Ukraine’s rent on oil and gas: how to share revenues fairly and make sure they grow

By Jonathan Popper, Executive Vice President, Corporate Development & Strategy of Ukrnafta, for Ekonomichna Pravda

Ukrnafta operates in many regions across Ukraine and works with many local communities. Some of them are better off, others are less so. But all of them could and should benefit more from oil and gas taxes collected by the central government. Right now all 100% of royalties from oil and gas go to the central budget.

Last week’s deliberations over draft law #3038 at the Rada's Energy Committee show that there is a solution to this problem. The bill initiated by Olga Bielkova and other MPs proposes to split the royalty revenues, with 5% going to the local budgets and 95% - to the central budget. The 5% share will be further split: local communities will receive 2% and oblast and rayons - 1.5% each.

Ukrnafta strongly supports this proposal. We even think the split could be more generous in favor of the local communities, but it's a good start anyway. The 5% means about 2 bln UAH in additional revenues for the oil and gas communities which could be spent on infrastructure, roads, hospitals, schools or diversifying away from oil/gas. Proper use of these funds is a valid concern, but the answer is more transparency and more civic activism, rather than withholding the money altogether. The proposal is in line with the government's commitment to decentralization which will shift more decision-making responsibilities but also more resources to the local level. It also aligns with the recommendations of the internationally-acknowledged National Resource Governance Institute for the central government to link revenue distribution to the expenditure responsibilities of local governments, and with the international practices from Canada, the US and some of the European countries where royalty revenues are shared between central and local governments.

We know that the local communities would support this proposal. In fact, so would many of the oil and gas companies - their license to operate depend on the local communities, both literally and figuratively.

While the government debates over how to share the royalty revenues, it should ensure sustainability of tax revenues. With the royalty on oil at 45% and on gas at 29%, Ukraine is not competitive in the European region. According to the review of royalties and similar taxes in Europe produced by Deloitte in September 2015, the average royalty rate in the EU was about 12%. The rates in the countries neighboring Ukraine range from 1% in Poland to 15.7% in Romania. Many European governments were considering revising down the effective tax rates on the back of declining prices for hydrocarbons.

The Ukrainian government lowered the royalty on gas from 55% to 29% last January. However, the royalty rate for oil remains at 45%. This is unsustainable even for maintaining the current rate of oil production at Ukrnafta, not to mention doubling the company’s output of oil to 3 mln tons a year by 2025 as per Ukrnafta’s long-term strategy. In order to achieve that, Ukrnafta will need to invest at least $100 mln a year starting now. However, if the oil prices fall to where they were in early 2015 the company will be generating a negative cash flow instead. Needless to say that with the current taxes on hydrocarbons, Ukraine is unlikely to see new investors either, especially when the neighboring jurisdictions offer a more favorable taxation regime and stable business environment.

The government has done the right thing by lowering the royalty for natural gas. As a minimum it should consider bringing down the royalty rate for oil to the same level. However, if the government wants to stimulate production and investment, and not just stave off the decline in the industry, it should consider setting oil and gas royalty rates on the par with the neighboring EU countries OR on the par with the EU average. In 2-3 years the government will be collecting more tax revenues due to higher production to cover any short-term decline from reducing the royalty rate, and ensure sustainable growth of tax revenues for the central and local budgets going forward.