Lower tax rates, simple administration mechanisms and new system for taxation of the gas production - those were the key recommendations for the Ukrainian energy sector presented by the special mission of the International Monetary Fund at the end of 2014. For months the Fund’s position remains unchanged - the Ukrainian government should abandon the traditional policy of raising the fiscal pressure on the gas production industry.
Catastrophic effect on the market
It is surprising though the Ukrainian government kept ignoring the investors calls for help. Despite the efforts and numerous discussions, in contradiction to recommendations of a number of Ukraine’s international partners, including the IMF, the government kept tightening up the knot for the private industry.
In addition to the above, the government recently caused a further increase of the royalty rate imposed on the state-owned gas producers to 70 percent, which is unprecedented and second to private industry’s 55 percent gas tax.
The government’s policy were politely called by IMF experts as “measures, with mixed positive and negative effects.”
There is a strong concern beneath these delicate words, as the fund’s economists are absolutely sure that such increase may delay investments in this strategically important sector of the Ukraine’s economy. Their expectations are now becoming the reality: due to the enormous fiscal pressure the private gas businesses have been put on the verge of extinction.
Some of the investors have put their investment and drilling programs on hold, while the other ones resorted to investment arbitration against Ukraine’s breach of investment treatment principles.
JKX announced that it is seeking repayment of more than $180 million from Ukraine, as the state failed to treat JKX's investments in a "fair and equitable" manner.
It is the first appeal to arbitration lodged by a private gas producer, but more investment arbitrations are expected to be launched against Ukraine in 2015.
What IMF recommends
The fund’s recommendations in this situation were simple and clear. The Government should immediately reduce the royalty rates to the previous level (i.e., 28 per cent for the natural gas extracted from the deposits up to five kilometers in depth and 15 percent for the natural gas extracted from deeper deposits).
Afterwards the oil and gas taxation system should be revised in line with the best international practices with reference to, for example to a variable corporate profit tax, additional profit tax or the so-called R-factor (coefficient expressing revenues against expenditures of the project).
The current taxation system in Ukraine is not following the best international practice, neither the tax rates raised by government are on par with Ukraine’s neighboring countries that are also competing for international oil and gas investors.
Yes, the exporting countries tend to establish higher rates of production taxes, while the countries that depend on oil and gas imports would logically try to motivate and encourage domestic production and, therefore, do not set rates higher than 30 percent of the gas price for end customers. This means that Ukraine currently has one of the worst fiscal regimes in the world. Its enormous tax rates now resemble those of a gas exporting country – the luxury, which cannot be afforded by the country wholly dependent on gas imports, as because of this - the domestic production will be driven down and gas import dependency will only grow, putting more pressure on the country’s currency reserves and budget.
New mechanisms and incentives
IMF’s experts also believe that Ukraine’s approach to taxation of oil and gas industry should motivate and take into consideration the peculiarities of production from small, exhausted and depleted fields. More than 70 percent of Ukraine’s gas prospective resources lie deep and are expensive to explore, as a result most such gas projects are classified as very small (with potential to produce up to 1 billion cubic meters of gas from such a field) and usually have a relatively low internal rate of return (up to 10-15 percent), also due to geological challenges.
In 2013 the Ukrainian government adopted regulations that offer preferential tax treatment for development of the depleted fields and reserves that are difficult to access. The tax rate for such projects is only 2 per cent.
However, this highly attractive option is now available only for companies with a state share of at least 25 percent.
The government could extend this favorable tax regime to private companies that wish to extract gas from the deposits with difficult geological conditions.
Given that much of Ukraine’s remaining gas reserves are deep or already depleted, such mechanism could be an effective instrument encouraging companies to invest in the risky and challenging projects.
One of the fund’s recommendations was to use Production Sharing Agreements (PSAs) for medium and large gas extraction projects. PSA is a contract between the government and investor for joint exploration and production of minerals at the investor’s risk.
The contract provides for in-kind or revenue sharing resulting from the minerals, or oil and gas produced by the operator of the project. Until recently PSA used to be the only viable and reasonable option for an investor to create a stable and legally solid framework for large-scale upstream oil and gas projects in Ukraine.
The Ukrainian government did sign a number of PSAs with major gas market players (Shell, Chevron, Eni, etc.). In 2014 as a part of the Government’s "tax reform" measures a number of privileges for the PSA investors were abolished.
Due to the incredible bureaucracy, tax burden, military crisis and annexation of the Crimean Peninsula the Ukrainian PSA projects worth hundreds millions of dollars were put on hold by investors. IMF advised to restore the attractiveness of the PSA mechanism, once the situation in Ukraine settles down. We believe that the PSA regime should be returned to its previous balance and more PSA projects should be initiated and offered for bidding by the Government.
With the falling levels of domestic gas production, Ukraine has no option but to focus on following these simple, reasonable and clear recommendations. In the current situation, it is both unrealistic and undesirable to increase the fiscal and administrative pressure on the private gas producers. The government’s tax policy is unreasonable and ruinous for the government itself and the country in general, as high tax rates make Ukraine weaker in all respects – producing less domestic gas and consuming more imported gas. The Ukrainian government should rather stabilize the Ukrainian energy sector by way of improving the investment climate, implementing the reforms and encouraging domestic oil and gas production.
April 15, 2015