Ukraine is too important for its energy investment and tax policies to be ignored by the European Union and the US. If the Yanukovych government is serious about closer economic and political ties to the west, it should reverse its current policies and opaque practices, which are discouraging western energy investment.

Ukraine needs to establish a transparent investment regime that encourages, rather than discourages, non-Russian business in all sectors, including in oil and gas exploration, development and production. Only a level playing field for all energy investors and rational tax policies that encourage western companies will lead to Ukraine's integration into the west. The development of a strong Ukrainian democracy and thriving economy is important for stability in central Europe and therefore vital to the security interests of Europe and the US.

Ukraine symbolises the dilemma faced by all of the central European states as they search for greater energy security in an era of high oil and gas prices. At the same time, they are compelled to deal with a Russia determined to dominate its neighbourhood by manipulating the flow of energy to its customers. The Kremlin's neo-colonial objectives are being achieved in central Europe by working with complicit business groups and collaborative politicians in the importing countries.

Ukraine is resource-rich, but control of natural resources by groups hostile to western investors is a serious drawback to attracting foreign investment in new energy production. Although Ukraine split from the Soviet Union in 1991, it has continued to maintain a more friendly investment climate for Russian energy companies than for transparent western companies. Three- quarters of Ukraine's refining capacity is owned by state-owned Russian companies, such as Gazprom. Gazprom creations, such as EuralTransGas, help fund pro-Russian politicians. Another Gazprom creation, RosUkrEnergo, is now increasing its ownership and control over Ukraine's internal gas market at the same time that western companies are coming under pressure to close.

Western energy companies find it difficult to gain a foothold in Ukraine. Several large integrated European companies have failed to break through business barriers facing anyone but Russian or Ukrainian oligarchic groups. The technology and financing advantages for Ukraine from western companies are substantial. Ukraine would clearly benefit from substituting greater domestic production for costly imports. Security benefits would also flow from a decreased reliance on a Russia that uses its massive energy resources to exert political influence.

The Ukrainian council of ministers made the situation worse in January this year. It approved a budget act that obliges any energy company that is part of a joint activity agreement, almost all of which are western companies, to accept a fixed price for Ukrainian natural gas. The price is about70 per cent less than the market price. This has depressed production and reduced investment.

Although the stated purpose of the new law is to supplement the state budget, the effect is to squeeze western investors out of Ukraine. The beneficiaries are local oligarchic groups which can avoid the new tariffs by not being tied to a joint activity agreement and/or by evading price limits through non-transparent deals with the state apparatus. Also benefiting through reduced western competition is RosUkrEnergo.

Europe and the US remember Russia's shut down in 2006 of the pipeline carrying Turkmen and Russian natural gas supplies to Ukraine. The cut-off affected gas supplies to several EU countries, raising European concerns about the consequences of relying too heavily on Russian energy supplies. The disruption resulted from a dispute between Kiev and Moscow over the validity of their 2004 agreement on import prices and transit fees. Within four days of the cut-off, Kiev agreed to a one-year, largely non-transparent deal over price and volume.

Because of Ukraine's geo-strategic importance, the west should focus more attention on the country's need for greater transparency, particularly in the vital energy sector. If Russia succeeds in reasserting control over Ukraine by manipulating the flow of energy resources from Russia and from central Asia, it will be even more -difficult for the west to prevent the undermining of democracy in the other newly democratic states of Europe. Russia's use of energy as a foreign policy tool could drive a wedge between Europe and the US. Much will depend on the policies of the central Europeans and especially the Ukrainians.

By Keith Smith
Article is provided by FT
The writer was a career diplomat with extensive experience in central Europe and is now senior associate at the Center for Strategic and International Studies in Washington, DC

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