11. SPARC RFP 72012124R00004 Amendment 8 Jan 11.pdf

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9A. AMENDMENT OF SOLICITATION NO.

72012124R00004 TO ALL OFFERORS x

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Thank you for your interest in USAID/Ukraine SPARC RFP.

Carter Saunders Contracting Officer

BY 01/11/2024

X

/s/

REQ-121-24-0000XX

720121

X

PHASING OUT THE HOUSEHOLD

PUBLIC SERVICE OBLIGATION IN

ELECTRICITY

GREEN PAPER

Energy Security Project (ESP)

July, 2023

RevD

PHOTO: ОЛЕКСІЙ КРАВЧУК-STOCK.ADOBE.COM

Attachment J.3 Part 3

This document is submitted to fulfill the Contract Section C.3, Activity 3 and Fee Deliverable 38 following its revision and discussion with the Energy Community, Ministry of Energy, and NEURC.

AUTHORS

George Karagutoff, Energy Sector Director

Nadiia Iermolenko, Senior Finance Expert, Nadiia.Iermolenko@tetratech.com

Inna Dzhurynska, Senior Legal Advisor, Inna.Dzhurynska@tetratech.com

Oksana Shevchuk, Deputy Senior Finance Expert, Oksana.Shevchuk@tetratech.com

Andrii Bykov, Financial Analyst Expert, Andrii.Bykov@tetratech.com

Valeriia Mizetska, Financial Analyst Expert, Valeriia.Mizetska@tetratech.com

USAID/Ukraine

Ms. Kathleen Kirsch

Contracting Officer's Representative

USAID Energy Security Project

Tetra Tech ES, Inc., USAID Contractor

Mr. Michael Trainor

Chief of Party mike.trainor@tetratech.com

4 Igor Sikorsky Street

Kyiv, Ukraine 04112

Phone: +38-044-521-5000 https://www.usaid.gov/ukraine

14A Yaroslaviv Val St.

Kyiv, Ukraine 01030

5-6th Floor www.tetratech.com mailto:Nadiia.Iermolenko@tetratech.com mailto:Valeriia.Mizetska@tetratech.com

CONTENTS

ACRONYMS 1

EXECUTIVE SUMMARY 3

1. PROBLEM STATEMENT 9

2. BACKGROUND 10

2.1. RECENT SUBSIDY MECHANISMS 11

PUBLIC SERVICE OBLIGATION 12

HOUSING UTILITY SUBSIDY (HUS) 14

3. ANALYSIS OF CURRENT HH PSO 16

3.1. KEY RISKS OF THE PSO MECHANISM 16

3.2. FINANCIAL RESULTS OF EA AND UHE UNDER HH PSO MECHANISM 19

3.2.1. EA FINANCIAL RESULTS ARE NEGATIVELY IMPACTED BY THE PSO 19

3.2.2. UHE FINANCIAL RESULTS ARE STABLE AS OPERATIONS WERE NOT THAT

IMPACTED BY THE WAR 24

3.3. SUMMARY OF PROBLEMS AND PROPOSALS FOR SOLUTIONS 26

3.3.1. SUMMARY OF THE PROBLEMS 26

3.3.2. PROPOSALS FOR SOLUTIONS 27

4. EU EXPERIENCE ON HH PRICE SETTING AND PROTECTION

OF VULNERABLE CUSTOMERS 29

4.1. ELECTRICITY PRICES FOR HH 29

4.2. ELECTRICITY PRICES BREAKDOWN 32

4.3. PUBLIC PRICE INTERVENTION 33

4.4. VULNERABLE CUSTOMERS 35

4. PROPOSED SOLUTIONS 40

4.1. GRADUAL INCREASE OF HH PRICE IS NEEDED 40

4.1.1. FORECASTING FOR PASS-THROUGH COSTS AND ENERGY PRICE TO

ESTABLISH THE TARGERTED INCREASE 41

4.1.2. APPROACHES ON DSO CHARGES IS CRITCIAL TO MAINTAINING OR

ABOLISHING UNIFIED HH PRICE 46

4.2. TARIFF INCREASES HAVE AN IMPACT ON THE AFFORDABILITY AND

INCREASE HUS OUTFLOWS 49

4.2.1. AVERAGE BILL PROJECTION AS A BASIS TO CALCULATE AFFORDABILITY50

4.2.2. AFFORDABILITY ANALYSIS TO ASSESS IMPACT ON UTILITY SPENDING

FROM MONTHLY INCOME 50

4.2.3. BUDGET BENEFITS FROM THE PRICE HIKE 53

4.2.4. HUS SYSTEM - INCREASE OF NEW BENEFICIARIES IS OFF-SET BY BUDGET

SAVINGS 55

4.3. STANDARD PRODUCTS IMPORTANT TO ENSURE MARKET MEETS USS

NEEDS 56

5. REQUIRED LEGAL CHANGES 58

5.1.1. TRANSPOSITION OF ENERGY DIRECTIVE IN UKRAINIAN LEGISLATION IS

NEEDED 58

5.1.2. PROPER ALLOCATION OF POWERS BETWEEN NEURC AND CMU FOR

PHASE-OUT 60

6. FINAL RECOMMENDATIONS 62

7. ANNEXES 64

ANNEX A. BRIEF HISTORY OF UKRAINE’S PREWAR PSO 65

PHYSICAL PSO INTRODUCED SUPPORT THROUGH SUBSIDIZED PURCHASES 65

“QUASI” FINANCIAL PSO INTRODUCED FINANCIAL SUPPORT TO USS FOR

THEIR MARKET PURCHASES 72

THE IMPACT OF THE WAR 73

ANNEX B. ROADMAPS FOR REMOVAL OF REGULATED RETAIL

PRICES IN EU COUNTRIES 77

ANNEX C. OVERVIEW OF MEASURES TO PROTECT ENERGY

CONSUMERS DUE TO COVID-19 IN SEVERAL EU COUNTRIES 78

ANNEX D. OVERVIEW OF SCENARIOS TO FINANCIAL MODEL 79

ANNEX E. FORECAST OF HH PRICE UNDER DIFFERENT HH PSO

PHASE-OUT AND INFLATION SCENARIOS 80

ANNEX F. COMPARATIVE TABLE OF PROPOSED LEGISLATIVE

CHANGES 82

ANNEX G. MEASURES APPLIED BY ENERGY COMMUNITY

CONTRACTING PARTIES TO PROTECT VULNERABLE

CUSTOMERS 86

ANNEX H. SENSITIVITY ANALYSIS OF PSO PHASE-OUT RESULTS

TO ELECTRICITY MARKET PRICE INCREASE FOR 5Y HH PSO

PHASE-OUT SCENARIO 88

ENERGYSECURITYUA.ORG PHASING OUT PUBLIC SERVICE OBLIGATION IN ELECTRICITY | 1

ACRONYMS

2H Second Half

ACER Agency for the Cooperation of Energy Regulators

B Billion

CBA Cost Benefit Analysis

CMU Cabinet of Ministers of Ukraine

DAM Day-Ahead Market

DSO Distribution System Operator

EA NAEC Energoatom (State Enterprise)

EML Electricity Market Law

EnCS Energy Community Secretariat

ENTSO-E European Network of Transmission System Operators

ESI Tetra Tech ES, Inc.

ESP Energy Security Project

EU European Union

F-PSO Financial PSO

FiT Feed-in Tariff

FS Financial statements

GB Guaranteed Buyer (State Enterprise)

GoU Government of Ukraine

HH Households

HPP Hydro Power Plant

HUS Household Utility subsidy

IMF International Monetary Fund

MoE Ministry of Energy

MS Member State

MSL Minimum Subsistence Level

NEURC National Energy and Utilities Regulatory Commission

NPP Nuclear Power Plant

NRA National Regulatory Authority

PSPP Pumped Storage Power Plant

PSO Public Service Obligation

RAB Regulatory Asset Base

RE Renewable Energy

REMIT EU Regulation on Wholesale Energy Market Integrity and Transparency

RES Renewable Energy Supply

SoE State-owned entities

TSO Transmission System Operator

UAH Ukrainian Hryvnia

UHE Ukrhydroenergo (State Enterprise)

USO Universal Service Obligation

USS Universal service suppliers

VAT Value Added Tax

WEM Wholesale Electricity Market of Ukraine

ENERGYSECURITYUA.ORG PHASING OUT PUBLIC SERVICE OBLIGATION IN ELECTRICITY | 3

EXECUTIVE SUMMARY

This paper presents a comprehensive strategy to phase-out the Household (HH) Public Service

Obligation (PSO) and offset it by increasing the Household Utility Subsidy (HUS). This paper demonstrates how consumers can be protected while simultaneously reducing fiscal burden on the

State Budget and improving the financial health of energy companies.

Ukraine is actively pursuing reforms in its energy sector in line with best practices and to meet the requirements for European Union (EU) accession. One aspect of reform that requires careful attention is how best to provide for the basic energy needs of the most “vulnerable” members of society. The Russian invasion has significantly complicated this task as the massive population displacement and the widespread loss of jobs across Ukraine significantly increased the number of potential vulnerable households while at the same time it challenging to identify them as they were on the move.

The Energy Security Project (ESP) funded by United States Agency for International Development

(USAID) and implemented by Tetra Tech ES, Inc., is supporting the Government of Ukraine (GoU) throughout the phase-out of household PSO in electricity sector as part of the energy sector reform. In the presence of the war, the path toward PSO phase-out should consider the current social and economic realities of Ukraine; it is the time to start the dialogue, conduct analyses, and begin helping policymakers, and the general public understand that there is a better option of providing support to vulnerable households and improving energy sector performance.

Ukraine’s approach to subsidizing electricity consumption by HH is multi-faceted, involving (i) price controls that keep electricity tariffs for all HH significantly below the true cost of supply, and (ii) direct cash transfers to HH to offset their expenditure on electricity service (HUS).

Article 5 of EU Directive 2019/944 sets forth that public interventions in the price setting should be applied for the supply of electricity to energy poor or vulnerable household customers only1. But also, under Directive (EU) 2019/9442, regulated prices are possible for households and micro-enterprises “for the purpose of a transition period to establish effective competition for electricity supply contracts between suppliers, and to achieve fully effective market-based retail pricing of electricity” under certain conditions.

Council Regulation (EU) 2022/18543 indicates that in the presence of the current exceptional rise of electricity prices, the Member States may exceptionally and temporarily set regulated prices for small and medium-sized enterprise (SME) and below cost.

In Ukraine the reliability, availability and price of electricity supply to consumers, including vulnerable ones, is in the public interest. The Cabinet of Ministers of Ukraine (CMU) may guarantee it by imposing PSOs on market participants. The end-user electricity price for HH is regulated and approved by the CMU at the level far below the market. The difference between market end-user price and HH price is covered by the state-owned producers – EA and UHE – through the HH PSO mechanism.

1 Article 5 (3) of EU Directive 2019/944 2 Article 5 (6) of EU Directive 2019/944 3 Recital 48, Article 13 of Council Regulation (EU) 2022/1854

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The purpose of this paper is to provide recommendations on the HH PSO phase-out in the electricity sector including the development of:

- methodology for HH regulated price calculation based on affordability analysis and budget efficiency.

- economically justified approaches of HH electricity price increase up to market level during

PSO phase-out period.

- economically justified period of PSO phase-out for HH in electricity sector.

Currently, vulnerable customers in the energy market are not defined in primary legislation. A CMU degree states, “The housing subsidy is an irreversible targeted state social assistance to vulnerable consumers of housing and communal services - residents of households who live in residential premises (houses) and cannot pay for housing and communal services on their own, pay the costs of managing an apartment building, costs of communal services, costs for the purchase of liquefied gas, solid and liquid stove household fuel in such a house." However, it does not provide guidance on the selection of those customers. Also, the laws do not provide a concept of energy poverty but do recognize certain aspects in alleviating it. Analysis of vulnerable customers and energy poverty is beyond scope of this paper. The matter of precise definition is now being entertained by

Government. A separate analysis should be prepared of vulnerable customers and energy poor criteria and recommendations on proper protection measures for these categories to be implemented by the State in line with EU and EnC acquis.

European Union (EU) Strategic Approach:

To protect customers against high prices and undesired price fluctuations, countries apply price interventions in the form of price regulation, price cap, and social tariffs. Under Directive 2019/944, the price intervention for non-vulnerable customers should be limited in duration and include additional measures to prevent distortions of price setting in the wholesale market.

Most of the Member States have defined vulnerable consumers in legislation commonly referring to income levels and critical dependency on electricity for health reasons. Following the requirements of the Electricity Directive, vulnerable customers are protected by a series of safeguards such as reductions in energy taxes and VAT, direct subsidies, and other similar measures.

While the EU acquis allow for price interventions under certain conditions, the EU also cautions against the potential negative consequences of using such measures to protect vulnerable consumers. EU Directive 2019/944 states (Recital 22):

“Nevertheless, public service obligations in the form of price setting for the supply of electricity constitute a fundamentally distortive measure that often leads to the accumulation of tariff deficits, the limitation of consumer choice, poorer incentives for energy saving and energy efficiency investments, lower standards of service, lower levels of consumer engagement and satisfaction, and the restriction of competition, as well as to there being fewer innovative products and services on the market. Consequently, Member States should apply other policy tools, in particular targeted social policy measures, to safeguard the affordability of electricity supply to their citizens. Public interventions in price setting for the supply of electricity should be carried out only as public service obligations and should be subject to specific conditions set out in this Directive. A fully liberalized, well-functioning retail electricity market would stimulate price and non-price competition among existing suppliers and provide incentives to new market entrants, thereby improving consumer choice and satisfaction.”

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Key Challenges with the Existing Support Systems:

Ukraine currently provides several forms of assistance and support:

− HUS system, which provides socially “vulnerable”4 household customers (e.g. with low income) with direct income transfers to support in the payment of their utility bills, including gas, heat, electricity;

− The Universal Service Supplier (USS) that ensures continuous supply to HH at predefined prices, with a limited right to disconnect under extraordinary circumstances such as COVID, war5, and other force-majeure conditions;

− PSO imposed on energy producers (EA and UHE) to facilitate a preferential electricity price, which is below the cost of service, for all HH.

Starting from the launch of the wholesale electricity market (WEM) the HH PSO mechanism in

Ukraine developed from the physical PSO to the financial PSO (F-PSO), including “quasi” financial

PSO (F-PSO) as a transition between the two above. The physical PSO effective from July 2019 until

September 2021 significantly retarded market development and posed other problems to market participants as indicated in the table below.

Table 1. Key problematic of the PSO mechanisms in Ukraine

July 2019 – September 2021

– Physical HH PSO

October 2021 – June 2023 –

“Quasi” F-PSO

June 2023 – F-PSO → PSO phase-out

Key problems:

• Significant volumes of electricity were excluded from the market decreasing its competitiveness

• EA and UHE faced a lack of liquidity to finance its operational and investment activities

• GB’s financial position was worsening with continuous debt accumulation

• The price for HH was set well below the market with the energy component becoming negative – i.e., households were paid to consume electricity

Key problems (incl. war impact):

• Low HH prices did not cover pass-through costs meaning that EA and UHE were providing support to DSOs

• Both – EA and UHE – faced difficulties with liquidity putting their operational ability in danger

• Occupation of Zaporizhzhia

NPP and Kakhovska HPP worsened the financial position of the producers decreasing their profits needed to fulfil PSO

• Low HH prices did not give signals for energy efficiency

The increased HH price of

2,200 UAH/MWh (excl. VAT) covers pass-through costs and eliminates cross-subsidization of DSOs and USSs.

It is assumed that with the price increase in June 2023, the

PSO phase-out process commenced.

Next steps:

1) CMU should continue its strategy on setting the HH price at the level to cover at least pass-through costs

2) Strategic document should be adopted with all parameters for PSO phase-out (as described in this

Paper)

4 Socially “vulnerable” household customers mean recipients of HUS as indicated in CMU Decree No. 848 dated October 21, 1995, and not “vulnerable customers” under EU acquis as the vulnerability criteria are yet to be defined 5 CMU Decree No.206 dated March 5, 2022

ENERGYSECURITYUA.ORG PHASING OUT PUBLIC SERVICE OBLIGATION IN ELECTRICITY | 6

• The HH PSO system was not balanced, and the mechanism of PSO loss compensation thru TSO tariff was creating another deficit due to its circular nature

• All households are beneficiary of low prices irrespective of their income

• Due to the war and post payment of HH, USSs have liquidity problems with further delays in payments to the producers (for energy) and Ukrenergo (for TSO tariff)

To address the challenges posed by the physical PSO, ESP collaborated with Energy Community

(EnC) on developing a financial PSO (F-PSO) mechanism. The F-PSO offers several advantages, including transitioning the operations of the USSs providing energy to households, as well as the volumes from EA and UHE, to market. Additionally, it facilitates a gradual increase in HH prices to reflect market costs. Another key benefit is the separation of HH PSO under GB from the RE PSO and elimination of their inter-relation through the GB and TSO tariff.

In October 2021, CMU declared a transition from the physical PSO to the financial and although, the main steps of the reform were adopted, CMU did not increase6 the HH price and no strategic document was developed on the price increase. Therefore, ESP considers that during October 2021

– June 2023, a “quasi” F-PSO was effective in Ukraine in term of PSO support mechanism and market price calculation for PSO support. From the state-owned producers’ perspective, all their volumes were mainly released to the market that actually meant a transition to F-PSO scheme (not considering the war period when EA and UHE are required to sell certain volumes of electricity to

USSs).

This scheme posed certain challenges to the PSO participants that worsened due to the war. One major problem of “quasi” F-PSO was setting the household energy prices at levels too low to cover the pass-through costs of network tariffs. This essentially meant that the energy component was negative; in other words, households were effectively being “paid” to consume energy.

In 2022, the total support amounted to 105 billion UAH, with Energoatom (EA) compensating 88 billion UAH, which constituted nearly 70 percent of its revenue – a clearly unsustainable situation.

Furthermore, EA is facing significant financial difficulties in providing such support, considering that a major asset, the Zaporizhzhia nuclear power plant (NPP) is under Russian occupation. This has resulted in a significant drop in production and revenue stream, which is disproportionate to the decrease in HH consumption, and the support needed. The war conditions and the decision on the prohibition of the penalties/disconnections during the martial law7 have also led to reduced payment discipline and necessitated an increase in regulated costs for distribution and transmission, adding additional financial burden on EA which is already facing liquidity issues. The PSO obligations are threatening the stable operation of Ukrainian electricity system.

6 On contrary, starting from October 1, 2021, CMU decreased HH prices, which contradicts the F-PSO approach 7 CMU Decree No. 206 dated March 5, 2022: https://zakon.rada.gov.ua/laws/show/206-2022-%D0%BF#Text https://zakon.rada.gov.ua/laws/show/206-2022-%D0%BF#Text

ENERGYSECURITYUA.ORG PHASING OUT PUBLIC SERVICE OBLIGATION IN ELECTRICITY | 7

Although adjustments have been made over time, the financial strain on the electricity sector remains heavy, highlighting the need for a more optimally designed system. The National Energy and

Utilities Regulatory Commission (NEURC), the Ministry of Energy (MoE), and CMU have acknowledged the financial strains on EA caused by the low HH electricity tariffs, and in response, have adopted a tariff increase effective June 1, 2023. This adjustment aims to ensure that the level of tariffs is sufficient to cover the pass-through costs and indicates that in June 2023, the PSO phase-out process commenced. Such tendency on setting HH price should be applied within the whole period of PSO phase-out: the HH price should cover all pass-through costs during the whole PSO phase-out period and a certain percentage of energy component that will be increasing on an annual basis to cover full end-user costs at the end of PSO phase-out.

ESP Financial Modeling and Analysis:

ESP has incorporated the HH PSO phase-out calculations into a developed long-term energy market financial model to analyze the results of Financial PSO (F-PSO) implementation and HH price increase. This model is developed for the period from 2023 through 2033 and considers three scenarios where the HH price reaches the market level within different timeframes: (i) 5 years, (ii) 7 years or (iii) 10 years.

The model considers two options for HH price increase – gradual and frontloaded:

• Under the gradual scenario, the HH price increases by equal percentage annually over the phase-out period,

• Under the frontloaded scenario, HH price significantly increases in the first year of phase-out to cover 100% of pass-through costs, and effectively eliminating the cross-subsidy of

Transmission System Operator (TSO), Distribution System Operator (DSO) and Universal

Service Supplier (USS) tariffs. From the second year, the HH price continues to increase to cover the pass-through costs and a fixed percentage of the energy component cost, which depends on the phase-out duration.

ESP Recommended Approach:

The analysis of HH PSO support, starting from the launch of WEM, in both physical and “quasi” F-

PSO schemes, as it is explained in Section 3 of this Paper, indicates a significant negative impact. This impact is evident in market developments, the financial position of major energy market entities, the cross-subsidizing of DSO and USS due to tariff increases and application of low energy price for all

HH irrespective of their income level. The solution to these problems should be two-fold:

1. A gradual increase of HH prices which will positively affect financial results of state-owned energy producers and increase their contributions to the State Budget,

2. A gradual PSO phase-out for both gas and electricity markets and provision of targeted support through HUS system due to additional inflows to the State Budget. This approach will capitalize on the additional inflows to the State Budget resulting from this process. Currently the HUS system is functioning effectively but requires on-going monitoring and control to ensure the subsidy is provided to appropriate groups of households, thereby preventing manipulation.

Transitioning to a pricing system that bridges the gap between market costs and the approved price level is a gradual, step-by-step process. This approach is intended to minimize disruptions and prevent abrupt price hikes. Closing the gap will decrease the overall support to all consumers and

ENERGYSECURITYUA.ORG PHASING OUT PUBLIC SERVICE OBLIGATION IN ELECTRICITY | 8

inevitably increase HH utility costs. With similar increases in gas prices, more families will require direct financial support through HUS to be able to afford a minimum level of energy service.

An increase in electricity price is faster than increase in real income due to war, economy crisis, high unemployment rate, thus, the State should consider a potential increase in budget spending for subsidies as well as the introduction of measures for addressing these challenges. In addition, while all existing recipients will receive income support for the increased costs, the new subsidy entrants will be covered up to the level of personal contribution as set by the HUS.

The proposed mechanism (HUS) is considered to introduce fewer economic distortions and mis-incentives than PSO in the form of price setting for the supply of electricity. It offers consumers greater flexibility, making it a preferable approach to managing the affordability of energy services for vulnerable households.

The increase in the HUS spending to compensate for the removal of the PSO will be more than compensated for by additional contributions to the State budget from EA and UHE. As tariffs increase, the financial support required from by EA and UHE will decrease, resulting in lower reported expenses and higher profits for these companies. Consequently, they will be paying additional value added tax (VAT) and other payments to the budget while having additional free resources for further development and working capital. The budget contributions will exceed the new potential outflows from the HUS.

The figure below illustrates the substantial overall positive benefits of adopting these recommendations.

Figure 1. Net effect to State Budget to HH PSO phase-out, BUAH8

In such a way, the main problems will be resolved – (i) vulnerable customers will be protected, (ii)

HUS will have enough sources to cover and meet increased expenditures, while (iii) EA and UHE will have sufficient financial resources to continue operations and support the system as required, and finally (iv) consumers face the real price of electricity, energy efficiency incentives will be created.

8 Additional taxes are “normative” assignments of profits by the government and do not represent actual profit of loss of EA and UHE

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1. PROBLEM STATEMENT

Ukraine’s approach to subsidizing electricity consumption of HH is multi-faceted, involving (i) price controls that keep electricity tariffs significantly below the true cost of supply, and (ii) direct cash transfers to socially “vulnerable” household customers to offset their expenditure on electricity service.

While the intent to protect vulnerable customers aligns with the EU acquis9 and the EnC and is commendable, the execution of these subsidies in Ukraine raises substantial concerns.

Unfortunately, the current subsidy mechanisms and tools that Ukraine is using were not designed cohesively, or backed by rigorous economic and financial analysis. The results are far from desirable;

the utilities are not financially solvent and as a result investment is suboptimal; consumers are using more energy than they otherwise would; the current subsidy is provided to all HH (regardless of income) and it is regressive since higher income consumers tend to consume more energy than poorer consumers, and the impact on the state budget is greater than it could be with a better set of tools.

In this paper, the ESP will demonstrate how households can be protected while simultaneously reducing fiscal load on the state budget and improving the financial health of energy companies. This includes addressing the burden to energy companies providing PSO support that totaled 104.7 billion

(B) Ukrainian Hryvnia (UAH) in 2022. The paper presents a strategy to phase out the household

PSO and offset it by increasing the household utility subsidy (HUS). The paper will detail how this readjustment can lead to better outcomes for consumers, substantial savings for the state budget, and notably enhanced financial conditions for utility companies.

9 The Third Energy Package required Member States to develop national plans to address energy poverty and protect vulnerable customers through social security systems, prohibition of disconnection of gas and electricity in critical times, and provision of energy efficiency improvements.

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2. BACKGROUND

The importance of effective protection of vulnerable customers from the impact of extreme market fluctuations or wartime adversities is well recognized. To assist households, policymakers can employ various support measures, such as price caps or direct tariffs, establishing Universal

Service Obligations (USOs),10 and specialized subsidies and tariffs for vulnerable customers. Support can take the form of direct financial assistance to individuals based on a predefined HUS scheme, or it can be indirect benefiting all households or specific group of customers through regulated tariffs.

The EU and EnC acquis allow, among others, such concepts of support as (i) a public service obligation, and (ii) a universal service, a concept which is used in particular relative to the liberalized market, as a means to protect household customers and small enterprises11 acknowledging that opening markets can have negative as well as positive aspects.

In either case, financial resources are allocated to support households through the regulated prices, mainly. In the case of direct financial support to households, the funding typically comes from the budget and normally the support is targeted, i.e., the individuals have the right to receive the benefits.

In the case when financial support is provided through an entity, customers often benefit from tariffs set below cost of electricity. In such case, all households may be benefitting irrespective of their income. The government then faces the challenge of covering the differences between the cost at which electricity is sold and the lower tariff rates, effectively compensating for lost revenues. This is often done by implementing a PSO, which obliges certain state-owned companies to sell electricity to households12 at prices below the actual cost. In this paper, the cost of the PSO is defined as losses or (foregone) profitability.

Price-setting PSOs can distort the market by preventing companies from earning sufficient revenue to cover their full cost. This deprives these companies of the financial resources needed to maintain and upgrade their systems (and therefore better serve consumers), limiting consumer choice, creating poorer incentives for energy saving and energy efficiency, and reducing security of supply.

However, there is a better way to provide subsidies to those in need. Therefore, it is advisable to apply alternative policy tools, in particular income subsidies similar to the HUS system in place in

Ukraine.

Price-setting PSOs, if used, should be implemented without overriding the principles of open markets. They should be applied in specific, clearly defined circumstances to targeted beneficiaries, and should be limited in duration. In Ukraine, PSOs for electricity was introduced in 2019, and as the country progresses towards becoming an EU member, their revision and improvement is pending.

Additionally, it has to be considered that the PSO was also introduced with the introduction of USO

10 “ In European law and policy, the concept of Universal Service Obligations refers to a set of general interest requirements ensuring that certain services are: (i) available throughout a certain territory (e.g. the territory of a Member State) for all consumers and users, independently of their geographical location (geographical component); (ii) at a specified quality, often including inter alia regularity/continuity of service (technical component; and (iii) at an affordable price, in the light of specific national conditions (economic component).“ source: https://www.concurrences.com/en/dictionary/universal-service 11 Article 27 of Directive EU 2019/944 12 In the case of a well-designed price control PSO, the utility would be compensated directly from the state budget for the difference between the cost to consumers and the full cost of service. This is not done in

Ukraine.

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entrusted to the Universal Service Suppliers (USS), to supply electric energy to all households at regulated prices. The USS function is a concept introduced in the Eu/EnC acquis and applied throughout the EU and the Contracting Parties of the European Community that ensures access of electricity to households and their protection, in case, they are not willing to engage in purely market supply.

The HH PSO in Ukraine provides support to all household customers through regulating the HH price below the market costs and introducing obligations to state generators to support it. Worth noting is that other categories of customers specified in the Electricity Market Law13 (e.g.

dormitories, building cooperatives) are also benefiting from the low HH price. Any changes needed to the “household” terminology in the Electricity Market Law are subject to additional analysis and are not included in this Paper.

2.1. RECENT SUBSIDY MECHANISMS

Like many countries that transitioned from centrally planned economies, Ukraine has a long history of subsidizing energy. The country has employed various subsidy mechanisms, including cross-subsidies, PSOs, and income transfer. However, these methods have not been well designed and implemented in an ad hoc manner. A case in point is that just ten years ago, the total energy-related subsidies in Ukraine amounted to a substantial sum of 115 billion UAH. 14

During 2018 and 2019, significant reforms were undertaken in Ukraine’s electricity market, starting with the unbundling of supply companies from Oblenergo Distribution System Operators (DSOs). In line with the EU Third Energy Package, Ukraine introduced a new wholesale electricity market model on July 1, 2019, instead of the single buyer mode operated under the state-owned company

Energorynok. Before this reform, Energorynok accumulated significant debts to/from market participants and the issue of their repayment was not solved. Until now Energorynok owes close to

11.6 billion UAH to EA, 1.1 billion UAH to UHE, and 1.7 billion UAH to Ukrenergo among other debts. In 2020, Law No. 719-IX15 was adopted providing different mechanisms for old debt repayments (please see section 3.3.2.4 for more details), but still the problem remains unsolved and critical, especially for the PSO participants.

The launch of new market model was accompanied by a special regulatory mechanism to ensure the continuous availability of electricity for household customers and to mitigate the risks of potential price shocks. The decision to impose special obligations on market participants was considered the best means to address such potential issues. In addition, socially “vulnerable”16 household customers

(e.g. with low income) are granted with direct income transfers to support in the payment of their utility bills, including gas, heat, electricity.

The introduction of WEM involved splitting off the Guaranteed Buyer (GB) and the Market

Operator – the major participants of WEM – from Energorynok, leading to major changes in the market’s dynamics.

13 Article 1 of Law on Electricity Market No. 2019-VIII dated April 13, 2017 (EML) 14 ffs_ukraine_draftinventory_en.pdf (iisd.org).

15 Law On the Measures Aimed at Repayment of the Debt, which was Formed on the Wholesale Market of

Electricity: https://zakon.rada.gov.ua/laws/show/719-20#Text 16 Socially “vulnerable” household customers mean recipients of HUS as indicated in CMU Decree No. 848 dated October 21, 1995, and not “vulnerable customers” under EU acquis as the vulnerability criteria are yet to be defined https://www.iisd.org/gsi/sites/default/files/ffs_ukraine_draftinventory_en.pdf https://zakon.rada.gov.ua/laws/show/719-20#Text

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Starting from the launch of WEM and until now, the GB performs several PSO functions:

1) household PSO including:

a. physical HH PSO from July 2019 until September 2021.

b. “quasi” F-PSO from October 2021 until May 2023.

c. F-PSO from June 2023 until now.

2) PSO supporting renewable energy (RE) sector (RE PSO) – from July 2019 until December

2029. This PSO is provided through RE service included in the transmission system operator

(TSO) tariff.

3) export PSO – from July 2022 until the end of martial law

From December 2019 until September 2021, when the physical HH PSO was in place, HH PSO and

RE PSO were closely interrelated. Any difference between GB’s income and expenses incurred as a result of HH PSO implementation (both positive and negative) was included into the RE service invoiced to Ukrenergo. This resulted in additional need for the TSO tariff growth (to compensate losses), which was not applied by Regulator creating additional deficit of HH PSO.

With the introduction of F-PSO (including “quasi” F-PSO), the GB started acting as an agent meaning the company does not recognize revenues and costs as a result of HH PSO implementation in the financial statements (the same applies to export PSO mechanism). Therefore, starting from the launch of “quasi” F-PSO the interrelation between the physical HH PSO and RE PSO was eliminated.

PUBLIC SERVICE OBLIGATION

There are two types of PSOs in the electricity sector: physical or commodity-based, and financial

PSOs. In Ukraine, under the commodity based PSO, the physical transfer of electricity between market participants is performed. It involves a defined volume of electricity sold by state-owned producers at fixed prices that are typically set below the prevailing market rates. Under the F-PSO, market participants freely buy and sell electricity on the market and are compensated financially under the PSO mechanism. For example, state-owned producers sell electricity at market rates and compensate Universal Service Suppliers (USSs) for the difference between the market price and the fixed one for households.

The HH PSO was formalized through a Decree17 by CMU, which came into effect on July 1, 2019, and became known as the PSO Decree. Since its inception, this decree has been amended several times and is scheduled to be phased out.

The physical PSO effective in Ukraine from July 2019 until September 2021 hindered the market development since significant volumes of electricity were excluded from the market. Moreover, the

PSO mechanism was worsening the financial position of state-owned producers (due to significant volumes sold to GB at low prices instead of placing them in the market) and GB (due to PSO deficit accumulation and unbalanced loss compensation mechanism).

To mitigate the negative impact of the physical PSO, ESP and EnC started developing F-PSO mechanism, whereby USSs buy energy on market terms while still receiving support from the producers (EA/UHE) to cover the gap between the fixed HH price and the market. The concept considers a gradual HH price increase during several years (5-7 years) until reaching a market level along with vulnerable customer support. The transition from the physical PSO was realized in

17 CMU Decree No. 483 dated June 5, 2019

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October 202118, but since CMU did not increase the HH prices and on contrary decreased them

ESP considers this approach as a “quasi” F-PSO.

Description of obligations and HH prices under each PSO mechanism is described in the table below.

Table 2. Obligations and prices under different HH PSO mechanisms from July 2019 until now

PSO parameters July 2019 – September 2021 –

Physical HH PSO

October 2021 – June

2023 – “Quasi” F-PSO

June 2023 – F-PSO →

PSO phase-out

Obligations • EA and UHE were mandated to sell electricity to the

Guaranteed Buyers (GB) at prices below the cost of production.

• GB was responsible for providing this electricity to the Universal Service

Suppliers (USS) to meet all their HH customers’ needs.

• USS, in turn, supplied electricity to HH at regulated prices set by the CMU, plus their service fees.

• USSs are required to buy from EA a baseload product for the purpose of HH at a weighted-average DAM price in M-319.

• USSs receive compensation for the difference between market price with tariffs and HH price from producers (EA and UHE).

• The compensation is administered by GB and calculated based on an indicative market price

(USS price for non-households determined according to NEURC Decree # 1177).

• An obligation on DSOs for technical losses effective until November 2022 – to buy baseload products from EA on auctions at a fixed price of

1,700 UAH/MWh, HH price From March 2017 until the end of

2020:

• 750 UAH/MWh net of VAT for Block 1 (consumption below

100 kWh),

• and 1,400 UAH/MWh net of

VAT for Block II (consumption above 100 kWh).

Effective January 1, 2021, CMU canceled the preferential tariff for

Block I and fixed the HH price at

1,400 UAH/MWh without VAT

Starting from October 1, 2021, the HH prices were decreased to:

• 1,200 UAH/MWh for monthly consumption below 250 kWh (without

VAT), and

• 1,400 UAH/MWh for monthly consumption exceeding 250 kWh

(without VAT).

Starting from June 1, 2023, the HH price is

2,200 UAH/MWh (excl.

VAT). This price covers pass-through costs and eliminates cross-subsidization of DSOs and USSs.

Please see Annex A for a brief history and key problematic issues of the PSO mechanism from when it was introduced in 2019 until before the Russian full-scale invasion.

18 Decree No. 859 dated August 11, 2021, on changes to PSO Decree 19 M-3 means price for the three months before

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HOUSING UTILITY SUBSIDY (HUS)

Ukraine has established a HUS system since 1995. The purpose of the HUS program is to assist low-income HH to cover the supplies of energy (gas, electricity, district heating), water (cold and hot) and other utilities20. Among these, the energy component represents the most significant portion of the subsidy distributed.

Subsidies under the HUS system in Ukraine are distributed either as direct payments to subsidy recipients to their regular bank accounts, or a cash delivery via Ukrposhta21. To encourage timely bill payments and fiscal responsibility, the program has a specific rule: if a recipient accrues a debt exceeding three months for energy, water, or other services, they will not be eligible for subsidies in the following six-month period22.

The calculation of these subsidies is based on predefined social norms of consumption rather than the actual volumes consumed. This approach is adopted to prevent potential manipulation of the system and to ensure that the subsidies cover the main, but not excessive, expenses. The calculations are based on:

• Social norms of consumption – a standard social norm of consumption per m2 is established,

• Utility prices/tariffs,

• Income and HH size,

• Monthly minimal subsistence level (MSL) as set by the State Budget Law for a respective year.

For 2023, the monthly MSL is set at 2,589 UAH,

• Percentage of mandatory payment. The base level of mandatory payment is 15 percent23 during the official COVID-19 lockdown and 20 percent after the lockdown is lifted. The percentage of mandatory payment is determined for each household based on the formula specified in the legislation24 and depends on the amount of average monthly income per person.

Figure 2. Formula to Calculate Subsidies

Since 2018, the GoU has been working to reform the accuracy and design of the HUS by reducing the amount of subsidy provided, ensuring greater accountability and transparency, and implementing

HUS monetization. To achieve these goals, the government has introduced stricter restrictions to both assess the status of low-income HH and ensure the system is not abused. For instance, under these restrictions, the evaluation process for subsidy applications now includes checking whether

20 CMU Decree No.848 dated October 21, 1995: https://zakon.rada.gov.ua/laws/show/848-95-%D0%BF#Text 21 Clause 100 of CMU Decree No.848 dated October 21, 1995 22 Clause 81 of CMU Decree No.848 dated October 21, 1995 23 https://zakon.rada.gov.ua/laws/show/1156-98-%D0%BF#Text.

24 CMU Decree No. 1156 dated October 27, 1998 https://zakon.rada.gov.ua/laws/show/848-95-%D0%BF#Text

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applicants own more than two apartments or possess significant banks deposits while reporting no income, among other things.

Currently, utility bills are calculated based on tariffs that do not fully reflect the actual cost, due to the implementation of PSO mechanisms. As a result, the entire population benefits from low energy prices while compensation is only intended for vulnerable customers and low-income HH. In addition, HUS spending from the State Budget will increase with the phase-out of the PSO. To manage this transition effectively, the Ministry of Social Policy should collaborate with the Ministry of

Finance before each heating season to conduct affordability analyses of all components of utility bills and include the accurate subsidy costs in the State Budget.

Overall, the design of HUS system is adequate and:

• Accounts for HH income and actual cost of services.

• Contains safeguards to account for “gray” income (for example, a car that is less than five years old or a larger flat than is reported).

• Stimulate payment discipline (otherwise, HH may lose subsidies).

• Stimulate energy conservation and energy efficiency (EE) if the actual consumption is less than social norms, subsidy recipients fully retain savings.

However, there are opportunities to enhance the targeting of the HUS system; this could involve fine-tuning parameters like social norms and/or secondary criteria, as well as optimizing operational processes through digitalization. Implementing these improvements would require in-depth analyses, including household surveys, and discussions with the Ministry of Social Policy. Such refinements would ensure more precise targeting of subsidies and potentially increase the system’s overall effectiveness and efficiency.

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3. ANALYSIS OF CURRENT HH PSO

3.1. KEY RISKS OF THE PSO MECHANISM

The Ukraine PSO mechanism is effective until December 2023. In May 2023, CMU approved an increase in the HH electricity price to 2,640 UAH per MWh (including VAT) or 2,200 UAH per

MWh (excluding VAT), marking a 74% increase from the previous average HH price. The increase is effective from June 2023.

In 2022 the average HH price was about 1,280 UAH per MWh; however, this price did not cover the pass-through costs from TSO, DSO and USS, which were about 1,460 UAH per MWh, excluding the costs of electricity itself. This indicates that the 2022 HH price did not even cover pass-through costs and the producers like Energoatom (EA) and Ukrhydroenergo (UHE) are providing support to

DSOs and USSs. Therefore, it is important to increase the HH price to the level that eliminates cross-subsidy in the market.

In 2022, the average market energy price was 2,869 UAH per MWh. A tariff that reflects the actual energy cost of HH would have been around 4,328 UAH per MWh, almost three times higher than the existing level. As a result, the required PSO support increased from 1,656 UAH per MWh in

2021 (under physical PSO) to 3,049 UAH per MWh.

In the first quarter of 2023, with the increase in tariffs, the total pass-through costs rose to 1,585

UAH per MWh. With an unchanged HH price and the actual energy price of 3,368 UAH/MWh, the required HH PSO support amounted to 3,674 UAH/MWh.

Figure 3. Scheme of current HH PSO [2022 results], net of VAT

Total support provided to HH in 2022 reached 104.7 billion

UAH (excluding VAT) considering a decrease in HH prices (compared to physical

HH PSO) and tariffs increase.

Moreover, support has significantly increased during the war period due to the reduced production and consumption and liquidity problems of all participants caused by deteriorated payment discipline.

The gap is covered through financial support from EA and

UHE. Due to low HH electricity prices, the producers were subsidizing not only energy cost but also the pass-through costs, before the June 2023 tariff change. The PSO service of EA is significant (66% of total company’s revenue in 2022 and more than 70% is expected in 2023) and if paid in full, it still does

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