What is
going on?

For three years already, “Rotterdam+” crops up in conversations about electricity prices. This comes as no surprise, taking into account that the Rotterdam+ formula was crucial to the introduction of market rules in Ukraine’s energy sector. However, even those with a good grasp of economics may find it difficult to explain how the formula works. Besides, Ukrainians have always been made believe that Rotterdam+ is merely a way to earn extra profits at the expense of citizens.

On 1 July, a new electricity market went live in Ukraine, entailing another round of debates about Rotterdam+. We went deep into the matter to understand what Rotterdam+ really means, what’s the current state of the Ukrainian energy sector and the outlook for the sector.

1
What is Rotterdam+
formula, in brief

Rotterdam+ is a formula used to calculate the price for steam coal burned by thermal power plants (TPPs). TPPs produce electricity and sell it at a specific tariff. The coal price influences the price of electricity produced by TPPs, as well as the tariffs for industrial consumers. The coal price does not affect tariffs for residential consumers. Thus, Rotterdam+ in no way influences the electricity tariffs for households.

The formula was approved by the National Energy and Utilities Regulatory Commission (NEURC) in March 2016. After the introduction of the new market in 2019, the formula is no longer effective

As of 24 September 2019, the price of one tonne of Ukrainian coal calculated under the Rotterdam+ formula stood at UAH»
1 794

2
End of “manual”
regulation in the
coal sector

After gaining independence, Ukraine gradually increased subsidies to the coal sector, while the coal sector was making more and more losses. Billions of hryvnia of government subsidies were lost to corruption, while the state-run mines were producing less and less coal. The scheme was based on artificially-lowered coal prices and electricity tariffs. The PR claimed it was to protect ordinary people against high market prices, but the reality was to earn extra profits for the owners of the non-modernised enterprises buying electricity at low prices and selling their goods overseas at high prices. The arising gap was closed by ordinary taxpayers subsidising the mines.

According to Oleksandr Trokhymets, Chairman of the Energy Association of Ukraine, the gap was really huge: “Sometimes, the price of coal was set at about UAH 400 per tonne, while the production cost of coal produced by state-run mines was around UAH 3700 per tonne. “By 2013, the production cost of Ukrainian coal was almost double its selling price.

Sometimes, the price of coal was set at about UAH 400 per tonne, while the production cost of coal produced by state-run mines was around UAH 3700 per tonne

Oleksandr Trokhymets,
Chairman of the Energy Association of Ukraine

A similar situation was observed in the electricity market. The price was artificially understated despite market factors, e.g. inflation. Between 1996 and 2017 average Ukrainian wages grew 64 times, while the price of a kilowatt-hour rose only one-third of the level of wage growth. Healthy economies cannot have such gaps.

Electricity prices were regulated “manually”. The National Energy and Utilities Regulatory Commission (NEURC) used to adopt a resolution specifying a price with no clear explanation of the factors affecting the price. Any method could be chosen to calculate the price. Such “manual” regulation resulted in non-economic factors affecting pricing decisions: agreements between influential groups, political expediency (no tariff increase before elections or, vice versa, an increase in tariffs to put the blame onto predecessors). Tens of billions of dollars went missing from the budget with such subsidy schemes

3
Rotterdam+ was the first time
that the real price of Ukrainian
coal was determined based on
market principles

Ukraine required the Rotterdam+ formula to abolish “manual” price regulation and its huge corruption risks. NEURC proposed a solution which is used all over the world, suggesting that the coal price should be determined by the global market. Growth or decline of global prices should translate into changes in domestic prices. It is a common mechanism.

Economists call it import parity price, i.e. the lowest price level at which importers have an incentive to import goods. If domestic producers offer a price higher than the import parity price, consumers find it more expedient to buy such goods from importers. With this mechanism in place, the price stabilises and it gets easier to predict it, while pricing becomes more transparent.

If Ukraine intends to support domestic coal production, it cannot ignore the impact of coal imports and should set the domestic coal price equal to the import parity price

Euracoal European Association for Coal and Lignite

Yet, there was a constraint specifying that the domestic price could not exceed the formula price. As a result, from time to time, the domestic coal price was lower than the price of imported coal.

Coal import price vs Rotterdam+ formula price
Coal import price vs Rotterdam+ formula priceCoal import price vs Rotterdam+ formula price

It sounds strange, but before the Rotterdam+ formula was enacted nobody knew the real price of Ukrainian coal. In 2015, Minister of Energy and Coal Industry Volodymyr Demchishyn claimed that the “real price” of coal was UAH 1100 per tonne, Chairman of the Independent Trade Union of Miners of Ukraine Mykhailo Volynets mentioned UAH 1500 per tonne, while the production cost of some state-run mines was UAH 4350.

Use of the import parity price for calculation of the domestic price was supported by the Euracoal European Association for Coal and Lignite. Euracoal experts said: “If Ukraine intends to support domestic coal production, it cannot ignore the impact of the coal imports and should set the domestic coal price equal to the import parity price. When facing the same issues, other countries used to take the import price as a basis for calculating the domestic price to put domestic producers on a par with importers.”

Abolishing “manual” regulation and enactment of a transparent tariff-setting formula for industries were inevitable after Ukraine and the EU signed the Association Agreement. Pursuant to Article 269 of the Association Agreement, Ukraine had to implement market-based pricing in the energy sector, i.e. introduce a competitive market (which was actually done on 01 July 2019). It also committed to use a transparent price calculation method before the market introduction

4
Rotterdam+ saved
the Ukrainian energy
industry

Rotterdam+ was enacted by NEURC Resolution 289 of 3 March 2016. The resolution was preceded by a number of events that entirely changed the course of Ukrainian history.

After the occupation of some parts of Donetsk and Luhansk regions in 2014, Ukraine lost control over companies located in that area. Early 2014, Ukraine owned 150 mines employing 250 thousand people. A year after, the number of workers decreased to 120 thousand people working at 81 mines. Domestic coal production declined twofold and continued to fall. Experts predicted coal shortages and industry collapse. Millions of people could have been left without heat and electricity, while Ukraine could have lost its energy independence.

In 2014, domestic coal production halved
In 2014, domestic coal production halvedIn 2014, domestic coal production halved

Ukraine had to urgently start importing coal to meet the needs of coal-fired generation. Thus, there arose a need for reasonable price constraints: Ukrainian power plants had to be able to buy coal on global markets at market prices. This would enable Ukraine to get rid of its critical dependency on coal supplies from the occupied territory and the Russian Federation. Yet, for this the existing production and procurement system had to be restructured and the old “manual” pricing system abolished.

In July 2015, a working committee at the Ministry of Energy and Coal Industry started to prepare a draft law “On Coal Product Markets“. The draft law was aimed at liberalisation of the market and implementation of coal exchange trading. Taking into account that drafting and adoption of the law is typically a lengthy process, NEURC started to prepare the documents required to implement market-based tariff setting. Resolution 289 was a key document. It was actively discussed by experts. A public discussion was held in early 2016. Finally, in March 2016, the Regulator enacted Rotterdam+. It was the first time that the formula setting coal price caps was employed.

After employment of the Rotterdam formula, the country had neither power or heating cuts, nor miner lay-offs. Pricing became transparent. State-run mines were saved from bankruptcy

5
The formula is as
clear as day

The formula-based approach is transparent and clear. Rotterdam+ means global pegging to the average weighted price in the ports of Amsterdam, Rotterdam and Antwerpen (API2 index). The international agency Argus Media sets the API2 index on a daily basis, which is regarded as the coal price for all of Europe. There is no way to impact their calculations.

The “+” in the formula stands for the cost of transportation to Ukraine (freight), transshipment from vessels to railway cars (transshipment) and delivery to a specific thermal power plant (transportation leg). This works in the same manner as pizza delivery. You order pizza at a certain price and pay an additional sum for it to be delivered to you. The greater the distance from you to the pizza place, the more expensive the delivery charge.

The formula has two components: ‘Rotterdam’ and ‘Plus’. The share of ‘Rotterdam’ in the coal pricing is higher
The formula has two components: ‘Rotterdam’ and ‘Plus’. The share of ‘Rotterdam’ in the coal pricing is higherThe formula has two components: ‘Rotterdam’ and ‘Plus’. The share of ‘Rotterdam’ in the coal pricing is higher

Eventually, a reference (indicative) price arises, which is used for the settlement. For the first time, pricing in Ukraine’s coal sector became market-based without influence of administrative corruption. This was and remains the strategic achievement of Rotterdam+

6
Did coal actually have to be
shipped from Rotterdam?
Spoiler: no

Starting from Q2 2017, Ukraine’s coal shortage has been covered exclusively with imported coal. However, it has not been imported from Rotterdam. The argument that the coal should be shipped from there is a part of the myth surrounding the formula. The Secretary General of Euracoal Brian Ricketts commented on this as follows: “The Rotterdam+ price does not stipulate that the coal has to or will ever be shipped from the ports of Amsterdam-Rotterdam-Antwerpen to Ukraine. That would be ridiculous!” The coal has been shipped from different countries, mainly from the USA, Russia, Kazakhstan, and South Africa.”

The Rotterdam+ price does not stipulate that the coal has to or will ever be shipped from the ports of Amsterdam-Rotterdam-Antwerpen to Ukraine. That would be ridiculous!

Brian Ricketts,
Secretary General, Euracoal

The most suitable shipments for the Ukrainian market are from South Africa, the USA and Columbia. Pegging the price to one of the indices of a local market would have led to an exposure to local risks on those markets. For instance, the coal price in South Africa is highly dependent on fluctuations in China. The latter is not always reflected in coal prices in Europe. The prices in the markets of the USA and Columbia are highly dependent on specific major producers. All those markets aim at long-term contracts, while it takes more than 30 days for vessels to arrive from there. Furthermore, the prices in those markets may exceed the API2 index even without inclusion of the freight cost.

In order to ensure supplies of anthracite coal, the market of the Russian Federation may act as an alternative. However, Ukraine could not consider it for permanent pegging due to obvious reasons: firstly, due to politics, and secondly, due to high dependence of the Russian market on the administrative decisions of its authorities. In June 2019, the Russian authorities once again ceased shipments of all coal to Ukraine.

Nevertheless, all these negative factors may be offset. To achieve that, the indicative price of the most liquid market in the Atlantic region should be used, which is the API2 index. So it was done that way. The Rotterdam+ formula includes the cost of freight from the ports of Amsterdam-Rotterdam-Antwerpen to Yuzhny port, coal transshipment in a Ukrainian port and the coal price based on CIF ARA. Moreover, even though the coal is actually purchased in the United States, Africa or Columbia, such an approach leads to correct approximation of the indicative price for imports to Ukraine.

According to Euracoal, the average price for a shipment of imported coal to Amsterdam port would be $9 cheaper than delivery to Ukraine’s Yuzhny port. The transportation (freight) price at the Yuzhny port amounted to $6-14. Thus, the proposed formula is considered as a correct indicator for determination of the average cost of the actual import

7
Rotterdam+ benefits
regular consumers

The Rotterdam+ formula made business pay transparent prices for electricity. A transparent price means the end of corruption. Regular consumers benefit where big corruption loses, since it was their pockets that were used to cover the discounts for specific favoured industry sectors.

A majority of industrial consumers welcomed the formula with understanding. But not everyone. Ukraine houses a group of plants producing ferroalloys (iron-based alloys), which are widely used in steel production. The share of electricity in their production cost reaches 50%. According to expert estimates, Zaporozhsky Ferroalloy Plant alone consumes more than half of the electricity of the entire Zaporizhzhia region, while Nikopol Ferroalloy Plant consumes more electricity than Ivano-Frankivsk and Ternopil regions combined. The purchase of electricity at dumping prices brought the most benefits for these very companies.

How much electricity was consumed by different industry sectors in 2018
How much electricity was consumed by different industry sectors in 2018 How much electricity was consumed by different industry sectors in 2018

The majority of ferroalloy plants and support companies are owned by oligarch Ihor Kolomoyskyi. They include Nikopol Ferroalloy Plant, Zaporozhsky Ferroalloy Plant, Pokrovsk Iron Ore Enrichment Works, Marganets Iron Ore Enrichment Works and Dniproazot. It is them and the Ukrainian Association of Ferroalloy Producers under their control, who attempted to revoke the NEURC’s resolutions challenging Rotterdam+ through courts, seeking to regain control over manually reduced tariffs.

TOP 10 industrial consumers of electricity in Ukraine
TOP 10 industrial consumers of electricity in UkraineTOP 10 industrial consumers of electricity in Ukraine

The Ekonomicheskaya Pravda newspaper reported that at the end of 2013, the government of Mykola Azarov signed a Memorandum of Understanding with Ferroalloy Companies, which allowed four ferroalloy plants to obtain a reduced electricity tariff. This resulted in losses incurred by generating companies, while the discounts had to be offset with funds from the state budget, i.e. taxes paid by regular Ukrainians

8
The formula did not
impact household tariffs

Big and complex economic notions become clearer when presented on an electricity bill. There are four kinds of electricity generation in Ukraine: thermal, nuclear, hydro and green. Those power plants would sell their commodities to the state enterprise Energorynok. After that, the electricity would be sold to households and businesses via oblenergos (oblasts being Ukraine’s regional units).

How electricity gets to consumers
How electricity gets to consumersHow electricity gets to consumers

While earlier, the NEURC could set an arbitrary electricity price, Rotterdam+ provided for calculation of its actual price. Arbitrary tariffs kept resulting in losses for industry. As Energorynok is a state-run company, the billions of lost hryvnias had to be covered through subsidising the industry with budget funds. In other words, earlier the prices in the bills could remain low, while the funds were spent behind the backs of people in such a way that they could not notice it.

Also, it is worth pointing out that the Rotterdam+ formula was used only for calculations of coal and electricity prices for industrial companies. This is only a part of the entire electricity generation industry operating within the state. The formula could not affect the tariff for households in any way

9
Is the coal shipped to Ukraine
from the isolated districts of
Donetsk and Luhansk
regions? Spoiler: no

There is a myth that the coal is shipped to Ukraine from the temporary non-controlled territories of Donetsk and Luhansk regions. That is not the case.

On 15 March 2017, the National Security and Defence Council of Ukraine adopted a resolution on complete termination of cargo transportation between the non-controlled territories and Ukraine. Law enforcement and military agencies maintain thorough monitoring over the cargo transportation from those territories. That is why the coal which is used by Ukrainian TPPs is either produced in the Ukraine-controlled territories or imported.

Currently, neither Ukraine nor any Ukrainian company maintain control over mines and companies located in the isolated districts of the Donetsk and Luhansk regions. They remain under control of the so called DPR (Donetsk People’s Republic) and Vneshtorgservice CJSC registered in South Ossetia. Those institutions do not have any impact on Ukrainian businesses.

As for the seized Ukrainian businesses and mines, 400-500 kt of anthracite coal produced in the occupied territories is transported to the Russian Federation from the non-controlled territories on a monthly basis. From there it is transported in the following directions: the Black Sea and Mediterranean Sea Basin countries, port of Ust-Luga to the Baltic and North Seas, Belarus and onward to the European Union. A share of the coal is consumed in Russia. The main countries purchasing coal from Russia are Romania, Belgium, Poland, Bulgaria, and Turkey.

According to paperwork, the stolen coal is listed as the coal ‘produced in the Russian Federation’. Despite that, it can easily be identified with the help of a laboratory survey. Furthermore, another proof of illegal coal origin may be the supplied Uspenskaya and Gukovo plants. They are located at the border between the non-controlled territories and Russia, and do not have any supply chains with Russian mines. Moreover, one of the Ukrainian energy companies with mines “stranded” in the non-controlled territories, DTEK, has repeatedly called on the international community to restrain from purchasing this coal, as Russia has actually stolen it from Ukraine

10
How the stereotype of
Rotterdam+ harmfulness
appeared

The media campaign against Rotterdam+ started immediately after the ferroalloy plants lost their reduced tariff and it has been going on for three years. According to experts’ estimates, the cost of this campaign may total more than USD 5 million.

On the air of 1+1 TV channel (owned by Ihor Kolomoiskyi) for the period from January 2017 to July 2018, the formula was criticized 71 times. A record number of materials was released in May 2018, totaling 27 negative items.

A pool of faux experts and analysts appeared. Their specialization has been exclusively criticizing Rotterdam+. One of the main public critics of the formula was the Energy and Utilities Consumers Association established in September 2017. Its activities focus mainly on criticism of the formula, e.g. the Association launched a website with a counter that calculated the losses of ordinary citizens from the formula, calling it a “corrupt royalty”. The “calculation” methodology has not been explained. The counter stopped working a few days before this text’s publication. Who are the members of this Association, except its founders? This is unknown. The Association’s website has stopped updating since May of this year.

Monitoring of the critical materials demonstrates almost complete absence of reasoned figures and methods of calculation. Most criticism is based on emotional clichés. The formula is called “scandalous”, “harmful”, “odious”, or simply a “scheme.” Some critics even started to claim that “the coal was supposed to be delivered from Rotterdam itself”.

An alliance of economic interests of large businesses (those who are against the Rotterdam+ formula) and experts who are striving to realize their political ambitions has created a myth that the formula is evil, and the only reason it was introduced is to rob citizens. This tale takes into account neither market factors, nor calculations nor the historical context in which the decision on the formula’s adoption was made

11
Why did DTEK bonds start
to rise? Due to economic
growth

DTEK is a group of companies that produces and sells coal to thermal power plants and it is the main player in the Ukrainian coal market. During the implementation of Rotterdam+, the price of DTEK bonds started to grow, which led to accusations of unfair excess profits. In fact, the reality is different.

The formula was adopted in March 2016 but it came into effect in May. It was then, for the first time after the outbreak of the conflict in the east of Ukraine, that the economy started to emerge from the crisis. In the second quarter of 2016, macroeconomic stabilization became broadly observed. This is evidenced by the growth of bonds of the main issuers in the country – MHP, Metinvest, FUIB and Ferrexpo. A rising tide lifts all boats.

In 2016 the prices of big Ukrainian companies’ bonds rose
In 2016 the prices of big Ukrainian companies’ bonds roseIn 2016 the prices of big Ukrainian companies’ bonds rose

DTEK and other issuers showed a correlation of growth of 95%. Shares of other players, e.g. Ferrexpo or MHP, could not have been growing due to Rotterdam+. This means that performance is not related to one piece of legislation. What is it related to then? To the post-crisis recovery of the Ukrainian economy.

In addition, in 2016, the profitability of Ukrainian mines and thermal power plants increased (compared with the crisis year of 2015, when their loss ratio fell to -25%)

12
Nowadays the Rotterdam+
formula is optional

On 1 July 2019, the energy sector of Ukraine entered a new era – a new model of the electricity market was launched. The state-owned enterprise Energorynok was liquidated, suppliers and consumers are concluding direct contracts, a “day-ahead” stock market platforms appeared, as well as intraday and balancing markets. All this led to the fact that manual regulation of tariffs has practically disappeared in the energy sector. In fact, the practice of objective tariff formation, which started with Rotterdam+, was extended to other types of generation.

It is impossible to finally evaluate the long-term consequences of changes in the energy market for the previous three months. However, their benefits to the country’s business climate are obvious. Energy Security Project experts with USAID rated the first results of the market as follows: “the results of the first ten days of the wholesale electricity market operation in Ukraine prove that the launch of the market was successful”

Ukrainian energy at a crossroads.
What will happen next?

Ukraine should develop its energy independence. A free European energy market is the main condition for this. Only then, with understandable rules of the game, will investors trust Ukraine. Indeed, trust is built on respect for private property, market rules and investment protection. Opaque rules changing almost every year scare investors. The state cannot and should not constantly subsidize state-owned companies, while punishing private ones for their efficiency. The state cannot and should not set higher prices for imported coal, demand coal availability and shift blame for the public market position. Such a scenario is utterly disastrous for Ukraine and especially in the energy sector.

Ukrainian energy sector has passed two stages since 1991. The question is what will be the third one
Ukrainian energy sector has passed two stages since 1991. The question is what will be the third oneUkrainian energy sector has passed two stages since 1991. The question is what will be the third one

The years 2016-2019, when the Rotterdam+ formula was in effect, were a transitional stage to a free electricity market. Whether it will work efficiently, without manual pricing, without discounts and a return to corruption schemes is an open question. In August 2019, the National Anti-corruption Bureau of Ukraine (NABU) reported suspicion to six persons who were involved in implementation of the Rotterdam+ formula. In fact, this is a litmus test, a test for corruption and whether Ukraine is ready for European rules. Further actions will be the answer to this test. We will understand whether we will have a civilized market economy and warmth in our homes this winter, or will we return to “manual control” with preferential tariffs for ferroalloy plants and an image of a third world country where the state is a means of pressure and a tool for realization of private interests.

Course of events. How
did the electricity market
become free and why is
there a threat to roll back?

1991
Manual regulation of prices and corruption

2013
August
Ferroalloy plants receive privileges for electricity according to a memorandum signed with the Azarov government

2014
April
Beginning of the war in Donbas. Ukraine loses control over mines in Donetsk and Luhansk regions

December
Coal shortage in Ukraine. Rolling blackouts begin

2015
June
The Ministry of Energy and Coal Industry prepares a draft law “On the coal market”

2016
Rotterdam+ – preparation for a free energy market

March
Adoption of the Rotterdam+ formula

April
Coal shortage eliminated. The price of Ukrainian coal starts to rise

May
The Rotterdam+ formula takes effect. The electricity tariff for ferroalloy plants grows by 5.6%. (Dis)information campaign against Rotterdam+ starts

October
Electricity tariff for ferroalloy plants grows by 9.9%

2017
March
Nikopol Ferroalloy Plant owned by Ihor Kolomoiskyi tries to return the old tariffs through the courts. Court rejects

June
The law “On the Electricity Market” comes into force. It anticipates a transition to a free electricity market in two years

2018
January
Electricity tariff for ferroalloy plants grows by 17%

2019
A free energy market or return to manual regulation and corruption?

July
Launch of a new electricity market in Ukraine

August
Court makes anti-market decisions and stops functioning of a unified tariff for the plants of Ihor Kolomoiskyi: Nikopol and Zaporizhzhia ferroalloys plants, Dniproazot, Marhanets and Pokrov Iron Ore Enrichment Works