Privatization Roadmap - SPIGOT - Ukraine.pdf

1 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

SUPPORT FOR PRIVATIZATION,

IMPROVED GOVERNANCE, AND

INCREASED TRANSPARENCY

(SPIGOT) PROGRAM

Privatization Road Map April 2017 ument was produced for review by the United States Agency for International Development.

It was prepared by Deloitte Consulting LLP for the Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT) project, Contract Number: AiD-OAA-

This document was produced for review by the United States Agency for International Development. It was prepared by Deloitte Consulting LLP for the Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT) project, Contract Number: AiD-

OAA-I-12-00036

2 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

SUPPORT FOR PRIVATIZATION,

IMPROVED GOVERNANCE, AND

INCREASED TRANSPARENCY

(SPIGOT) PROGRAM

PRIVATIZATION

ROAD MAP

SUPPORT FOR PRIVATIZATION, IMPROVED

GOVERNANCE, AND INCREASED TRANSPARENCY

(SPIGOT)

CONTRACT NUMBER: AID-OAA-I-12-00036

DELOITTE CONSULTING LLP

USAID/UKRAINE ECONOMIC GROWTH OFFICE

APRIL 2017

DISCLAIMER:

This report is made possible by the support of the American people through the United States Agency for International Development (USAID). The contents of this report are the sole responsibility of Deloitte Consulting LLP and its implementing partners and do not necessarily reflect the views of USAID or the United States Government

3 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

ACKNOWLEDGEMENTS

USAID

Susan K. Fritz, Mission Director, Regional Mission for Ukraine, Belarus and Moldova

Stephen Gonyea, Director, Office of Economic Growth

Steven Rynecki, Deputy Director, Office of Economic Growth

Luis Velazquez, Mission Energy Officer, Economic Growth Office

Deloitte

Markus Mueller, Engagement Managing Director

Joe Oliver, Project Manager and Transaction Advisor

Craig VanDevelde, Chief of Party

Olexandr Sopronenkov, Deputy Chief of Party

Chris Johnson, Governance and Restructuring Manager

Alfredo Zarate, Privatization and Governance Manager

Jason Alvarado, Privatization Finance Specialist

Ethan Doyle, Transaction Consultant

Inna Babenko, Local Privatization Manager

Maksym Perets, Local Privatization Manager

SPFU

Ihor Bilous, former Head of the SPFU

Andriy Gaidutskiy, Deputy Head of the SPFU

Oleksandr Vizir, Deputy Head of the SPFU’s Department of Management of the State Corporate Rights

4 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

ACRONYMS

AMC Antimonopoly Committee of Ukraine

CMU Cabinet of Ministers of Ukraine

EBIT Earnings Before Interest and Tax

EBITDA Earnings Before Interest, Tax, Depreciation and Amortization

EBRD European Bank for Reconstruction and Development

EU European Union

FDI Foreign Direct Investments

FTE Full Time Employee

GOU Government of Ukraine

IFC International Finance Corporation

IFI International Financial Institution

IMF International Monetary Fund

JSC Joint Stock Company

LP Large Privatization

MEDT Ministry of Economic Development and Trade

MinFin Ministry of Finance

NEURC National Energy and Utilities Regulatory Commission of Ukraine

NSSMC National Securities and Stock Market Commission

OE Oblenergo

OECD Organization for Economic Cooperation and Development

OPP Odessa Portside Plant

PMU Project Management Unit

PWG Privatization Working Group

RAB Regulatory Asset Base

RDO Reforms Delivery Office

REIT Real Estate Investment Trust

SAGSUR Strategic Advisory Group for Supporting Ukrainian Reforms

SAIDI System Average Interruption Duration Index

SAIFI System Average Interruption Frequency Index

SOE State-owned Enterprises

SP Small Privatization

SPA Sale and Purchase Agreement

SPFU State Property Fund of Ukraine

SPIGOT Support for Privatization, Improved Governance, and Increased Transparency

USAID United States Agency for International Development

WACC Weighted Average Cost of Capital

5 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

TABLE OF CONTENTS

EXECUTIVE SUMMARY

SECTION 1: PRIVATIZATION IN UKRAINE

1. OVERVIEW OF UKRAINIAN LAWS AND POLICIES FOR LARGE-SCALE PRIVATIZATIONS8

a. Current Legal Overview on Privatization

b. Roles and Responsibilities for Privatization

2. PRIVATIZATION ROADMAP FOR LARGE-SCALE PRIVATIZATIONS

a. Descriptions of Steps for Large-Scale Privatizations

b. Analysis of Privatization Steps, Phases, and Responsibilities

c. Analysis of Oblenergo Progress as Case Studies for Privatization Roadmap Framework

3. OPPORTUNITIES FOR POLICY AND LEGAL IMPROVEMENTS TO PRIVATIZATION

a. Process Improvements to Accelerate and Improve Privatizations under Current Legal Framework

b. SPFU New Draft Law on Privatization

c. Energy-Specific Policy and Legal Changes to Accelerate Energy Privatizations

SECTION 2: SPFU ORGANIZATIONAL REVIEW

1. SPFU OPERATIONS

a. SPFU Organization & Staffing

b. Financial Targets vs. Results in 2016

c. 2016 Financial Results

2. UKRAINE’S STATE-OWNED ENTERPRISES

3. SPFU GOVERNANCE ANALYSIS AND RECOMMENDATIONS

SECTION 3: SPFU PORTFOLIO STRATEGY

1. PRIVATIZATION PRIORITIZATION FRAMEWORK

2. DATA GATHERING AND ORGANIZATION

3. KEY PRIORITIZATION CRITERIA

a. Size – 30 percent weighting

b. Solvency – 30 percent weighting

c. Ownership – 20 percent weighting

d. Geographic Location – 20 percent weighting

e. Potential Additional Prioritization Criteria

6 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

EXECUTIVE SUMMARY

The Privatization Roadmap (the “Report”) is implemented under Deloitte’s contract, Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT) Activity in Ukraine, with the U.S. Agency for International Development (USAID). The work undertaken during SPIGOT began in February 2017 and continues the work performed by Deloitte under Financing Growth from October 2015 to August 2016. Deloitte retained much of the original team from the Financing Growth project in order to maintain consistency in contacts with international investors for select Oblenergos and leverage relationships between the Deloitte team and relevant public sector agencies in Ukraine, especially the State Property Fund of Ukraine (SPFU), the Council of Ministers, (CMU), the Ministry of Economic Development and Trade (MEDT), the National Energy and Utilities Regulatory Commission of Ukraine (NEURC), and the other members of Privatization Working Group established by CMU resolution #525 dated 24 June 2015, which include community of international donors represented by USAID, the European Bank for Reconstruction and Development (EBRD), International Monetary Fund (IMF) and International Finance Corporation (IFC).

Deloitte commenced SPIGOT through holding a series of interviews with the previously mentioned stakeholders to evaluate the current status of critical pieces of legislation supporting privatization efforts fostering development of the enabling environment for privatizations of the Oblenergos.

These interviews informed the Deloitte team that the enabling environment for privatization had become more difficult in between the close of Financing Growth and the commencement of SPIGOT. It became evident to the Deloitte team that in the absence of clear signals of political will for privatizations from high level Ukrainian government officials, the international investment community would require more definitive legislative and regulatory changes to entice entry into the Ukrainian energy sector. This Report provides detailed descriptions of these legislative and regulatory initiatives, analyzes their importance to and sequence of an effective privatization strategy for the Government of Ukraine, and provides tactical recommendations for Ukrainian government officials to consider in the months ahead for the privatization of select Oblenergos.

The Report is divided into three main sections: Section 1: Privatization in Ukraine; Section 2:

SPFU Organization; and Section 3: SPFU Portfolio Strategy.

Section 1: Privatization in Ukraine analyzes the existing Ukrainian laws and policies governing large scale privatization, and considers the roles and responsibilities of various actors within the Ukrainian government (GOU), such as the CMU, the Verkhovna Rada, the Reforms Delivery Office (RDO), the SPFU, Privatization Commission, the Tender Commission, and the NEURC whose role will be critical for the success of the privatization of the Oblenergos through the adoption of RAB rates. As a result of this analysis, the Deloitte team recommends several policy improvements and several action items including:

Increased coordination among various actors in the Ukrainian government, especially the SPFU, MEDT, and CMU, to improve the quality and preparedness of assets and companies for privatization prior to acceptance by the SPFU. Examples include obtaining full shareholder registries for Oblenergos as well as adherence to clear accounting standards.

Increased coordination between the PWG and the RDO to provide the consistency and timeliness of the suggested steps and initiatives on the improvements of privatization processes, as well as acceleration of the related decision-making flow and monitoring of their implementation.

Passage and implementation of the Privatization Law by the Rada which will address impediments to the privatization process, such as permitting valuations of assets or state-owned enterprises (SOEs) by objective third-party financial advisors, as opposed to relying on SPFU valuation professionals to set floor prices for assets. Another critical improvement of

7 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT) the Privatization Law would allow for foreign governing law provisions in sale and purchase agreements and other commercial contracts.

Coordination of the GOU with the NEURC to ensure the passage and implementation of the Regulatory Asset Base (RAB) Tariff including clarified and standardized methodology for calculating reasonable returns on new and existing capital improvements for Oblenergos, which will improve the enabling environment for their privatization.

Implementation of the newly-passed Electricity Law that provides clarity on how Ukraine will meet EU Third Energy Package requirements (e.g. unbundling to prevent vertical integration and debt settlements).

Deloitte uses Financing Growth’s six target Oblenergos as case studies for large scale privatizations on the rest of SOEs under the responsibility of SPFU and illustrate the impact of policy uncertainty and sequencing on attracting investors and completing transactions.

Section 2: SPFU Organizational Review performs an initial analysis of the SPFU and provides several initiatives to improve governance, accountability, capacity, skills and transparency.

Deloitte has examined each of the five SPFU pillars: Privatize, Liquidate, Management, Leasing, and Valuation to evaluate the importance of each pillar to the SPFU’s mission and the products, services, budget, and people required to perform the work effectively and efficiently. Deloitte has identified several initiatives that can improve the organization effectiveness, capacity building and governance of the SPFU including:

Definition of responsibilities of specific staff to support select activities critical to the achievements of the SPFU, namely privatization of assets;

Streamline the communication channels and oversight between the SPFU and the CMU;

Enhancement of technical skills of key staff involved in the privatization processes, including

– but not limited to – subjects such as Cost Benefit Analysis, Financial Modeling, Technical Communications, and Economic Regulation.

Improve the current capacity of the SPFU in terms of the alignment of the resources available (people and budget) with the tasks and targets set, considering that previous unsuccessful privatization experience affected the reputation of SPFU and was partially referred to the insufficient capacity. The staffing of the SPFU is 460 FTEs at Headquarters (in Kyiv) and 1,194 FTEs within the regions (25 regional offices). In 2016, the SPFU’s approved budget was UAH 180m (~US$6.6m), and the CMU budgeted and tasked the SPFU to raise UAH 17.7 billion.

Increase transparency on the decision-making process for how assets become property under the SPFU;. Deloitte envisions completing a Needs Assessment at the SPFU to support this work with more tactical recommendations and to support their implementation in later stages of the project.

The improved capacity and enhanced empowerment of the SPFU will drive the effectiveness of future privatizations in Ukraine.

Section 3: SPFU Portfolio Strategy examines the current holdings of the SPFU and performs a triage to define which assets align with privatization, restructuring, and liquidation options for transferring assets away from government ownership. Deloitte developed a methodology to conduct this analysis based on a variety of metrics including the sectors or markets in which the assets operate, governance aspects such as the presence of toxic shareholders, and company financial performance based on information made available to the SPFU. Deloitte’s analysis revealed that the GOU has over 3,400 SOEs and assets in its portfolio. SPFU has incomplete data on many of these entities. A majority of SOEs are losing money or have weak business fundamentals, making them challenging prospects for privatization. Deloitte has provided several critical recommendations including:

Develop a more systematic approach to privatization through the establishment of a more empowered central authority to collect and compare data prior to acceptance of assets by the

SPFU;

Define a core set of assets for privatization that has agreement from principal actors in the privatization process

8 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

Identify assets for liquidation and transfer them to an appropriate agency to enable the SPFU to concentrate its efforts on privatizing specific assets;

This Report represents the first deliverable under SPIGOT and provides tangible recommendations to improve the capability of the SPFU to fulfill its mission of privatization. During the course of drafting this deliverable, the Ukrainian government approved an important reform by passing the Electricity Law in the Rada. While much work remains in Ukraine to liberalize energy markets, this Report is an incremental measure to support the development of transparent markets, limit corrupt influences, and permit private companies to thrive.

SECTION 1: PRIVATIZATION IN UKRAINE

OVERVIEW OF UKRAINIAN LAWS AND POLICIES FOR LARGE-SCALE

PRIVATIZATIONS

Current Legal Overview on Privatization

The legal foundation for this analysis and the privatization process rests on three primary laws:

1) The Law “On Privatization,” which defines the following authorities:

Enumerates the responsibilities of the SPFU;

Maintains the characteristics of SOEs that are not eligible for privatization;

Describes the general steps of privatization; and

Issues specific guidelines for certain types of enterprises (e.g. Group G: Energy Sector enterprises or Agricultural Entities).

2) The Law “On Property,” which establishes the concept and parameters of different forms of property including SOEs and Joint Stock Companies (JSCs).

3) The Law “On Joint Stock Companies,” which is the foundational corporate governance document in Ukraine for JSCs and defines the procedure for the establishment and sale of JSCs and outlines shareholder rights and obligations. Based on the legal language, the Law On JSC’s defers to the Law on Privatization and specific entities’ privatization plans on the process for corporatization necessary to convert SOEs to JSCs.

Roles and Responsibilities for Privatization

The section below summarizes the key roles and responsibilities of the various GOU stakeholders in the Privatization Process as proscribed by the current law.

Appendix 1 includes a detailed list of the Laws, Bylaws, and Orders that create the enabling legislation on privatization in Ukraine and details on each step and which actors have leading and oversight responsibilities.

CMU

As the highest government executive body, the CMU presides over the implementation of legislation and oversees ministerial affairs. The CMU’s wide authority allows them to issue by-laws to declare political priorities or targets of privatization, to issue approvals for steps in the privatization process, or to implement/clarify/interpret procedural steps in the privatization process. Line ministries and GOU bodies (like the AMC and SPFU) must implement CMU bylaws.

Since the heads of ministries are appointed by, and answer to, the CMU, CMU bylaws are especially effective ways to incite activity at the ministerial-level.

CMU Resolution № 271 “On conduction of transparent and competitive privatization in 2015- 2017,” targets a number of entities, including the Oblenergos, OPP, and Centrenergo for privatization before the end of 2017. This Bylaw is not an action step in the formal legislative process required for privatizing assets. It represents another power of the CMU, which is their

9 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT) ability to shape political and public opinion by conveying the GOU’s priorities and rallying political support.

The CMU also issues specific approvals, as required by multiple steps in the defined privatization process. These procedural decision points are extremely important, and a successful privatization cannot be conducted without convening the CMU for approval on at least four separate decisions.

These approvals are outlined in the Law “On Privatization,” and include

Announcement of intent to privatize, Approval of the Privatization Plan, Approval of the investment conditions, and

Approval of the starting price of the auction.

As per the current law, each SOE must undergo these approvals separately (i.e. selling six Oblenergos will require 24 separate interventions by the CMU).

The CMU will also exercise its powers through bylaws intended to define, clarify, or introduce steps of the privatization process. These declarations comprise a wide array of jurisdictions, from the creation of a Privatization Working Group (PWG) as an advisory body1 to detailing the responsibilities of line ministries during the pre-privatization phase. The governing principle supporting these decrees is that the CMU presides over line ministries, and thus has broad jurisdiction in the pre-privatization phase. The CMU’s application of this particular power often overlaps with the SPFU’s authority to regulate the privatization process through Orders. The CMU has, in the past, issued Orders giving itself authority to approve valuations and determine the qualification criteria for supervisory positions within Group G entities. (Group G entities include all large energy and some large industrial assets: the target Oblenergos, Centrenergo, Odessa Portside Plant, etc.; they are considered the most strategic assets up for privatization.) The existence of these Bylaws and Orders show that the CMU’s may apply its authority to responsibilities delegated to the SPFU according to the Law ‘On Privatization.” In addition, potential overlaps between the authorities of the CMU (and the ministries) and SPFU exist in the area of corporate governance of SOEs: CMU decrees #142 and #143 on the certain issues related to the management of state-owned assets dated 10 March 2017, regulate requirements, process and procedures of appointment of supervisory boards in SOEs. Those decrees do not stipulate any special procedures for those SOEs under SPFU management or for those being transferred from the relevant ministry to the SPFU. This may create potential conflicts of authority, for example, whether the SPFU may / should appoint new supervisory board after the SOE with previously appointed supervisory board by the ministry is transferred to the SPFU.

SPFU

The SPFU, as empowered by the Law “On Privatization” and the Law “On the State Property Fund of Ukraine” may issue Orders to clarify or define discrete steps in the privatization process outlined by the Law “On Privatization.” The Ministry of Justice officially reviews these Orders (and those informally by affected line ministries) before approval by the CMU. Since 2016, the SPFU has used this mechanism to implement important process improvements, such as the acceptance of a bid bond in the absence of a 5 percent deposit held by the National Bank of Ukraine.

The ultimate responsibility for the execution of the privatization process rests with the SPFU; which engages with bidders during the process of registration and counter-signs the final Sale and Purchase Agreement (SPA). Post-privatization, the SPFU ensures that winning bidders fulfill the investment conditions in the SPA. The SPFU also appoints, oversees, and directs the creation of the Privatization and Tender Commissions.

Privatization Commission

The SPFU convenes and oversees the Privatization Commission, which consists of a long list of stakeholder groups (see Appendix 1 for details). The Privatization Commission develops the

1 CMU 525 “Procedure for Adoption of the Decision on Privatization and Approval of the Sale Conditions of Group G Objects, as well as of Energy Sector”

10 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

Privatization Plan, which contains information about the SOE from its corporatization process and on guidance for the recommended tender process (e.g. tender auction, listing on a stock exchange, preferential sales to workers, etc.). Privatization Plans can also combine two or more of these mechanisms. The SPFU reviews this document and submits it for approval to the CMU.

Tender Commission

The SPFU convenes and oversees the Tender Commission (the Commission), an influential body in the privatization process. The Commission writes auction rules, sets the floor price of the auction, and determines the investment commitments for incoming bidders. The Commission consists of members of relevant line ministries, i.e. the MEDT, Ministry of Finance, and the Oblast Administrations. Representatives from the Ministry of Internal Affairs, the Security Service, and SOE’s trade unions also sit on the Commission but do not have voting rights.

The Commission oversees the tendering for an independent appraiser to conduct an official valuation of the target, reviews the valuation, and submits the valuation report to the SPFU. The SPFU (with inputs from the PWG) reviews the methodology of the valuation report and passes it to the CMU for approval.

The Commission conducts a similar process for the creation of the investment requirements of the incoming buyer. Privatization requirements commonly include requirements that winning bidders maintain or upgrade specific assets and current SOE operations. The SPFU is responsible for reviewing these requirements and passing them to the CMU for approval.

Finally, the Commission writes the rules for the auction, including bidder submissions, deadlines (within the confines of the law’s prescriptions) and step limits for live auction bids.

Line Ministry

The line ministries preform pre-privatization activities that occur prior to the transfer of shares or property to the SPFU. Line ministries also sit on the Privatization and Tender Commissions. Some line ministries (such as the MEDT and the Ministry of Finance (MinFin)) have broad precedent to sit on Privatization and Tender Commissions across industries.

NSSMC (National Securities and Stock Market Commission)

The NSSMC approves the registration of the shares of a JSC, which is the final step prior to corporatization and transfer to the SPFU.

AMC (Anti-Monopoly Committee)

The AMC approves that the privatization of a certain company does not create market distortions or monopolies in the SOE’s given sector. The AMC also approves tender submissions by each bidder on an asset-by-asset basis.

PWG (Privatization Working Group)

The PWG is a temporary advisory body of the CMU. According to the CMU resolution #525 dated 24 June 2015 the PWG facilitates the coordination of GOU authorities relating to privatization and prepares recommendations and suggestions to decisions of CMU on privatization and conditions of sale of state property. The PWG has the right to propose revision of start price of shares for large-scale privatization and energy sector SOE.

Reform Delivery Office (RDO)

The RDO is an advisory body to the CMU, headed by the Minister of the CMU, with focus on ensuring consistency of delivery of reforms across ministries and Public administration reform, in particular. RDO funded by the donors on a temporary basis to provide targeted technical support and assistance to the Secretariat of the CMU and to the respective Ministries in the course of designing and implementation of the sectorial strategies and priority reforms, analysis of the results achieved and the preparation of operational management decisions.

11 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

PRIVATIZATION ROADMAP FOR LARGE-SCALE PRIVATIZATIONS

Descriptions of Steps for Large-Scale Privatizations

Deloitte examined the present steps for large-scale privatization by working with the SPFU to create an internal list of privatization procedural steps. Deloitte analyzed relevant laws and precedent transactions to organize this list into a chronological order. To the extent allowable under the legal requirements of the current privatization law, this list mirrors international leading practices.

The following section discusses the steps in this process and categorizes these steps into groupings based on which GOU agency holds primary responsibility. After outlining these steps, the Report uses six target Oblenergos as case studies, detailing their level of completion for each step. This section intends to provide a checklist the SPFU and the donor community can use to evaluate the overall progress of enterprises as well as the completeness of individual steps for specific enterprises.

For the purpose of this analysis, Deloitte has grouped these steps into five Phases: Information Gathering, SOE Preparation, Privatization Planning, Tender Planning, and Tender Execution. The subsequent portion of this section provides an overview of these key phases:

12 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

Figure 1: Large Privatization Phases and Process Steps

# Process Step Name

1 Collection of Economic Information about SOE by Ministry

2 Information disclosure conducted by the SPFU (if needed)

3 Announcement of State Privatization Targets by CMU

4 Pre-privatization Preparation by Ministry

5 SOE valuation by appraiser to create JSC by Ministry (or SPFU)

6 Creation of Joint-Stock Company by Ministry (or by SPFU)

7 Share Issue Registration by NSSMC

8 Approval for the Privatization of an Asset by CMU and Ministry

9 Transfer JSC to SPFU for Privatization by Ministry

10 Creation of Privatization Commission by SPFU

11 Privatization Plan Approval by CMU

12 Preferential Sale of Shares for Workers of SOE by SPFU

13 Creation of Tender Commission by SPFU

14 SOE inventory audit, valuation to set auction floor price by CMU

15 Fixed investment conditions approval by CMU

16 Public Announcement of Auction for Privatization of an Asset by SPFU

17 Auction Entry Submissions by Bidders

18 SPA Negotiation by SPFU and Bidders

19 Evaluation of Auction Entry Submissions by Tender Commission

20 Auction Conduct / Evaluation / Announcement by Tender Commission

21 Post-Auction Steps and Transaction Close

22 Post-Transaction Oversight

Figure 2: Large Privatization Process Detailed Overview

14 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

Analysis of Privatization Steps, Phases, and Responsibilities

Oversight during Pre-Privatization

At the SOE level, many entities transferred to the SPFU have outstanding issues that require resolution prior to their ultimate sale to potential buyers, including: improper registration of property, plants, and equipment; improper creation and chartering of the JSC; poor financial accounting practices; or poorly-maintained records. It is the responsibility of the SPFU to address these issues during the SOE Preparation phase.

Current international leading practice does not provide for the corporatization of a company that currently suffers from one or more of these issues. However, because the responsibilities for pre-privatization lie squarely with the line ministries and the CMU prior to the transfer of the company into the SPFU, the SPFU often lacks visibility into the actual condition of the SOE for privatization prior to transfer.

In the current legal framework, the responsibility for fixing an ill-prepared company remains unclear. Addressing these problems requires the payment of legal fees, documentation fees, and the commitment of financial and human capital resources. In a scarce budgetary environment, neither the SPFU, the line ministry, nor the SOE itself have the means to fund these expenses.

The SPFU and CMU should develop a political and funding framework for oversight of pre-privatization activity and could include the hiring of independent advisors to work on behalf of the CMU to ensure proper formation and charter of JSC’s prior to transfer to the SPFU. The SPFU is focused on the preparation of the documents necessary for privatization itself, rather than preparation of the SOEs for privatization in the economic and financial sense, i.e. addressing the issues that negatively affect investment attractiveness of SOEs and may decrease the price of privatization, such as clearing liabilities, addressing bad debt issues etc.

One of the key problems is limited focus of SPFU on the privatization tasks, and not on the outcomes. SPFU considers a company “ready for privatization”, but the SOE is unlikely to be privatized because other issues – usually under the responsibility of other institutions. The privatization process should follow the recommendation of the PWG and address the complete range of issues required for a successful privatization.

Another key problem with the GOU is that it conceives privatization as an opportunity to raise revenues to state budget. This approach is incomplete and should be modified. Since most of the energy infrastructure assets in the country are degraded, need investments, and improve operations, the privatization is an opportunity to change the current status. Major goals of privatization of energy assets include but not limited to the following: (1) modernize the energy sector, (2) improve management of energy SOEs, (3) eliminate sources of public corruption, (4) create a more favorable business enabling environment for private investments, (5) attract FDI to Ukraine, (6) build a reputation as a credible and safe place for qualified foreign investors, and (7) support the long-term objectives of energy security and integration with the EU through privatization of SOEs and compliance with EU Directives, among others.

CMU Approval Processes

The privatization process hinges on a number of CMU decisions that allow the SPFU and line ministries to begin mobilizing resources for the different phases of privatization. The priorities for privatization are determined by high-level working groups within the CMU or at the behest of the international community.

15 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

Figure 3: CMU Interventions in Privatization

The early phases of privatization require a high level of involvement from the CMU because the CMU has responsibility over the line ministries. The CMU’s first action announces a list of privatization priorities to help mobilize resources and political capital to begin preparation work.

The second CMU action approves the privatization of a specific entity, which should initiate the pre-privatization and preparatory steps within the line ministry and ends with the transfer of a fully-formed company to the SPFU. However, in practice, this process also creates difficulties. It is a cumbersome process for smaller-scale privatizations to undergo, and is subject to delays or manipulation for larger, more strategic assets. The creation, CMU approval, and ultimate implementation of the Triage List for Privatization by the MEDT and SPFU will greatly alleviate these requirements.

The approval of the privatization plan by the CMU marks the end of privatization planning and the beginning of the tender planning. This decision, which essentially determines the types of privatization (tender, preferential share sale, listing, e-auction, etc.) and the allocation of shares for each method of sale, is critical. It marks the end of preparatory measures for privatization. In many cases in Ukraine, assets may be approved for privatization without having been properly prepared (i.e. incomplete or missing documents). Any further improvements after this stage often fall to the incoming investor, which represents a significant imbalance of risk for investors and is not aligned with international leading practice.

The SPFU only manages cases of full asset divestitures. Other forms of privatization (i.e.

management contracts, leases, concessions) are not included in the privatization model at the

SPFU.

The final approval, which sets the valuation of the company, also poses challenges for privatization. While approval of the valuation by the CMU provides oversight, it creates incentives for local appraisers, the SPFU, and the tender commission to set high valuation floor levels that may exceed actual market values. There is little downside penalty on any parties involved for a failed privatization tender, whereas tenders resulting in lower valuations can create personal liability for the approving parties and can be openly challenged years later by political opponents.

The approval of investment conditions further exposes investors to risks. Required investments may exceed the valuation of the privatized SOE and lower the price that an investor would be willing to pay. In regulated sectors of the economy, including energy distribution, these investments will only occur after approval by the regulator and the regulated rate of return on these investments adequately rewards investors. Furthermore, these commitments, if not clearly defined, can be written in ways that open incoming investors to significant political risks or even, in the case of non-compliance, renationalization of the asset. Improving the lines of communications between the CMU and the SPFU, therefore, both on political as well as technical matters, is crucial to a successful privatization process.

16 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

The newly-formed Strategic Advisory Group for Supporting Ukrainian Reforms (SAGSUR), whose authority has been delegated by the senior-most members of the GOU to advise the CMU, is positioning itself to play an important role in future privatization decisions. The high-level strategic guidance of SAGSUR is supported through the implementation-level Reforms Development Office (RDO), a set of sector-specific advisors responsible for providing the CMU and line ministries with tactical support in implementing SAGSUR priorities. Although these bodies do not have a formalized role in privatization de jure, the CMU and international community formed these groups to oversee the reform efforts broadly and also to provide concentrated support to specific reform priorities, including energy and privatization. Analysis of Oblenergo Progress as Case Studies for Privatization Roadmap Framework

The lack of an approved Regulatory Asset Base (RAB) Tariff is the most pressing impediment to the privatization of the Oblenergos. Buyers have little incentive to invest in capital improvements for these assets, without a firm commitment from the regulator guaranteeing reasonable rates of return for these investments. In order to demonstrate a reliable commitment to reform and sector investment, the NEURC should approve a RAB tariff with a reasonable rate of return for new investments for qualifying Oblenergos as soon as possible. The rate of return calculations in this tariff should be transparently-formed and reliably-implemented, even in the face of political discomfort and as electricity tariffs rise towards greater cost reflectivity. According to discussions with potential investors, NEURC’s commitment to recapitalize the sector demonstrates its political commitment to promote transparency and stability in the electricity sector.

In terms of privatization procedures, improper asset registries, corporate charters, and charter capital documents create roadblocks for the SPFU during the privatization and tender planning phases. This issue becomes especially apparent during asset valuations and investment decisions. It is difficult to justify a valuation of an enterprise if bidders cannot confirm ownership of the underlying assets or accurately appraise asset values, due to lack of information.

Pre-privatization preparation by the Ministries has proven especially problematic. Due Diligence uncovered gaps in the titling of real estate and fixed assets for every Oblenergo, a problem which in the future should be resolved by the relevant Ministry prior to incorporation and transfer of the SOEs. Other issues highlighted in the Vendor Due Diligence reports by Deloitte include absent asset registries (Mykolaivoblenergo), loss of shareholders registry (Ternopiloblenergo), unresolved bankruptcy proceedings (Cherkassyoblenergo and Zaporozhyaoblenergo), and blockages in transfer of outside-held shares (Cherkassyoblenergo). These issues create problems in other preparatory steps as well, but all begin in the pre-privatization preparation proceedings carried out by the Ministries. In the case of the Oblenergos, most of these problems date back to the early 1990s and have remained unresolved during the tenure of ministry and SPFU ownership.

The first chart below highlights legal and procedural issues for each Oblenergo that must be resolved prior to a legal privatization tender taking place.

Figure 4: Oblenergos Status Analysis

The chart below highlights the overall attractiveness of these Oblenergos based on Deloitte’s observations made during due diligence reviews.

These overlap with Deloitte’s assessment, provide additional details on the specific challenges, and also serve to set expectations for future valuation and investment decisions for each Oblenergo based on its current operational and financial viability.

Figure 5: Oblenergo Transaction Readiness Heat Map

19 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

RECOMMENDATIONS FOR POLICY AND LEGAL IMPROVEMENTS TO

PRIVATIZATION

Process Improvements to Accelerate and Improve Privatizations under Current Legal Framework

Increase Coordination between SPFU and CMU

The SPFU and the CMU should coordinate more closely, both on fixing existing issues in current privatization targets and in selecting and preparing the next round of targets in a systematic, repeatable way. In regards to improving the standing of current privatization targets, the CMU should use its political and strategic influence over the line ministries to demonstrate a high-level focus on specific obstacles for high-priority privatization targets. Such declarations would give the SPFU additional leverage (and potentially resources) for fixing pre-privatization issues that demand the cooperation of the line ministries, the targets, and the SPFU.

Clarifying and coordinating these entities’ roles for oversight and implementation of privatization action steps will improve this process. The CMU and SPFU can better coordinate their actions through formal and informal measures without requiring changes to existing legislation. SPIGOT recommends capacity building to the SPFU through a PMU and close coordination with the SAGSUR and its implementing body, the Reforms Delivery Office, which provides direct oversight to the CMU on privatization.

Capacity building on pre-privatization due diligence would also improve the interactions between the two entities. Trainings and technical assistance on corporatization and governance leading practices, attended by both line ministries, CMU, and SPFU personnel, would greatly benefit forthcoming large strategic privatizations which are still held within the ministry (e.g. Turboatom or Ukrspirit).

Improve the Process for Setting Auction Prices through Market Sounding

The current law requires independent appraisers at two separate periods to establish the enterprise value of the JSC during formulation and set the floor price during tender planning.

Deloitte’s experience under the Financing Growth technical assistance demonstrated that there is a wide divide in technical skills and capacity to carry out valuations between internationally-recognized financial advisors and local independent appraisers.

Rather than relying solely on local appraisers for this step, the SPFU should utilize international leading practices for market sounding and solicit indicative offers from potential bidders after a period of buy-side due-diligence. The SPFU should use the lowest received indicative bid as the upward limit of the floor price range that it suggests to the Tender Commission for submission to the CMU. These indicative ranges may also include prospective, simplified investment plans in order to support a more market-driven process of setting investment requirements. Deloitte recommends removal of the local appraiser step from the process during the adoption of the new Law on Privatization. A preferred approach based on best international practices is to schedule the tender with no floor price range, and let the market determine the ultimate valuation of the privatized SOE. For large strategic enterprises, including infrastructure and utility enterprises, Deloitte recommends that SPFU retain an experienced advisory firm prior to the tender to prepare a valuation report that outlines the range of potential values that bidders for the target enterprise are likely to offer. The valuation range should be based on: 1) comparable acquisition transactions (where public data is available), 2) valuations of comparable public companies in the sector and size range of the target enterprise, and 3) a discounted cash flow valuation or similar approach based on projected financial results of the target enterprise. The valuation report should make appropriate discounts based on size, lack of liquidity, and Ukrainian market risk, while including a premium for selling a controlling interest in the target enterprise, if applicable. These principles are commonly accepted practices for conducting corporate valuations and can form the basis of SPFU’s decision on whether bidders are likely to offer prices that meet the expectations of the

20 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

GOU for conducting a tender. The valuation report should provide a valuation range, as market conditions may change during the interval between the report issuance and actual tender. The low end of the valuation range should represent the base price that the SPFU and GOU would be willing to accept for tendered shares of the target. For smaller enterprises, Deloitte does not recommend that the SPFU incur the costs and time to prepare valuation reports. Instead, conducting an open and transparent competitive tender is the best determinant of the base price of the enterprise at a given point in time.

Clarify the Framework for Investment Requirements

The investment requirements determined by the Commission and approved by the CMU impose additional capital considerations on bidders in determining their valuations on target SOEs.

International leading practice would include all investment requirements as part of the overall negotiation between the GOU, with interested bidders during the competitive tendering process.

However, based on the current laws, the CMU fixes investment conditions and does not reopen them for negotiation during the tendering process. These investment requirements represent liabilities to potential buyers and serve to reduce the potential enterprise value of the SOE. In order to attract qualified investors, who may prefer to make investments based on their own expertise to generate returns, these requirements would reduce the potential price an investor would pay for an enterprise.

There are a number of strategic, attainable steps that the SPFU, the CMU, and the Commission could take to improve the efficiency of this procedure without changing the current legal framework. To mitigate risks, SPIGOT recommends two approaches: standardizing methodologies for setting investment requirements and integrate the valuation and investment requirements steps.

Standardize and Simplify Investment Requirements Using Financial Calculations

Currently, for the Oblenergos, the SPFU has proposed using past privatizations investment requirements as the standard model. However, some of these requirements are vague (e.g.

“maintain current activities”) or overly prescriptive (e.g. “spend $100,000 updating a specific substation in the first year”). These impose demands on the buyer, who must abide by these requirements, even if they are vague or not in line with international leading practices. It also constrains the SPFU, which must oversee buyers’ activities and confirm implementation of investment commitments.

The SPFU could create a simplified framework for calculating investment commitments for enterprises in certain sectors, based on financial calculations or on industry-accepted efficiency metrics (depending on the sector). A standardized approach based on financial calculations would have a number of benefits for the GOU and could require that every investment requirement has an associated dollar value based on a transparently-formulated equation. Some of these benefits include:

Updating outdated requirements in current “standardized” templates;

Improving the ability of the buyer to self-report;

Enabling a smoother, less contentious process for approving investment requirements and integrating them into the valuation / floor price for the SOE; and

Reducing the burden on the SPFU to spend time and resources evaluating whether or not investment criteria are met (the company could self-report these in financial disclosures, therefore the SPFU would not need to conduct onsite assessments of specific investment projects).

This mechanism would also benefit buyers and improve bidder interest by:

Allowing bidders to project future investment activities with greater certainty;

Improving bidder flexibility to allocate capital expenditures based on their own needs, experience and expertise; and

Providing mechanisms for buyers to self-report investment activities.

21 USAID Support for Privatization, Improved Governance, and Increased Transparency (SPIGOT)

There are a variety of different calculations and financial covenants that could enable a standardized calculation of investment requirements based on international leading practices for infrastructure transactions. SPIGOT could help build the capacity of the SPFU to develop such a methodology, utilizing the following factors in determining investment requirements:

Replacement of Depreciation of Fixed Assets;

Minimum Percentage of EBITDA;

Maintenance of Industry-Standard Efficiency or Reliability Requirements (e.g. SAIFI and SAIDI for electricity distribution companies); and

Adoption of “Reasonable and Prudent Operator” Standards Based on accepted international practices or standards set by independent regulators.

Without changing current laws or bylaws, the Tender Commission could also integrate the above investment requirements framework into setting the floor price-setting. Required investments should be considered to have a negative impact on floor prices. For Oblenergos, the RAB tariff would alleviate this issue because it would clarify investors’ expectations on return for investments into its regulatory asset base.

The SPFU, the CMU, and the Tender Commission should ensure that, in approving both the floor price and the investment requirements, they clearly communicate the liabilities of investors associated with maintaining staff, social assets, licensed activities, or other investments.

Adopting this approach would affirm the GOU’s stated position that transparent ownership changes, rather than high starting prices, are the most valuable goal of privatization.

SPFU New Draft Law on Privatization

Summary of New Privatization Law and Key Changes

In April 2017, the SPFU sent the New Privatization Draft Law (the “Draft Law”) to various state authorities, in particular, to the MEDT, thereby beginning the Reconciliation Procedure. The Reconciliation Procedure intends to build consensus among appropriate organizations within the executive branch prior to the CMU sending the Draft Law to the Rada. Appendix 1 details this process, along with the legislative processes once the Draft Law arrives in the Rada.

The SPFU developed the Draft Law, with support from the European Bank for Reconstruction and Development (EBRD), which has comprehensively reviewed its contents and provided comments to the SPFU and MEDT. The SPFU has shared the final version of the Draft Law with the EBRD, the IMF, the US Embassy, Deloitte, the CMU, and the Prime Minister of Ukraine.