO becomes attractive for Western partners;

Very cost-attractive Ukrainian transit route of the East-to-West gas corridor; Attractive capacity products are offered by SSO + competitive gas price from RF =>

shippers are incentivized to store gas in UGS and trade during the periods of peak

consumption

30

Documents

Gas sales to industrial consumers and budget …Gas sales to industrial consumers and budget organizations (non-regulated prices) 2.7 1.5 1.3 1.2 0.4 0.3 0.2 1.5 Naftogaz Ukrnafta