What the “Rotterdam Plus” formula means: Viewpoint of experts of the Economic Competition Development Committee under the Ukrainian Chamber of Commerce and Industry

Author  Gennadii RIABTSEV, Leading researcher at the National Institute for Strategic Studies, member of the Public Council under the Anti-Monopoly Committee of Ukraine, Doctor of Science (Dr. Hab.) in Public Administration, Professor

For three weeks in January-February 2018, twenty-nine experts from the Economic Competition Development Committee under the Ukrainian Chamber of Commerce and Industry researched the compliance of energy coal prices used in the formation of projected wholesale electricity prices (starting from the second quarter of 2016) with the average market prices in Ukraine and average European prices. The discussion was held at the PsycheaEXPERTUS system and the Economic Competition Development Committee under the Chamber. Despite controversy and almost a scandalous nature of the so-called “Rotterdam Plus” formula, research results appeared to be quite as expected.

Bare facts

1. Implementation of Ukraine’s obligations under the Energy Community Treaty and the Ukraine-EU Association Agreement, including the implementation of Directive 2009/72/EC
   on common rules for the internal market in electricity, entitles a regulator, which in Ukraine is the National Energy and Utilities Regulation Commission (NEURC), with the duty of “fixing or approving, in accordance with transparent criteria, transmission or distribution tariffs or their methodologies” (Article 37, paragraph 1 (a)).

In doing so, the NEURC shall work “in close consultation with other relevant national authorities including competition authorities” (Article 36 of the said Directive).

2. On September 21, 2015, the Anti-Monopoly Committee of Ukraine (AMCU) submitted to the NEURC a set of recommendations mandatory for consideration, in line with which the NEURC had among other things to develop and approve the procedure for forming the projected wholesale market price for electric energy, including conditionally fixed costs of businesses producing electricity at thermal power stations. The reason the recommendations emerged was the actions spotted by the AMCU, which contained signs of competition law violations and took place due to lack of a necessary regulatory act; relations between prices of electricity and energy resources, in particular energy coal; and predictability of the wholesale price of electric energy.
3. The rules of forming the projected wholesale market price of electric energy (hereinafter referred to as the Rules) were approved at the NEURC’s open meeting after the necessary approvals were obtained from the Ministry of Energy and Coal Industry, the AMCU, and the State Regulatory Service of Ukraine.
4. According to the approved Rules, one of the components of the projected wholesale market price of electricity is the projected sales price of electricity in the wholesale electricity market, which is set by power generating companies that operate with the use of price bids. The sales price is based on the indicative price of coal.
5. The indicative price of coal is calculated based on the average market price in the European market, which is determined by the average API 2 indices on CIF ARA terms 12 months prior to the month when the price is set, taking into account the weighted average rate on the interbank market, and is aligned with the one specified in the forecast structure of thermal power plants’ fuel for the corresponding period and the caloric content of domestic coal (paragraph 3.1 of the Rules).
6. Pegging the indicative (marginal) coal price in Ukraine to the “average market price in the European market” corresponds to Clause 1.7 of Article 4 of Law of Ukraine On Prices and Pricing, stating that the main direction of the state price policy is to ensure “orientation of domestic prices on the market of goods toward the level of prices on the world market.”
7. Setting the indicative (marginal) price of coal through import parity is due to the lack of the anthracite coal resulting from the termination of its supply from enterprises located in the temporarily occupied areas of Donetsk and Luhansk regions [also referred to as ORDLO]
   and the need to import coal from other countries to ensure balance on the market.

The NEURC identified as key advantages of such approach: giving up on a non-transparent, unpredictable, manual coal pricing; pegging to generally accepted price indices; autonomy from ORDLO in the implementation by the thermal power plants of their coal accumulation plan; and an opportunity to balance operations of coal mines subordinate to the Ministry of Energy and Coal.

8. Choosing API 2 indices under CIF ARA terms as the basis for calculating the indicative coal price is due to a long period of their application (over 20 years), a wide range of participants in European energy markets, as confirmed by studies by the Argus Media agency.

Choosing API 2 indices was also due to the lack of reliable official statistics on volumes, prices and quality of coal sold in the customs territory of Ukraine.

9. The approach proposed by the NEURC to determining the indicative (marginal) coal price through import parity has been supported without comments by the Ministry of Energy and Coal Industry, the AMCU and the State Regulatory Service of Ukraine. At the same time, the AMCU considers it is progressive to peg the procedure for calculating the marginal price to the generally accepted price indicators, since before the appearance of the Rules, a non-transparent manual regulation de-facto prevailed on the electricity market.
10. The transition to determining the indicative (marginal) coal price through import parity took place during the expanded reproduction, as evidenced by GDP growth and investment in coal mining (in 2016 – by 2.3% and 82%, respectively). According to the conclusions of the Institute of Economics and Forecasting of the National Academy of Sciences of Ukraine, this has mitigated the situation that arose as a result of tariff growth.

Bottom line

1. Before 2016, Ukraine had no methodology, based on a formulated approach, for determining the price of energy coal for the thermal power plants.
2. The application of the formula-based approach to determining the indicative (marginal) coal price allowed abandoning the non-transparent, unpredictable, manual pricing, and reduced the influence on the functioning of the electricity market of administrative and corruption-related factors.
3. The API 2 index at the ARA coal hub is a generally accepted price indicator for energy coal.
4. Pegging domestic prices of goods to price indicators recognized in Europe is feasible in view of the need to adhere to the main directions of government pricing policy and the lack of energy coal in Ukraine.
5. The use of the API 2 index of calorific value as the main quality indicator allows comparing prices of different grades of energy coal.
6. Indices of the quality of domestic coal are taken into account by the need to bring the indicative (marginal) price in line with its caloric value.
7. The use of the API 2 index on the CIF terms of supply of physical goods eliminates the negative impact of the speculative component that is present when trading in financial instruments (futures, options, derivatives) on commodity exchanges.
8. Averaging the indicative (marginal) coal price for 12 months smooths out price fluctuations caused by random factors, which makes the wholesale electricity market more predictable and stable.
9. Since, in accordance with Article 190 of the Commercial Code of Ukraine, prices “of all types of products (works, services), except for those regulated by the government,” are free and “determined by the economic entities on their own with the consent of the parties,” any indicative price that is not higher than the maximum one and not lower than the minimum one from among the reference prices available in open sources can be considered justified from the economic point of view.
10. Experts who participated in the discussion are not aware of other approaches, given price data available in open access, to determining the indicative (marginal) coal price based on generally accepted price indices. Meanwhile, the formation of the coal market in Ukraine is impossible without such benchmarks.
11. Projected wholesale market prices of electric energy, calculated by the experts of the Ukrainian Chamber of Commerce and Industry with the use of data available in open sources, are in general in compliance with those laid down in the NEURC resolutions that were the subject of the analysis.

Conclusions

1. Ukraine’s current legislation lacks definitions of the terms “average market prices,” “market prices,” as well as mechanisms for their definition.
2. Average API 2 indices on CIF ARA terms are not an “average market price on the European market,” as stated in the Rules, because trading in energy coal in Europe is conducted not only on CIF terms and not only at the indicated ports, while the API 2 index does not cover all trading operations.
3. The indicative price of energy coal, determined based on the average API 2 indices on CIF ARA terms, is not the average market price in Ukraine, since, according to the AMCU, a significant share of energy coal is sold among economic entities affiliated through relations of control. At the same time, in the opinion of the Anti-Monopoly Committee, the coal market does not exist in Ukraine, and therefore there is no average price of coal (Clauses 15, 16 of the Conclusions, p. 114 of the report on the results of the integrated study of the electric energy and coal markets, approved by the AMCU on June 1, 2016).
4. Reference coal prices available in open sources both in Ukraine and beyond are not “average market prices” because they reflect the market partly. In addition, they do not take into account the terms of contracts with real goods (the payment procedure, volumes of supplies, quality of coal, partnerships between contractors, discounts, trade within financial groups (relations of control), coal production costs, and costs of transportation from coal mines to thermal power plants). Therefore, comparing them directly with the indicative price of energy coal, which is determined based of the average API 2 indices, is wrong.

In this regard, the experts noted that it was impossible to establish compliance of the coal prices used in the formation of projected wholesale energy prices (starting from the second quarter of 2016) with the average market prices in Ukraine and average European prices.

Obviously, the issue requires further discussion. The Committee members suggested extending it and applying to the NEURC to obtain data, absent in open sources, necessary for a more detailed analysis.

The Committee invited all experts to join in the discussion on the PsycheaEXPERTUS platform. Please follow the URL to register: https://psychea.com.ua. (Under the project titled “The Economic Competition Development Committee under the Ukrainian Chamber of Commerce and Industry”).

Subscription — Tel.:(+38 044) 263-68-39, email: terminal.psychea@gmail.com

Halyna Karp, Ukraine’s First Deputy Minister of Energy and Coal Industry (until April 25, 2018), shares with TerminaL her vision of the current stage of reform in the industry.

– The Ukrainian energy sector is being reformed. Last year, the Energy Strategy until 2035 was adopted. What other events from 2017 do you view positively, and which negatively?

– Undoubtedly, the adoption of the Energy Strategy of Ukraine until 2035 is the key news of the past year. At the same time, equally important was one of the most important steps in reforming and liberalizing the electricity market – the adoption of Law of Ukraine “On Electricity Market.” As a result, the process has begun of the introduction of a new model of the Ukrainian electricity market and integration of Ukraine and EU energy grids. The implementation of these processes will create conditions for competition in the electricity market, attract investment in the industry, and realize the rights of consumers to get the most attractive terms of electricity supplies.

Among the achievements of 2017 is the continued reform of the natural gas market through the implementation of Law of Ukraine “On Natural Gas Market,” in particular, in relation to the unbundling – separation of functions of the operator from those of natural gas producers and suppliers; the launch of the Ukraine-EU Energy Bridge project; the construction of a centralized spent fuel storage facility; and pilot projects to replace scarce anthracite coal.

– What do you consider your main achievement while working in the ministry?

– Our joint achievement is the formation of the regulatory base in accordance with the requirements of the EU Third Energy Package and taking steps toward the formation of market relations in the energy sector. Basic legislation has been adopted, that is, the law on the natural gas market, electricity market law, and law on the national energy and utilities regulation commission.

A number of concepts and programs have been adopted for the industry. An important achievement is also strengthening the resource base of and balancing Ukraine’s energy grid. We managed to accumulate the necessary amount of gas and coal for the heating season and ensure unhindered supplies of electricity and heat to consumers. Another important step I’ve already mentioned is the start of the construction of a centralized spent nuclear fuel storage facility, which will not only allow us to stop buying Russian services for the storage of spent nuclear fuel coming from Ukrainian nuclear power plants, but also substantially strengthen energy security and save about $200 million annually on storage. Also, throughout the year, many measures have been taken to diversify energy supplies, which contributed to the boost in energy security and overall national security of Ukraine.

Statistics for 2017 year-over-year testify to the achievements mentioned:

• Electricity output increased by almost 700 million kWh, or by 0.5%;
• Production of natural gas grew by more than 800 million cubic meters, or by 4%;
• Gas transit shipments increased by more than 11 billion cubic meters, or by 13%;
• Electricity exports grew by more than 1.2 billion kWh, or by 34%; and
• The amount of gas pumped into our underground storage facilities rose by almost 2.8 billion cubic meters.

The main thing is to keep up the pace and continue moving forward.

– What are the main problems the Ukrainian energy industry is facing, in your opinion?

– The first one is the dependence of the Ukrainian economy on import of energy resources. The key task is to achieve energy independence, which in turn is a guarantee of national security. The importance of the task is perfectly illustrated by the latest gas crisis we faced in early March as a result of Gazprom’s moves. It is realistic to achieve such energy independence by 2020 due to the growth of own natural gas extraction. In 2017, natural gas production in Ukraine increased significantly.

Another important issue is energy efficiency. The Ukrainian economy remains very energy intensive. We consume 2.5 – 3 times more energy than in most countries to produce a conditional commodity unit. Energy losses in the municipal sector remain very high due to the low energy efficiency of households. Energy costs of production are also significant, in particular, in generation and transmission of electric and thermal energy. A lot is being done in the direction of boosting energy efficiency. And this yields certain results. But the problem remains ambitious and complex. Its solution requires time and investment.

– What indicators should be applied to evaluate the effectiveness and efficiency of the ministry’s operations?

– There may be plenty of performance indicators: it’s drafting and implementing new legislation, ensuring the stability of the Ukrainian fuel and energy sector, creating a favorable investment climate, introducing modern standards of public administration, ensuring transparency and openness in the work of the Ministry of Energy and Coal, and preventing corruption risks. In all directions, the Ministry of Energy and Coal has been working systemically.

– Has the ministry changed after the new Directorates were introduced? What is missing?

– Today, it is somewhat premature to talk about changes in the ministry’s work as a result of the emergence of new Directorates. The Directorates have not yet formed their full-time staff. Staffing competitions are underway. Probably the process will last for another month or two. But a number of specialists are already working on the tasks assigned to them.

. . . 

Read the complete version of the interview in the magazine TerminaL.

Tel.:(+38 044) 263-68-39, email: terminal.psychea@gmail.com

Interview  STC “Psychea”