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Rotterdam+ formula: national energy security or bureaucratic corruption?

14 July 2017

Is energy security just a fiction?!

For almost six years, Ukraine has been participating in the European Energy Community, and three years ago, it signed the EU-Ukraine Association Agreement. This meant that reforms in the energy sector would facilitate integration of Ukraine into the European energy space. Such integration could simultaneously become a serious incentive for further internal reforms.

The primary objective of the energy sector development under the Energy Strategy of Ukraine for the coming years includes the elimination of the critical dependence of the national economy on monopoly energy sources, diversification of energy supply of Ukraine through its accession to the European market. However, the existing realities of life are making their own adjustments to a considerable extent.

Due to the hostilities in the Donbas region, all mines that extracted anthracite coal for a number of heat power plants (HPP) happened to be located on the occupied territory. Therefore, the problem of finding new energy sources for heat energy has remained acute for more than 3 years, but recent events have put the question bluntly.

The blockade of rail transportation of coal which is extracted in the territories of Donbas that are not controlled by Ukrainian authorities has become the catalyst of public attention to the situation in the electricity market of the country. As a result of the anthracite shortage, on February 15, 2017, the Ukrainian government introduced a state of emergency in the electricity sector, which has since been regularly extended. By May 2017, five out of six HPPs using anthracite had stopped their work temporarily.

What happened and why did the country turn out to be unprepared for the occurrence of the energy crisis? Was there any alternative to coal supplies from the occupied territories? In the opinion of a number of high-ranking officials, a new mechanism for the formation of the wholesale market price for electricity and the establishment of an appropriate marginal price for coal should become the answer to these questions and their solution.

Upon approval of the procedure for formation of the forecast wholesale market price, the Head of the Regulator - the National Commission for State Energy and Public Utilities Regulation (NERC) Dmytro Vovk presented a new scheme, which received the name "Rotterdam-plus" in everyday language. In his opinion, due to the use of this formula, Ukraine would have many advantages, namely:

1) autonomy from the ATO zone in implementing the plan of the accumulation of resources;

2) absence of a manual pricing regime;

3) pegging to the world prices for coal;

4) possibility of balancing the activities of state-owned mines.

Such an approach seems to be the solution to the security of supplies and many other problems in the Ukrainian energy sector. Due to the scheduled increase in the wholesale market price, it would be possible to purchase the necessary volumes of coal in advance in the European market and to create its required reserves at the HPP warehouses in case of unforeseen circumstances. But, for some reason, when the H-hour came and a complicated situation for the domestic energy sector occurred, it turned out that neither the state operator "Centrenergo" nor private DTEK and "Donbasenergo" were prepared for it.

After the cessation of solid fuel supplies from the ATO zone, on February 21, 2017,  Prime Minister Volodymyr Groysman  stated that there would be no alternative to Donbas coal for several years. Two days later, he was supported by Minister of Energy Ihor Nasalyk:  "There is no effective Rotterdam-plus price because the formula was created as a fiction and is not applied for tariff determination."

DTEK's Chief Executive Officer Maksym Tymchenko objected to these statements of the officials almost two months after they were made:  "It ("Rotterdam-plus" scheme – author's note) works with regard to the fact that the wholesale market price for electricity is formed on the basis of this formula." He stressed that there are political manipulations with the term "Rotterdam-plus". "What is called "cost-plus tariff setting system", summed up M. Tymchenko, "is the highroad to corruption".

While high-ranking officials and executives of the major players in the energy market were thinking and guessing, interpreting in different ways and applying the Rotterdam-plus scheme, the wholesale prices for electricity rose sharply, while coal reserves at the HPPs decreased to a critical level. At the same time, against the background of a deep crisis, the main players in the energy market have sharply improved their own financial performance. How could that happen? In order to understand the paradoxes of the national energy market, we decided to conduct our own investigation.

What does "Rotterdam-plus" mean in action?

On March 3, 2016, the NERC approved a new methodology  for determining the forecast wholesale market price for electricity. It determined the cost of power-generating coal (both anthracite and other types of coal produced in the country) using the following formula: "The average market price of imported coal in the ports of Amsterdam-Rotterdam-Antwerp over the previous 12 months plus the cost of its delivery to Ukraine."

"We have changed the philosophy from "cost-plus" (the price for coal), as to which we could not reach agreement, to the pegging to the international prices for coal,"  explained director of the NERC D. Vovk. "Such a peg can be a short-term solution before the transition to a new model of the market, when the Regulator does not set the price for the generation."

The Rotterdam-plus formula became effective from the 2nd quarter of 2016, when the tariff for HPP was based on the price for coal at CIF parity for the previous year (including delivery).

Among the main elements of the formation of the wholesale market price, the only "weak point" was the non-regulated tariff for HPP, which ultimately allowed the adjustment of the procedure for recalculating the wholesale market price level.

In 2016, the NERC approved a constant increase in the forecast wholesale market price for electricity by 12% (from UAH 1,178.08 per 1 MWh to UAH 1,318.69 per 1 MWh). However, by its Resolution No. 1178, dated June 24, 2016, the NERC made amendments to its previous decision, approving the increase in the wholesale market price in 2016 by 26.5% (from UAH 1,178.08 per 1 MWh to UAH 1,490.63 per 1 MWh). 

Upon approval of the forecast wholesale market price in the 1st quarter of 2017 in the amount of UAH 1,341.57 per 1 MWh, the National Commission initially planned to reduce the wholesale market price for electricity by 6% (down to UAH 1,263.76 per 1 MWh), but by its Resolution No. 377, dated March 23, 2017, the NCEPUR increased the wholesale market price by 1.8% (up to UAH 1,365.72 per 1 MWh) again.

We asked the Head of the Regulator Dmytro Vovk to comment on the sharp change in the price trend and another increase in the wholesale market price this year. We also wondered whether "Rotterdam-plus" became an incentive for accumulating resources to ensure energy security of the country, and whether there is no corruption element in this formula.

In response to our request, the Head of the NERC explained the revision of and increase in the wholesale market price in 2017 by many factors, namely: changes in the structure of production, reduction in the share of subsidy certificates, review of various tariffs, the need for additional purchases of coal due to the termination of fuel supplies, etc. However, D. Vovk, on three pages of his letter, failed to answer why the "security reserve" in the energy security sector had not been formed in Ukraine within a year, and whether there was a corrupt component in the "Rotterdam-plus" formula.

However, almost a year ago, the Head of the NERC stated that 40% of the coal for HPPs was produced in the territory not controlled by the state, and its delivery was very costly.

"To be no longer engaged in such heroism," said D. Vovk, "we decided to provide them (heat generating companies – author's note) with the budget that will definitely allow not to bring up the issue of coal procurement." That is, the Regulator deliberately based the forecast wholesale market price on an overestimated value of coal through the "Rotterdam-plus" formula. It was a kind of "tips" for suppliers to "have no problems with coal".

Interestingly: what was D. Vovk thinking of when approving a new methodology for determining the forecast wholesale market price? Was it a concern for the country's independence from coal supplies from the occupied territories or the use of official position in the economic interests of major players in the electricity market?

Why are the tariffs rising and the level of energy security is not?

During the period of the "Rotterdam-plus" scheme and the "scheduled" increase in the wholesale market price, industrial enterprises, depending on the class of consumers, began to pay for electricity 20.6-23.4% more. Against this background, electricity tariffs for the population increased 2.46-2.67 times, according to the schedule approved by the NERC Resolution No. 220 dated February 26, 2015.

However, due to the separation of industrial prices, the growth of tariffs for the population did not reach its goal – equation of prices and reduction of cross-subsidization. Obviously, the Regulator put a burden of expenses for the consumed electricity which tariffs incorporated additional profit of the generating companies on its citizens and industrial consumers, not acting in their interests.

Ultimately, the consumers paying high tariffs for electricity could hope they thereby provide a financial contribution to the energy security of the country, to reforms in the national energy sector, help to create a sufficient reserve of power-generating coal for heat power plants during the blockade of its supplies from the uncontrolled territories. That was stated by the authors of "Rotterdam-plus" when the methodology for determining the forecast wholesale market price for electricity was approved.

This did not happen though. An inquisitive reader would ask a natural question: Why? Let's analyze together what has happened in the power-generating coal market over the last 1.5 years, based on public information.

The fuel cost component reaches 80% in the structure of the price for electricity at the coal HPPs. Therefore, it is important how much, which brands and from where the coal is delivered for generation, to ensure energy security of the country.  According to the press center of Ukrzaliznytsia, 8.1 million tons of coal were transported from the occupied territory in 2015, and more than 6.2 million tons in 2016. What will happen now that coal supplies from the occupied Donbas region are completely blocked?

According to the forecast fuel structure  for 2017, the the Ministry of Energy and Coal Industry schedules annual supply of 7.9 million tons of anthracite and 20.1 million tons of gas coal for the generation. Anthracite supplies from domestic enterprises make up only 40%, and the rest are import deliveries, including from Russia – just over 1%. In the structure of gas coal supplies, import deliveries (from Poland) make up less than 1%, the rest are domestic supplies.

Someone may object to the author's opinion that everything is not so bad. Plans for 2017 have been approved. This year, DTEK has contracts for anthracite supply not only from Russia, but from the Republic of South Africa as well. Since 2016, Centrenergo State Enterprise has been modernizing two units of the Trypillia HPP and converting them from anthracite to gas coal. DTEK has similar plans at Prydniprovska HPP.

There is already an agreement on the supply of 2 million tons of coal from Pennsylvania (USA) to Ukraine.

At the same time, the pace of implementation of the plans is very slow (only one unit of the HPP has been upgraded). Scheduled volumes of imported anthracite procurement trigger a reasonable concern as to their implementation. Plans do not always become reality. An example is the actual coal reserves over the past few years at the Ukrainian HPPs, which did not match the ministerial plans.

Considering the quarterly dynamics in coal reserves ("A" and "G" grades) at the Ukrainian HPP warehouses in the pre-war 2013 and "Rotterdam" 2016, the average annual drop in coal reserves by 2.7 times can be observed during this period, including "A" grade coal – by 3.7 times, and "G" grade coal – by 2.1 times. This indicates that the military actions in Donbas had significant devastating consequences for the country's energy potential. The blockade of coal supplies from the occupied territories has only accelerated the existing process.

In the first quarter of 2017, the reserves of "A" grade coal at the Ukrainian HPP warehouses, compared to the same period in 2016 (before the introduction of the "Rotterdam-plus" formula), decreased by 43.3%, while "G" grade coal – by 17.8%.  In the first quarter, "A" grade coal reserves were reduced by half (down to 463.5 thousand tons). And although during that period, "G" grade coal reserves increased by 30%, they were unable to replace anthracite at the HPPs that had not undergone modernization. The blockade led to a complete shutdown of a number of power plants (Trypillia, Zmiiv, Prydniprovska, Kryvyi Rih and Sloviansk HPPs) for several months.

Did government officials and managers of generating companies think in advance about the import of scarce coal? The Regulator's management, when approving the "Rotterdam-plus" scheme, hoped for the reduction in coal supplies by self-proclaimed "republics", the switching of anthracite HPPs to gas coal, and the creation of a fuel accumulation plan.

However, the facts indicate otherwise. According to the State Statistics Service, in the first quarter of 2017, Ukraine imported only 170 thousand tons of scarce anthracite coal, 169 thousand tons were delivered from Russia.

The only anthracite HPP which continues to work in the country is Luhansk HPP. It is a part of DTEK Skhidenergo. Due to its specific logistics, this power plant received 66 thousand tons of anthracite from the Russian Federation in the first quarter of 2017. Fuel was bought at USD 70  per ton in January and USD 80 per ton in February-March from its DTEK structure, Obukhivska Colliery Group. The latter extracted coal in Rostov region of the Russian Federation.

Thus, until the beginning of this year, the coal had been delivered to Ukraine not from overseas countries, but from Russia and the occupied Ukrainian Donbas, according to well-known schemes. However, the prices for it were, for some reason, close to the "Rotterdam" prices.

For example, Acting General Director of DTEK Energo Dmytro Sakharuk reported in July 2017 that "Russian" anthracite (from Obukhivska Colliery Group) was bought at the price of USD 95, and from South Africa – at USD 100 per ton.

Due to the blockade of coal supplies from the occupied territory, the fuel reserves at the domestic TPP dwindled fast. Over three weeks of April 2017, anthracite reserves declined by 33.8% (from 260 to 172 thousand tons). The coal reserves of the said grade began to increase at TPP warehouses only in May this year. It turns out that, until the expected "H-hour", no energy "safety bag" with sufficient solid fuel reserves had been created in Ukraine, which would have ensured operation of the Ukrainian HPPs.

So why was the forecast wholesale market price for electricity in effect for almost a year, which price implied import deliveries of scarce fuel at the world prices (in the port of Rotterdam) with the cost of delivery to Ukraine, while the expensive coal was actually imported from the occupied territory and the adjacent Russian region? And what happened to the money of Ukrainian taxpayers, who have been paying overestimated prices for electricity?

Who was screwed over?

DTEK enterprises (up to 30% of the entire country's electricity generation), Centrenergo PJSC and Donbasenergo PJSC are the main players in the market of "coal" generation of electricity.

After the introduction of the "Rotterdam-plus" formula, these generating companies – HPP operators began to sell electricity at the price which was 15-20% higher. At the same time, they stated that the anthracite import was unprofitable for them, while the "Rotterdam-plus" formula, which did not correspond to real market prices, did not cover the costs for purchasing coal in the world market.

In addition, the problem with the "Rotterdam-plus" formula is connected with the fact that the tariff for electricity generation is calculated according to the left-over principle. It looks as follows: Energorynok SE (the centralized wholesale buyer of all electricity in Ukraine) has no money to immediately reimburse the costs to the coal power generation plant in full. Therefore, initially, the funds which the company receives for electricity are distributed among other electricity producers, and only thereafter transferred to the coal power generation plant.

Then HPP operators settle accounts under the contracts with the suppliers of solid fuels.

To form the wholesale price, it does not matter for Energorynok from where the fuel is imported to the HPP. As a result, the intermediaries were interested in purchasing cheaper coal from mines that are located in the uncontrolled territory of Ukraine, and not more expensive imported coal required to replace the Donbas anthracite.

Additional revenues remained in the pockets of generating companies and various intermediary firms that sold fuel to them. Typically, the latter are trading companies of the operators themselves ("DTEK Trading") or other traders. Instead, with each increase in the wholesale price for consumers, the amount of money received by Energorynok increased as well. Their subsequent redistribution to the power generation plant brought a considerable income to the latter. There was no economic sense for coal suppliers to spend money on imports (from South Africa, the USA, etc.), when they could get cheaper coal "within easy reach" (Rostov region of the Russian Federation, occupied regions of Donetsk and Luhansk oblasts) and gain excessive profits.

The growth in revenues did not push operators towards a reasonable policy of procuring solid fuels, and insuring their risks at the expense of imports. Although "Rotterdam-plus" contributed to that, they did not buy the necessary fuel in the world market in the scheduled volumes. 

Naturally, in such a situation, economic entities were not interested in spending money on the energy independence of the state and its security. There are public institutions for that purpose. But they had neither the leverage nor the will to directly interfere with the business practice of the HPP operators and to force them to act in the interests of the state. There was also no system of sanctions against operators for non-fulfillment of plans for the accumulation of coal reserves. In fact, there was no responsibility for the execution of the resolution of the governmental authority. So much for the energy sector reform, focus on consumers, national energy security and diversification of coal sources, of which the Ukrainian establishment declares from the high stands and TV screens!

As a result, DTEK, a vertically-integrated company, being the dominant company in the energy market and having the whole production chain from coal extraction to heat and electricity production, got the most part of additional revenue from electricity sales. For example, in 2016, according to DTEK,  its annual EBITDA (operating profit before paying interest, taxes, and depreciation) increased by 2.37 times (from UAH 7.508 to UAH 17.804 billion).

Moreover, in the second half of last year, this indicator grew 4.6 times compared to the first half of the year. According to the stock exchange reports, the amount of cash and cash equivalents of DTEK increased 10.7 (!) times in that year. Such a positive financial trend for the company remains today.

The net profit of another entity in the energy market - Centrenergo PJSC - grew 17.7 times (from UAH 21.856 million to UAH 386.687 million) over the last year.

According to the Ukrainian Stock Exchange , this company increased its net profit more than threefold – from UAH 269.9 million to UAH 851 million – already in the first quarter of 2017 compared to the same period of 2016. One can only wonder at the statement made by acting director of Centrenergo Oleh Kozemko at the shareholders' meeting held on April 25, 2017, regarding the lack of circulating assets due to the debt in the amount of almost UAH 1 billion for electricity on the part of Energorynok SE, when the company's accounts as of March 31, 2017, showed cash balances in the amount of UAH 1.23 billion.

Donbasenergo PJSC, the third largest player in the domestic market for the production of electricity from coal, considerably improved its financial performance as well. According to the report for 2016, the company increased its net profit by 25% (by UAH 1.3 billion) up to UAH 4 billion, while its gross profit increased by 20.4% (by UAH 279.7 million) – up to UAH1.7 billion. Positive revenue trends of the enterprise are noted in the current year.

According to the calculations of experts of the Ukrainian Exchange, the tariff of Energorynok SE for HPPs increased by 47% in Q1 2017 compared to Q4 2016. Nevertheless, electricity generation, for example, at Centrenergo, for the reporting period decreased by 30% down to 1.7 billion kWh. Such an economic paradox became possible only after the Regulator approved the scheme for calculating the forecast wholesale market price for electricity in 2016.

It turns out that after the introduction of the "Rotterdam-plus" formula, the generating companies were the first to win as they began to receive super profits. And who was duped: the country, which still depends on the fuel supplies from Russia, industrial consumers and, indirectly, the population who pay the overestimated "Rotterdam" price for electricity. 

Impregnable "Rotterdam-plus"?

The justified alarm with respect to the adequacy of the "Rotterdam-plus" formula was immediately sounded by experts and the public.

Using the example of "DTEK Pavlogradvuhillia" PJSC, journalist Serhii Holovniov  conducted economic calculations and established how DTEK, thanks to the "Rotterdam-plus" scheme, received a margin of UAH 9.6 billion for the last year at this one particular enterprise.

Andrii Herus, a former member of the NERC, and now a public expert, believes that "Rotterdam-plus" is applied to set tariffs for electricity, but is not used to form the price for coal produced by the state-owned mines.  He documented and proved , how, thanks to the scheme developed by the Regulator, HPPs, having the coverage of the coal price at the level of UAH 2,200 per ton on the tariff, bought fuel from Ukrainian miners at the price of UAH 1,330 per ton.

It's a paradoxical situation, but the coal mines that produce fuel for electricity production have large debts for electricity owed to power plants. This is because the revenue from the "Rotterdam-plus" scheme goes to the generating companies and traders.  And the state-owned mines remain unprofitable, as they have always been. What kind of economy is this, where a cobbler goes without shoes?

In September 2016, A. Herus brought a claim to the administrative court seeking the court to declare Resolution No. 289 of the NERC, dated March 03, 2016, illegal and cancel it. The expert believes that the Regulator's decision was adopted and made public with a gross violation of procedural rules, which led to a significant increase in electricity prices, which is unacceptable in the current economic situation.

Full text of the statement of claim.

However, the District Administrative Court disagreed with the plaintiff's arguments for the abolition of the NERC resolution, which introduced the so-called "Rotterdam-plus" formula. According to the Court, the key advantages of the approach proposed by the NERC with respect to the determination of the ceiling prices for coal are the same arguments as were declared by its Head D. Vovk in 2016. "Determination of the indicators of the "Rotterdam-plus" formula, that is, the ceiling price for electricity, falls under the discretionary powers of the NERC," stressed the Court in its resolution, "and therefore, the legitimacy of determining its indicators is a form of interference with the discretionary powers and goes beyond the scope of the tasks of the administrative courts."

In his interview, A. Herus explained that the experts tried to hold a professional discussion with the managers of the NERC on the expediency of the "Rotterdam-plus" formula, but D. Vovk and other involved officials avoided public discussions regarding the approved decision.

"The funds were collected (over UAH 10 billion) from the consumers," said the expert, "and were not spent on the energy security but hidden in their pockets." "If the Regulator is a part of the energy business and not the arbitrator it is supposed to be," said our interlocutor, "businessmen-oligarchs gain super profits." "Rotterdam-plus", summed up A. Herus, "is just a corruption scheme.".

The public activist plans to go all the way through court proceedings in Ukraine and, if the Ukrainian judicial system fails to give an adequate assessment of the Commission's actions, apply to the European Court of Human Rights.

Viktor Chumak, Deputy Chairperson of the Verkhovna Rada of Ukraine Committee for Preventing and Counteracting Corruption, took an interest in the activists' fighting against the controversial decision of the Regulator in the energy sector.

On February 21, 2017, he sent a request of a member of parliament to the National Anti-Corruption Bureau of Ukraine (NABU), claiming that the NCEPUR's actions "led to a significant and unreasonable increase in utility tariffs, which led to serious consequences for legally protected rights and interests of citizens, as a result of which members of an organized group illegally enriched themselves."

Three days later, a criminal proceeding was instituted over abuse of official position by members of the NERC.

For member of parliament V. Chumak it is obvious that the "Rotterdam-plus" formula is a corruption scheme. According to him, law enforcement agencies must consider this case, and the final verdict must be delivered by the court.

For comments on the corruptogenicity of the "Rotterdam-plus" scheme, we addressed Yulia Usenko, the chief expert of the group Reforms in the Energy Sector within the Reanimation Package of Reforms.

She believes that adoption of the "Rotterdam-plus" formula is a sheer manipulation, which allows creating a new corruption scheme. Yu. Usenko hopes that the NABU investigation will clarify the situation, although it will be difficult to follow the case to its logical end under the existing judicial system.

In Lieu of an Afterword

The more you get involved in the "Rotterdam" topic, the more issues arise that require a further response from the law enforcement agencies. This case can be a challenge not only for the law enforcement and judicial system, but also a catalyst for profound changes in the Ukrainian society.

More than a year has passed since the introduction of the "Rotterdam-plus" formula. This phenomenon attracts more and more criminal and political issues. It is clear that the case of Rotterdam-plus will have a significant public response. It affects interests of all the citizens, enterprises consuming electricity, electricity market participants, as well as the highest level of the Ukrainian political and economic elite.

On May 24, 2017, reporting to people's deputies, Prosecutor General of Ukraine Yurii Lutsenko said that the "Rotterdam-plus" scheme can facilitate embezzlement of budget funds, it is a "mafia-style threat".

First of all, the actions of the NERC management can be considered as an official crime. Various charges may be brought against specific officials, from using their official powers, conflict of interest to making a false decision which will benefit only individual players in the market. In addition, one can also mention political responsibility of both the members of the Commission and those who have appointed them to their offices. Issues of trust / rating of the current authorities became much worse after the "Rotterdam" scandal.

It's no secret to anyone that the main beneficiary of the "Rotterdam-plus" scheme is the owners of the generating assets, primarily the owner of DTEK and Ukrainian oligarch Rinat Akhmetov. "The Case of Oleh Seminskyi" , which has gained wide publicity over the recent weeks, added a new sound to the "Rotterdam" decision of the NERC.

According to Member of Parliament of Ukraine Serhii Leshchenko, the "Rotterdam-plus" formula approved by the Regulator is the result of a conspiracy between President Poroshenko and the country's main oligarch Rinat Akhmetov regarding the division of the domestic market of resources.

The investigation has to solve a lot of puzzles. Is it a coincidence that cheap shares of Akhmetov's DTEK were actively bought up by Investment Capital Ukraine (ICU), where high-ranked officials previously worked, such as Valeria Hontareva (the Head of the National Bank of Ukraine), Volodymyr Demchyshyn, (former Minister of Energy and Coal Industry, co-owner of ICU), Dmytro Vovk (the Head of the NERC) and others. - and a sharp increase in the cost of redeemed shares after the adoption of the "Rotterdam-plus" scheme? Was the methodology for determining the forecast wholesale market price for electricity adopted to diversify energy sources, increase energy security of the country, or as a tool for obtaining additional revenues by the main business groups of the energy market? Did President of Ukraine P. Poroshenko influence the approval of the procedure for formation of the forecast wholesale market price? These and a number of other questions will help you to understand the main issue: Is there a conspiracy between the oligarchs of the country in the distribution of the zones of influence on the political, economic and other spheres of life of the country?

Corrupt "metastases" of the notorious formula are gaining momentum. Therefore, it is too early to draw the line in our investigation.  To be continued …

Oleh Peretiaka for Parallel Media; Infographics made by the author.

The material was prepared within the framework of the Transparent Energy Project with the support of the United States Agency for International Development (USAID).


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