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Tax Regime To Blame for Ukraine’s Energy Woes

Tax Regime To Blame for Ukraine’s Energy Woes

The Ukrainian government has adopted a dangerous stance on its taxation of domestic gas production. Despite the recommendations of its international partners, the Ministry of Finance continues to insist on exorbitant tax rates; the highest in Europe.

Investors, instead of actually delivering investments and work programs, which would boost the country’s production, continue to withdraw from Ukraine to more favorable business environments.

Investors care more about gas industry

For the past year, investors in the energy industry of Ukraine have listened to the government state that it will cut taxes and create an attractive investment environment for domestic gas production.

The president and lawmakers have sought to reassure current investors, heads of state, ambassadors and foreign dignitaries that issues surrounding the strategically vital energy sector will be resolved soon.

Further, the president, the prime minister, and the energy minister all state that Ukraine will be energy independent by some unspecified date but these statements are hollow at best.

Investors are leaving in droves. In terms of bad publicity from an investment standpoint, one company, JKX Oil & Gas, is suing the government, while imports are increasing and domestic production is declining significantly.

The energy minister recently admitted to investors from the European Business Council that neither he nor anyone in government has an energy strategy.

On The Brink Of Extinction

In August 2014, the Cabinet of Ministers almost doubled the rental fee for private gas producers to reach a high of 55 percent. Companies were forced to review their business plans dramatically and terminate projects that ceased to be economic. Gas production declined by 10 percent by the end of 2014 and with it, a decline in potential tax revenues for the state. Related: Carbon Emission Regulations Could Jeopardize Multi Billion LNG Projects

But this is only the beginning as gas production in 2015 is expected to decline by more than 20 percent.

It is hard to see how Ukraine can ever achieve the government’s stated goals of becoming energy independent when production has declined so dramatically, in part because of high fees. To make up for the shortfall, a decrease of domestic production will have to be compensated with further imports. This leads to further devaluation in the hryvnia (Ukraine’s currency) and higher unemployment rates.

The International Monetary Fund realized how challenging the situation is and, more than once, recommended that the government reduce the rates to the 2014 level and switch to a new income-tax based taxation system for the industry.

At the request of the Finance Ministry, IHS Cambridge Energy Research Associates analyzed the models of fiscal regimes for gas production and recommended a differentiated tax rate system for various depths until 2018 and having them reduced to no higher than 34 percent for production from depths above 3,500 meters while lowering the rates as the production depth grows. These were the “honest rates” that the energy minister promised to investors.

Position of the Finance Ministry

However, after consulting with IHS and a working group composed of consultants, investors and lawmakers, the Ministry of Finance announced that the rate must not be lower than 40 percent. In, addition, companies will have to pay the standard 18 percent income tax and in the long-term will also pay a 30 percent additional income tax instead of the rental fee. This also includes the standard income tax rate.

In other words, out of every 100 hryvnia a gas producer earns, they will have to pay more than a half of this amount to the government. The proposed taxation policy is not reasonable.

Private companies and investors offer the only chance to make Ukraine energy independent and a stable tax rate and simplified licensing procedures would allow the government to increase the volume of private production.

Three steps to Energy independence

At present five state-owned companies control around 300 licensed areas (Ukrgazvydobuvannya alone holds rights for the development of 140 of them). Ukraine lacks the time, expertise, capital and technology to develop all of these areas. Led by the energy minister and executed by the CEO of Naftogaz, data rooms of license areas can be held in Houston, Denver, Calgary and London, where the major and minor oil and gas players reside. Related: Now Is A Good Time To Pick Up Some Oil Stocks

There are several things Ukraine can do to improve the situation:

Increasing the transparency of auctions and the issuance of special permits. This will encourage and foster the development of heretofore undeveloped non-state license areas. At present, you can forget about fairness and equality before the law, since companies in which the state owns a share enjoy absolutely exclusive, monopolistic conditions. Only two special permits for exploration and development of oil and gas fields were sold through auctions last year, which is less than 7 percent of the total number of permits issued in 2014. The rest were issued to state-owned companies or without holding an auction. Historically, license areas and joint activity agreements have been used to return favors which have exacerbated corruption in the sector which, in turn, reduces potential investment, further increases the influence of a circle of companies and leads to further degradation in the sector.

Update regulations governing oil and gas field development. The existing legislative framework regulating the development of oil and gas fields is absolutely out of date. Just as European companies continuously update the industry rules and standards trying to adapt them to present-day conditions and technologies, Ukrainian companies still have to operate to the field development rules of 1984.

Overhaul the gas pricing regime. At present, gas prices are regulated by the National Energy Regulation Commission and no market player is allowed to sell gas at higher prices. This practice distorts the market and makes further development of the industry difficult at best. Ukraine has signed the Energy Charter with the European Union and, in doing so, the country must supposedly conform to market pricing which will create a competitive gas market that will allow its participants to carry on free trade under direct agreements. This has yet to become a reality, however.

The Harsh Reality

According to a study conducted by consulting company IHS Cambridge Energy Research Associates, Ukraine’s subsoil contains reserves of approximately 11.5 trillion cubic meters of gas, which, given the current level of the country’s requirements, can meet its energy needs for more than 200 years.

However, actually developing those reserves is another matter. The current leadership lacks any experience in the energy sector and is consistently held by their commitment to their respective political relationships. The finance minister, however, has shown allegiance and leadership to Ukraine. For instance, in spring of 2015, the parliament adopted a long-awaited and important piece of legislation on the natural gas market that provides for gradual and complete liberalization of the market. In response, the government even developed a consistent action plan for the reform of the oil and gas sector. Related: Cyber Threat Has Oil And Gas Majors On Edge

Since that period of time, nothing has happened. The key message investors are receiving is inconsistent and non-transparent. While announcing its intentions to make radical reforms and create proper conditions for investment in the industry, the government is actually tightening the noose. It’s creating an untenable situation in which, without investment in the sector, Ukraine will be unable to become an independent and secure energy state.

Production will continue to drop, concomitant tax revenues will decrease and dependence on foreign resources will increase. Leaders in government must develop and agree to a coherent energy strategy that increases production and investment in the sector. They cannot continue to blame the war, the former government, or political infighting amongst the coalition partners as it is really the lack of a coherent energy strategy that is to blame for the difficulties.

I have immense respect and admiration for the prime minister and finance minister, and empathy for the energy minister who was placed in a job that he had no prior experience in. They, however, are the leaders of the country. They, with the approval of the president, hold Ukraine’s energy independence in their hands. Decreasing taxes will increase investment in the sector. Increased investment will lead to an increase in tax revenues, decreased dependence on foreign gas and ultimately to an energy independent Ukraine.

By Robert Bensh for Oilprice.com

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