Energy market should be based on a competitive rather than directive model

Energy market should be based on a competitive rather than directive model
Energy market should be based on a competitive rather than directive model

Question: DTEK has reported that it has lost control over its companies in the non-government controlled territory (NCT) of Ukraine. How does the situation as of the 1st of March and 15th of March differ for those companies?

Answer: Unfortunately, what happened is exactly what this whole predicament with the blockade was gradually progressing towards. We kept saying that there was a serious risk of the 'local lords' would use the blockade to physically seize our companies. And so they did.

Following our attempts to unblock the key railway section Yasynuvata-Skotovata we received a notification demanding that we register our companies in the unrecognised republics and pay taxes in the non-controlled territories. Under no circumstances we would agree to such a demand.

Question: What exactly happened?

Answer: Consider Mine Komsomolets Donbasa. It is one of the best mines in the coal industry of Ukraine. During the blockade the mine continued to operate as it was supplying coal to the Luhanska TPP. It was the only railway section that allowed us to supply coal from Mine Komosomolets Donbasa to the Luhanska TPP and, consequently, keep the enterprise running and pay miners their wages. On the 13th of March heads of our companies received copies of the documents confirming that the 'state companies' with the same names had been registered in the so called Donetsk People’s Republic (DPR). They also received orders launching the inventory processes at our companies and imposing bans on the disposal of our property. All this was followed by a demand to pay taxes to the budgets of the so-called LPR and DPR. It goes without saying we could not agree to such terms.

Question: Do you think it will be possible to bring the coal from the NCT? Will it be sold to Ukraine, or go to Russia?

Answer: There are two key reasons why it is impossible to sell this coal: no sales market and illegal status of the product.

Let's start with the sales markets. Our three coal-mining companies that produce anthracite in the non-controlled territories (Sverdlovanthracite, Rovenkyanthracite and Mine Komsomolets Donbasa) should have produced 12.8 mln tonnes of coal this year. As the Starobeshivska TPP of Donbasenergo accounts for about 2.2 mln tonnes of coal consumption in the ATO zone, there appear to be about 10 mln tonnes of coal left without any market to be sold on.

And now to the Russian Federation. They produce about 12 mln tonnes of saleable anthracite, whereas their internal consumption totals about 3.5 mln tonnes. 85% out of 3.5 mln tonnes is consumed by the Novocherkasskaya GRES located in Rostov Region and owned by Gazprom. It is the key, if not the only buyer of the coal produced by the Rostov mines. Thus, Ukraine remains the strategic market for the anthracite produced in the non-controlled areas.

Those who are not experts in coal business can assume that if Ukraine no longer wants to buy this illegal coal and Russia does not simply need it, it can be exported. But the quality of this coal does not meet the external market requirements. The average sulphur content in Ukrainian anthracite is 1.7%, whereas in T grade coal it is 2.6%. But for export you need 0.9% and less. In layman terms, this coal cannot be exported.

The second reason is the 'toxic' legal status of such coal. We have already launched criminal proceedings relating to the seizure of our companies. Eleven criminal cases have been initiated following a police report filed by DTEK. All movable and immovable property will be arrested as per the list we have submitted. It means that production and shipment of any goods will become criminal. And we have legal grounds to file a claim if we find out that such coal is consumed.

The first thing we did was to send a caution to Donbasenergo, whose Starobeshivska TPP operates in the non-controlled territory. When the 'lords' from the self-proclaimed republics came to Mine Komsomolets Donbasa, the first thing they said was 'we will take five thousand tonnes of coal per day for the Starobeshivska TPP'. And when we made our public statement - on the 21st of March - Donbasenergo reported that it lost control over the Starobeshivska TPP.

We take the same measures with regard to the Novocherkasskaya GRES, which is the second potential buyer of the illegal coal. The plant is owned by Gazprom whose securities are traded on more than ten stock exchanges. The plant will receive a similar caution in the very near future. We also plan to forward notifications to all stock exchanges.

Question: Who else can buy this anthracite?

Answer: We have a list of 32 companies that can potentially buy this coal. Each of them will receive a similar letter of notification. We've set up a special 'anti-crisis centre' in the company, where lawyers play a leading part. We've been warning from the very beginning that we would defend our property and our product by all available legal means. Metinvest takes the same legal position and we coordinate our actions. As I said, any entity’s interaction with the 'nationalized' enterprises can actually be qualified as complicity in crime.

Question: Will your employees and executives continue to work there after the intrusion of the armed people?

Answer: The most tragic thing is that the people who have suffered more than enough over the last three years are affected. We employ 36 thousand people, and unfortunately, it's impossible to find jobs for all of them here. Everything that the local lords managed to get their hands on ended up either shut down, or destroyed, or plundered. On our part, we proposed that the employees consider taking a job at other DTEK companies. To date we have been approached by more than 500 people, mainly managers.

Question: What in your view are the chances of getting back control over your assets if the President revokes his blockade order? Is that a realistic scenario?

Answer: I doubt that the next months will see something happening. Time is the key factor here. The later the local lords realise the consequences and the impossibility for these companies to operate normally, the more severe would be the damage and the less would be the chances to bring them back to a full-fledged operation. So far I have seen no signs of things moving in that direction. All the talks at the international level that this is a temporary administration rather than a property expropriation are just tales for naive people.

Question: If the mines are shut down, how serious might be the environmental implications?

Answer: The implications may turn out catastrophic. One of the basic principles is: one cannot close a mine just like this. Mines that have not been producing coal for 10-15 years still have water pumped out and workings ventilated. There should be 100-200 people keeping such mines safe 24/7.

For example, in the Donetsk region the Mine Komsomolets Donbasa has another five abandoned mines adjacent to it. Underground water from these mines, through cracks in the rock growing year by year, is making its way to the working mine. And while in 2014 we pumped out about 5 million cubic meters of water, the 2016 saw its volume rising to 12 million cubic meters. In volumetric terms it is comparable to a huge and deep lake. If this water makes it to the surface, about 200-300 hectares of land will get flooded, which is equivalent to almost two Kyiv botanical gardens. As the mine waters are not crystal clear, aside from flooding, you have the risk of having the potable water polluted and the epidemiological situation worsened.

In the Luhansk region, each of the two coal mining plants pumps out even more water - almost 30 million cubic meters.

I am saying this with an absolute certainty because we faced a similar situation in August 2014. At that time, the hostilities resulted in Komsomolets Donbasa being fully de-energised, and there were only few hours left before the mine would have got flooded completely. And there would have been no way to restore it in the future. I remember our workers bringing back power supply under fire, and we did save the mine. Given that the current attitude to the occupational safety is most likely very superficial, the mines are facing a genuine threat of being destroyed without gunfire. And the same fate awaits all neighbouring communities.

Furthermore, there is a real threat of uncontrolled methane explosions in both regions.

Question: Let's switch to the company's financial standing. Has DTEK already started talks with the Eurobond holders to inform them of potential consequences and risks?

Answer: Absolutely. We are on a difficult path with the restructuring of our debt. In December last year we signed a restructuring agreement with all the bond holders, and our present bond issue matures in 2024. Its conditions are not unbearable for the company. We made an official statement after what happened, saying that those events would not negatively affect our performance of the obligations to service the Eurobonds. Last week, as part of the Dragon Capital investment conference we held meetings with major funds which hold our securities. We keep our investors constantly updated and are utterly open with them.

Question: What overall effect will the blockade have on Ukraine?

Answer: There are several serious negative consequences of the blockade, which have been talked about for a month. You may remember that last summer railmen of the Donetsk Railways came out on strike. If we take a look at the monthly trend of the country's GDP, the only month where that indicator went down by 3 % was the very month when railway shipments from the ATO zone stopped. So the whole situation will undoubtedly take its toll on the industrial growth, if any, on the GDP and on the trade balance as a whole.

As a result of the IMF delaying its tranche, everybody started actively looking for accurate economic information. We gave the Ministry of Finance data showing that the seized DTEK companies had paid more than UAH 4 billion of taxes in 2016. The losses in 2017 are forecast to reach about UAH 5 billion.

There are risks for the national currency as well because today anthracite is produced only in the non-controlled area, and the alternative source is its imports. Even with the anti-crisis initiatives of the industry leaders in place, which are mainly aimed at increasing Energoatom's output and the output of power plants running on G grade coal, we will still need about 5 million tonnes of precisely this type of coal, anthracite, by the end of the year. It means that the external trade balance shortage will increase by $0.5 billion more.

Another direct consequence of the blockade will be the growth of the wholesale market price for electricity. The Ukrainian industry is going to feel it in its tariffs. All these consequences brought about by the actions of the populist deputies and pseudo experts, who are in fact destroying the country's economy, will be felt by each and every Ukrainian. I hope that the initiators of the blockade will be made at least politically accountable for Ukraine losing its industrial companies, an inevitable growth of tariffs and deteriorating living standards.

Question: Do the external markets have the coal resource we need?

Answer: It can be delivered. We have reviewed all the supply options currently available in the global coal markets. The key sellers are the RSA, Asia and Australia. So, coal is available; it is the question of its price. Now, the tariff of the coal-fired generation covers the coal price of UAH 1,730 per tonne.Yet, today's price of the imported coal with the quality parameters acceptable for our thermal power plants varies within the range of $100-110 per tonne when delivered to the plant. You can easily make the calculation. Let's take the required volume of five million tonnes, multiply by the above price, and we can estimate the additional financial burden on the Ukrainian energy sector. Furthermore, this amount has to be paid in foreign currencies as prepayment.

Question: Has DTEK already managed to reach some agreement to import coal?

Answer: According to our estimate, our demand till the end of the year is over two million tonnes. As of today, we have already contracted one ship; the delivery is expected in early May. As for the remainder, we continue negotiations. This week we should approve the commercial strategy for providing our TPPs with coal till the end of the year.

Question: Does the company have enough financial resources?

Answer: It is related to the efficiency of management, including governmental management. In 2013, they adopted Law No. 663 "On the Electricity Market". The law's transitional provisions stipulate the state enterprise Energorynok will continue operating till the middle of 2017. As no one even remembers about this law, and no one has tried to implement it properly, and now, we are going to have the new law, it has been completely forgotten.

Yet, from the start of this year, Oschadbank formally cannot extend the credit lines for Energorynok as pursuant to this 'forgotten' law No. 663, this state enterprise has to terminate its activities. This means that Oschadbank has to close the credit line, and money will be 'taken away' from the energy market. Thus, it is now when money is needed to import coal, we do not have the possibility to do so because of some legal complications, and we are losing this financial resource.

The second issue is the thermal generation tariffs that currently do not allow the companies to import coal or sufficiently invest in national coal production. Provided the problem with the extension of credit lines is resolved, and the tariff is adequate, we will be able to fully satisfy the demand of our TPPs for coal.

Question: As for switching generating units at TPPs from anthracite to run on high-volatile steam coals, are you ready to seriously consider this option now?

Answer: It is a popular myth that Ukraine has a surplus of G grade coal, and only due to the shortage of the suitable units, the TPPs have to burn anthracite. The reality is different: late last year, we had to import G grade coal from Poland as due to the declined coal production in the controlled territory, Ukraine suffered a shortage of this coal too. This had been a result of politicians' games with 'cheap' Ukrainian coal. The industry responded to the price discrimination exactly as this could have been anticipated: the production dropped. Thus, before investing billions in the transfer of units from anthracite to G grade, you have to be sure that the G grade coal would be available. At the moment, we do not have this coal, and to get it, huge investments in coal mining are necessary.

Moreover, there are some important organisational and technical aspects. For instance, to transfer the units of the Prydniprovska TPPs from one coal grade to another, we have to take them out of service for nine to twelve months. Yet, the generating units at the Prydniprovska and Kryvorizka TPPs are very close to the end of their service life: they have been in operation for 40-50 years and require mandatory retrofits as early as in four to eight years. The Kryvorizka TPP has only two retrofitted units, whose service life has been extended for 15 to 20 years. So, we have to consider new build projects instead of wasting money on upgrading old facilities to run on another fuel. This issue should be raised by the government as part of the energy strategy discussions.

The situation in the Ukrainian energy sector remains critical; so, our current tactical task is to enable G coal-fired units to bear the highest load and ensure sustainable imports of required coal to satisfy the remaining demand. As for the hubs where the energy system requires the operation of anthracite-fired plants, we have to transfer the minimal number of units to run on G grade coal and in future consider new construction.

Question: Will DTEK scale up its G grade production capacities at Pavlogradugol in the current year? What plans do you have regarding coal imports from Poland?

Answer: Given the changes in the coal balance, we need about two to three million additional tonnes of coal. Now we can use the coal produced by our mining companies in the controlled territory that we used to supply to the Zuivska TPP located in the non-controlled territory. As for imports, even last year we imported G grade from Poland, and this year, we plan to import up to 500 thousand tonnes.

Apart from the above, we are focusing on scaling up our internal production. In order to increase coal output, we have to invest in Dobropolyeugol and Pavlogradugol. Again, it is an issue of economy, since it makes sense to invest only if your investment is protected and you have resources to invest.

Question: What guarantee do you want?

Answer: The first thing we need is pricing rules. We have always said - earlier this year and in previous years - that we need a market price for coal and an indicator for fair and transparent price-setting. The name and components of the formula do not really matter. What matters is a set of rules recognised and respected by the state. When the coal prices go up, we are ready to invest more and develop our business; yet, we can scale down when the prices decline.

But how can we invest if everything depends on of public officials' mood or political will? We cannot! Recently, we have seen tremendous growth in the renewable energy sector, with many western companies entering the market building and planning to build new generating capacities. It has become possible due to the regulatory tariff setting to be in force for several years. You invest, get a good rate of return on you investment and feel safe.

In the coal business we do not feel protected by any price-setting mechanism. When a formula is based on market indicators or indices, in my opinion, it is the most objective reference as it cannot be influenced. The coal price changes every day, and anyone can easily check the values with a calculator. If your calculator works well—accurately and objectively, it does not matter which index you take — European API2, or South African API4.

Anyway, it is an uncontested value, which cannot be manipulated with and that is the advantage. The Russian market is closed for us. The Polish low-liquidity market does not have much to offer us—maximum 1-2 million tonnes of coal. Therefore, API2 represents the biggest and the most liquid market of steam coal.

Unfortunately, the regulator has introduced a 12-month lag. At the beginning of the year, API 2 was $40, whereas at the end it was already $85. As a result, the coal prices factored into the effective tariff happened to be below the market ones. As long as Ukraine was able to satisfy its coal demand itself, the problem was concealed. But after the mines in the non-controlled territory of Donbas have been lost, the inadequacy of the formula has become critically obvious. We have to import anthracite coal. The formula-based price is $66 plus around $15 for trans-shipment and delivery, which is $82 in total. Yet, the real cost for anthracite import confirmed by experts is minimum $100. Who will cover the difference of $20 per a tonne? Nobody knows.

Instead, they continue to manipulate public opinion and juggle with different prices for different grades of domestic and foreign coal. I have a question: “Gentlemen, it is a high time to stop playing with anthracite prices and blockades, isn't it? Or the G grade coal will be your next toy?”

Coal production is a capital-intensive industry. To produce enough coal, let alone to increase the coal production by 1-3 million tonnes, continuous investments are needed. At a time when it is extremely important to substantially increase the output, heavy investment is rather a vital necessity than a strategic choice. Development, sustenance of production and maintenance of the surface infrastructure require significant investment. So, who, in your opinion, should be entrusted with setting prices: facebook pseudo-experts whose opinions are politically biased or the real global coal market? I wonder why the market based pricing in the gas sector is not a problem. After all, coal is used to produce electricity and heat for millions of Ukrainian people.

Question: How to cover the $20 tariff gap you mentioned?

Answer: As far as I know, the discussion about coal prices has been launched. We insist on market indicators. Any indicators can be used, but they should be market-based and serve as a transitional measure before the implementation of a new energy market, operating under a competitive rather than prescriptive model. And it also has to be a real price at which coal can be imported. What is most important now is to adopt Law No. 4493 On the Electricity Market. As soon as the law comes into force, the public discussion on pricing will subside.

Question: Please comment on the statement that over the last month Ukrainian TPPs have improved their profitability, which makes it possible to cover the $20 gap.

Answer: In March, TPPs have had what we can call relatively high tariff rates, but our share in the total generation has been record low. There is a logical explanation to that: the emergency situation announced in the energy sector, shortage of anthracite, and higher output by Energoatom and Ukrhydroenergo. But it’s not only about the volume. The TPP tariff for March that we see today averages some 1.7 UAH / kWh, but covering today’s coal price, which reaches UAH 3 thousand, and having at least a 5% margin would require a tariff of at least 1.9 UAH / kWh.

Coal contracts have to be made already now, but the market requires 100% prepayment, and you need to accumulate this money. If today the regulator says that the March tariff will be extended until the end of the year, then with this tariff source, it will be possible to start talking with banks about letters of credit. Yet, while the regulator's December resolution, envisaging the average annual tariff of 1.3UAH/kWh, remains in force, it is impossible to import coal.

Question: Are there any alternatives to coal imports?

Answer: When we were getting coal from the anti-terrorist operation (ATO) zone, the fuel price was UAH 1,730 per tonne. This possibility is not available any more. The option you are talking about is to start units operating on gas and heavy fuel oil. There are such capacities, but if we purchase gas and use these gas-fired units as an alternative, we will burn the fuel which price will to be equivalent to 4,300 UAH per tonne of coal. So, if the resource is not allocated, and the tariff situation is not improved this year, and consequently, coal is not imported, we will switch to using the gas-fired generating units, which will result in the actual cost of UAH 4,300 instead of UAH 2,800. Thus, the fuel component in the tariff will drastically increase.

Question: What is the production growth potential of your mines provided the investments are made?

Answer: This year, we are planning to produce 3.8 mln tonnes of run-of-mine (ROM) coal at Dobropillia. I guess that we can increase up to 5 mln tonnes. As for Pavlograd, due to the technical limitations, 19-20 mln tonnes is the amount we should produce. If we have 25 mln tonnes of ROM coal produced at those two mining companies, this will be enough according to our estimates.

Question: Does DTEK consider an acquisition of state-owned mines or is it easier to invest into your own assets?

Answer: We are not planning to expand our coal business through buying new assets yet.

Currently we have two coal mining companies: Dobropolyeugol and Pavlogradugol. When we purchased Pavlogradugol in 2005, it was producing 10 mln tonnes of coal, while in 2016 the production was more than 19 mln tonnes. This is an example of what can be done by an efficient private investor. With the original level of production, we would be lamenting of 20 mln tonnes of anthracite deficit instead of 9 mln tonnes. The available G grade coal volumes are to a great extent due to our investments in the development of the coal business, which amounted to more than USD 2 bln over ten years. That is the answer to the question where our credits were allocated to and what effect they brought. We are currently balancing our demand through investments into Dobropolyeugol and Pavlogradugol.

Question: Does DTEK consider switching from the thermal generation to alternative energy sources?

Answer: We are not just considering, we are doing it. As an example I can mention the 200 MW Botievo Wind Farm, which we constructed. Even today, despite the existing situation, we are actively negotiating with General Electric the construction of a new 200 MW wind farm in Primorsk area. GE is eager to enter the market and deal with big projects. Moreover, we are dealing with a consortium of banks. These are mostly German banks with government guarantees. If we can establish a pool of the banks not scared to invest in Ukraine and make a deal with GE, it will boost the wind generation development.

Largely DTEK's strategy is about replacement of the retiring capacities with green generation facilities: wind and solar. We are also launching a pilot solar power plant project in Kherson region. It is not a big project with the capacity of only 10MW, but we would like to try, and if financing is available, this pilot will be scaled up. These are our investments in the future, in new generation.

However, all estimates show that in the nearest 20 years, the country will not stop using coal. We need to optimize thermal generation where we have surplus capacities and carefully consider the construction of new and environmentally clean coal units on a case basis. Thus, we can start designing blueprints in 3-4 years from now. Yet, in the next 10 years, we plan operating the facilities that we retrofitted and the service life of which was extended. These are 18 out of 21 retrofitted units in Ukraine. But if to consider new build projects, our priority is the solar and wind energy segments.

In general, DTEK's strategic priority is building energy independent Ukraine. Here we see three key areas.

The first area is to increase gas production. This year we have produced 1.6 billion cubic metres of gas, a record output in the entire history of the private gas production in Ukraine. We have also sold the gas we produced in 2015, but could not sell due to some court restrictions.

The second area is to increase the production of G grade coal. This requires concentrating investments into two mining companies: Dobropolyeugol and Pavlogradugol, a potential increase in production will be at least 2 mln tonnes of coal.

The third area is to develop the new ‘green’ generation. Here, our ambitions are to construct 1 GW within 5 years.

Via Interfax-Ukraine

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