Association EnergyTransparency. Center NOMOS

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2 Association EnergyTransparency Center NOMOS ANALYSIS of progress in transparency of hydrocarbons producing companies and natural monopolies responsible for pipeline transportation of hydrocarbon resources in Ukraine using adapted reporting templates of Extractive Industries Transparency Initiative. Kyiv 2010

3 Expert Group: Michael Gonchar, Project Coordinator Olexandr Malynovsky Andriy Chubyk Serhii Zhuk Olena Ptashnykova The Center NOMOS was established in November, 2003 in Sevastopol as a non-governmental organization the goal of which is participation and support of strategic research projects in the areas of national and international security; international relations in the Caspian, South Caucasus and Black Sea regions; Ukraine's integration into the EU and the NATO. Since 2005, the Centre has published all-ukrainian quarterly journal The Black Sea Security. Materials of the edition available online at Since 2006 the Office of Energy Programs of the Center has operated in Kiev. During this period several projects aimed at increasing transparency in the oil and gas sector of Ukraine were implemented in cooperation with the International Renaissance Foundation, Friedrich Ebert Stiftung, and Robert Schuman Foundation. In 2009, the Center NOMOS in partnership with other NGOs initiated the accession of Ukraine to Extractive Industries Transparency Initiative (EITI). The Center NOMOS together with DiXi Group, Association EnergyTransparency and Kyiv International Energy Q-Club supports online resource Contacts: 24 M.Muzika St., off. 2 Sevastopol, Ukraine phone/fax: +38 (0692) phone: + 38 (0692) е-mail: sevnomos@ukr.net 13 Olzhicha St., off. 22 Kyiv, Ukraine phone: +38 (044) fax: +38 (044) е-mail: geostrategy@ukr.net Design, printed: Private company Lanovenko

4 CONTENTS. 3 Introduction 5 І.Analysis of the hydrocarbon extraction sector s transparency using adapted reporting templates of the Extractive Industries Transparency Initiative 7 1. Analysis of the issue of transparency in oil and gas sector in the context of sectoral legislation Code of Ukraine On mineral resources The Law of Ukraine On Oil and Gas Law of Ukraine On Production-Sharing Agreements The Law of Ukraine On Licensing Certain Types of Business Activity General conclusions about legislative level to ensure transparency in oil and gas industry Real sector of hydrocarbons extraction in Ukraine Licenses for deposits development and mining Oil production Oil deposits in Ukraine Base volumes of oil extraction Sale of equity production oil on the domestic market Gas production Payments to the State budget from oil and gas production General conclusions about the level of transparency in the subsoil use and sale of extracted hydrocarbons Testing of level of readiness by extractive sector companies to work according to EITI reporting templates Reasoning: The testing results of Oil & Gas extracting companies General conclusions 26 ІІ. Analysis of progress in transparency of natural monopolies activities responsible for pipeline transportation of hydrocarbon resources in Ukraine. Comparative analysis of respondent responses on requests to provide information, based on EITI sample form, in 2009 compared with 2007 information requests (probationary assessment of transparency of natural monopolies responsible for transit of hydrocarbons) 27 The overall conclusion 33

5 4 Annex 1. Resolution of the CMU on joining the Extractive Industries Transparency Initiative. Statement by the Cabinet of Ministers of Ukraine on joining the Extractive Industries Transparency Initiative Annex 2. Samples of reporting templates for NJSC Naftogaz of Ukraine example

6 INTRODUCTION. 5 Ensuring transparency in the oil and gas sector has never been a real priority of the state authorities of Ukraine and commercial entities. As a result, the operation of the sector remains insufficiently transparent even to the state. Corruption in the state apparatus encourages preservation of opaque relations, which, in turn, provide life-giving medium for corruption and shadow schemes. So it is no coincidence that the expert group of the International Energy Agency in its work Ukraine. Energy Policy Review identifies three key priority areas for action: energy efficiency, cost-reflective pricing and transparency: Greater transparency in energy data and market rules could boost investment and thereby enhance competition and service quality. A second element of transparency needed is clear market rules that are enforced uniformly. Such rules would stimulate investment and enhance fair competition in Ukraine. Ukrainian society is in need of creating some monitoring mechanisms over the activities of public authorities and companies that use natural resources, which are extracted in Ukraine or transported via the territory of Ukraine and form the lion's share of social wealth. The Monitoring should cover entire technological chain production - transportation consumption (including processing, distribution and sale), where major financial flows circulate. However, to cover immediately the whole chain looks rather unreal. The civil society in Ukraine began testing transparency from the sphere of energy production, using Extractive Industries Transparency Initiative (EITI). The EITI field is namely mining. Joining the EITI that began with the adoption of the Resolution No of the Government of Ukraine of September 30, 2009 aims to: provide more rational use of natural resources; create conditions for reducing corruption in the extractive industries; ensure participation of civil society in controlling fullness of revenues to state budget from activities related to mining; increase public confidence to public authorities, which are managing extractive industries; improve investment image and attractiveness of the country. In addition, participation in the EITI can be included in the calculation methodology of sovereign credit rating of the country. It is obvious that the way from the declaration of intent to the practical result is considerable and may require years of efforts and political will of both the government of Ukraine and companies operating in the extractive sectors. The Expert Group, which worked on adaptation of the EITI in Ukraine under the auspices of the Center NOMOS in the framework of the project Creation of the case on Hydrocarbon Transit Transparency in Ukraine (EITI methodology), which was implemented in 2009 under the support of the International Renaissance Foundation, worked out a version of reporting templates taking into account the whole technological chain. However, in the opinion of the Expert Group, on the current stage Ukraine should use the EITI with appropriate reporting templates only in mining sector, as stipulated in the Resolution No of the Cabinet of Ministers of Ukraine of September 30, 2009 (Annex 1). Only after official extension of the EITI on

7 6 the transportation sector it may be implemented on national levels. At the same time, the Expert Group tested the companies involved in production and transportation of hydrocarbon resources concerning their previous acquaintance with the EITI methodology and sensing the current (starting) level of transparency before implementation of the EITI nationwide. Hereafter it is an analysis of legislative and regulatory basis concerning mining, real state of things with the production of hydrocarbon resources in Ukraine, and assessment of transparency levels on the basis of adapted reporting templates.

8 PART І. 7 Analysis of the hydrocarbon extraction sector s transparency using adapted reporting templates of the Extractive Industries Transparency Initiative.

9 8 1. Analysis of the issue of transparency in oil and gas sector in the context of sectoral legislation Code of Ukraine On mineral resources. Mineral resources, including hydrocarbons and other demands of social production, protection of mineral resources, ensuring safety of people, property and environment while using them, and protection of rights and legitimate interests of enterprises, institutions, organizations and citizens, are regulated by the Code of Ukraine On Mineral Resources No. 132/94-VR of According to Article 8 of the Code of Ukraine On mineral resources, the state control over geological survey, use and protection of natural resources, as well as the creation and use of man-made deposits and mineral processing belongs to the competence of the Cabinet of Ministers of Ukraine. According to Articles 9 and 10 of the Code of Ukraine On mineral resources, monitoring the use and protection of mineral resources belong to the jurisdiction of the Supreme Council of the Republic of Crimea, regional, Kyiv and Sevastopol city Councils of Deputies in their territories and to the competence of village, town and district Councils of Deputies in their territories. Article 12 of the Code of Ukraine On Mineral Resources envisages that citizens and their associations contribute to the local Councils of Deputies and specially authorized executive bodies in the implementation of measures on rational use and protection of mineral resources. Thus, the main emphasis in the Code of Ukraine On Mineral Resources is made on the state control over survey, use and protection of mineral resources. The rights of citizens and their associations to implement similar control are formulated vaguely (it provides the right of citizens only to help local governments and public authorities in the implementation of measures on rational use and protection of mineral resources), are not specified and there is no mechanism for their implementation. Ensuring maintenance by all state bodies, enterprises, institutions, organizations and citizens of the established order of subsoil use, performing other duties for the protection of natural resources, fixed by the legislation of Ukraine is a subject of state control, which forms and types are specified in section VII (Articles 60-63) of the Code. Instead, there are no provisions for the types and forms of public control and monitoring of works on geological survey of mineral sources, their use and protection. According to Article 6 of the Law of Ukraine On Oil and Gas, the public policy in the petroleum industry and its management in provided by the Cabinet of Ministers of Ukraine and other authorized bodies of executive power according to law The Law of Ukraine On Oil and Gas. The main legal, economic and organizational bases of Ukrainian oil and gas industry functioning are determined by the Law of Ukraine On Oil and Gas No III of July 12, 2001, which regulates the relations connected with the features of using oil-and-gas bearing basins, production, transportation, storage and use of oil, gas and their products to ensure energy security of Ukraine, development of competitive relations in the petroleum industry, protec-

10 9 tion of the rights of all subjects of relations arising in connection with geological survey of oil and gas basins, development of oil and gas fields, processing of oil and gas, storage, transportation and selling of oil, gas and their products, consumers of oil and gas as well as industry employees. Among the set on the state legislative level principles of state policy in the petroleum industry and the main tasks of state regulation of oil and gas industry is the lack of such principle of state policy as ensuring transparency of relations in oil and gas industry and such goal of state regulation as informing society about the situation in the oil and gas sector. Article 11 of the Law of Ukraine On Oil and Gas provides that the use of oil and gas mineral resources, search and survey of oil and gas deposits, their development, construction and operation of underground storage facilities for oil and gas are permitted only under special licenses on use of oil and gas mineral resources, issued by specially authorized central executive body of geological survey and rational use of mineral resources, in terms as defined by the law. These special licenses on use of oil and gas mineral resources are provided on a competitive basis in accordance with Article 14 of the Law. The procedure of appropriate competition is regulated by the Law of Ukraine On Oil and Gas and adopted for implementation the latter the Procedure and general conditions of competition on obtaining a special license on use of oil and gas mineral resources, approved by the Resolution of the Cabinet of Ministers of Ukraine No of September 17, 2003 (hereinafter Resolution on competition). It should be noted that the Resolution on competition foresees the publication in the newspaper Governmental Courier information only about holding the competition with indication of the deadline for applications, address where the documents are accepted, phone for information. At the same time, neither the Law On Oil and Gas, nor Resolution on competition do not contain provisions that would establish the duty of informing the community about the winners of the competitions on receiving special licenses on use of the oil and gas mineral resources. The Resolution on competition fixed a duty to inform only participants of competition about the winner. Among responsibilities of the owner the special license on use of oil and gas mineral resources, defined by Article 20 of the Law of Ukraine On Oil and Gas, there is neither duty to inform the community about activities concerning the use of oil and gas mineral resources nor parameters of such informing, notably, a list of information to be made public. Here it should be noted that according to Article 20, the additional list of rights and obligations of the owner of a special license on use of oil and gas mineral resources is determined by the agreement on conditions of use of oil and gas mineral resources. However, it seems doubtful that an agreement on conditions of use of oil and gas mineral resources may foresee a duty of special license owner to inform the community about his activities. Evidence of this is the lack of disclosure of relevant information in practice. Article 29 of the Law of Ukraine On Oil and Gas defines the mechanism of state control over following the rules and regulations on use of oil and gas mineral resources, the conditions of special licenses on use of oil and gas mineral resources and agreements about conditions of use of oil and gas mineral resources. One element of this mechanism is the responsibility of the user of oil-and-gas bearing basins to provide

11 10 bodies of state control (central executive authorities of the geological survey and the rational use of mineral resources, on the ecology and natural resources, supervision of mining, local governments) needed for their work documentation and information, oral or written explanation on the issues within the competence of these bodies. However, the Law of Ukraine On Oil and Gas does not contain any mechanism for public control over activities in the use of oil and gas mineral resources. Article 33 of the Law of Ukraine On Oil and Gas provides that any person or entity may send a request on geological information (concerning oil-and-gas content) to the State Geological Information Fund of Ukraine. It can provide information on oil and gas reserves by request of any natural or legal person in accordance with the legislation. However, this provision can hardly be regarded as sufficient and effective tool for ensuring transparency in the oil and gas industry, because: first, obtaining of relevant information should be preceded by a request of an interested individual or legal person, due to the need to follow certain bureaucratic rules, and second, only a limited segment of information can be provided (concerning oiland-gas content) Law of Ukraine On Production- Sharing Agreements. The Law of Ukraine On Production Sharing Agreements No XIV of September 14, 1999 is aimed to create favourable conditions for investments into survey, exploration and mining of mineral resources (including oil and gas) within the territory of Ukraine, its continental shelf and exclusive (maritime) economic zone. Under the production sharing agreement, one party (Ukraine) grants another party (an investor) for a specified period the right on survey, exploration and mining, including oil and gas in the defined area of subsoil and related to the contract works, and the investor undertakes to carry out these works at its own expense and at own risk with subsequent compensation of costs and receipt of payment (remuneration) in the form of part of profitable production. According to Article 5 of the Law of Ukraine On Production Sharing Agreements, the issue of concluding and implementing production sharing agreements is authorized to the Permanent Interdepartmental Commission (hereinafter - the Interdepartmental Commission), which is formed by the Cabinet of Ministers of Ukraine and consists of representatives of government bodies, local governments, People s Deputies of Ukraine. If necessary, the relevant industrial and scientific organizations, as well as experts and consultants can be involved to the work of the Interdepartmental Commission. Although in this case involvement of scientific organizations, experts and consultants to participate in the Interdepartmental Commission can be considered as a form of public control in the implementation of projects on product sharing, the practical implementation of such public monitoring can be characterized as of low efficiency, because: the obligatory involvement of scientific organizations, experts and consultants to participate in the Interdepartmental Commission is not provided. It is set up only that such involvement will be made if necessary, while not determined subject, which defines such a need and not given the criteria of the latest; the participation of research organizations, experts and consultants in the Interdepartmental Commission and the scope of their authorities are not clearly defined.

12 11 The Law of Ukraine On Production Sharing Agreements involves mechanism of information of the public about the list of subsoil areas (mineral resources deposits), which may be available for development in terms of production sharing agreements (hereinafter - the List). According to Article 6 of the mentioned Law of Ukraine, the List is to be improved by the Cabinet of Ministers of Ukraine on a joint submission by the Interdepartmental Commission and relevant central executive bodies with prior coordination of the List with local governments (depending on the type and location of mineral resources) and published in official publications of Ukraine and foreign media. However, it should be noted that regarding oil and gas sphere, the specified mechanism of society informing has been used in practice ineffectively. Thus, the List, approved by the Cabinet of Ministers of Ukraine on March 15, 2006 under the number 308, contains only one block of fossil fuels (oil and gas) Scythian Platform on the continental shelf of the Black Sea. Herewith the inclusion of the Scythian Platform into the List was made after a decision to carry out a tender on signing a production sharing agreement for the hydrocarbons, to be produced in the Prykerchensky sector of the Black Sea continental shelf (Resolution of the Cabinet of Ministers of Ukraine No of December 22, 2005). It is interesting to note that on September 3, 2008 with its Resolution number 788 the Cabinet of Ministers of Ukraine introduced a rule whereby the Scythian Platform is to be placed at disposal in separate sections of no more than 1000 square km and identified the exact coordinates of 33 such blocks. According to Article 6 of the Law of Ukraine On Production Sharing Agreements, production sharing agreement is concluded in accordance with the results of the competition 1. Article 7 of the Law of Ukraine On Production Sharing Agreements provides that a decision on holding a tender is adopted by the Cabinet of Ministers of Ukraine; and the Interdepartmental Commission within two months from the date of such decision should develop and approve bidding documents, publish an announcement on holding a tender in official Ukrainian issues and foreign media. The results of the competition should be published in official issues of Ukraine and brought to the attention of every participant of the tender. In this part (regarding publication of results of the competition to conclude production sharing agreements) the Law of Ukraine On Production Sharing Agreements is more progressive than the Law of Ukraine On Oil and Gas, which does not include the duty of official publication of the results of competition to obtain a special permit to use the oil and gas mineral resources. Article 11 of the Law of Ukraine On Production Sharing Agreements provides that the draft of the production sharing agreement should be coordinated with local governments in whose territory the subsoil platform is located and submitted for use under this agreement. Article 28 of the Law of Ukraine On Production Sharing Agreements establishes a mechanism of state control over the implementation of production sharing agreements. It foresees that state control over the implementation of production sharing agreements is provided by the Cabinet of Ministers of Ukraine or on its behalf by 1 Exceptions from this rule are set up by paragraph 5 of the Article 6 of the Law of Ukraine On Production Sharing Agreements : (i) if the mentioned agreement is conducted concerning areas with limited stocks of subsoil mineral resources, as evidenced by the findings of relevant state authorities, or (ii) if the agreement is concluded with investor, which had on July 1, 1999 a license for use of subsoil mineral resources and began work on the conditions stipulated by it, but later indicated willingness to sign a production-sharing agreement. In both cases it is necessary to get the resolution of the Cabinet of Ministers of Ukraine.

13 12 the Interdepartmental Commission or the appropriate body (bodies) of the central executive authorities in the manner and conditions stipulated by the agreement and Law. At least every five years, the Cabinet of Ministers of Ukraine with the participation of the Interdepartmental Commission should organize and conduct a comprehensive review of conditions stipulated in the agreement on production sharing. If significant violations of the terms of the agreement by the investor will are found, the Cabinet of Ministers of Ukraine is obliged to cancel agreement with loss compensation. At the same time, however, the Law of Ukraine On Production Sharing Agreements foresees no mechanism for public control over the implementation of production sharing agreements, and does not involve the public in the implementation of appropriate government control The Law of Ukraine On Licensing Certain Types of Business Activity. According to Article 9 of the Law of Ukraine On Licensing Certain Types Of Business Activity, following types of economic activity in oil and gas sector are to be licensed: survey (exploration) of mineral resources; extraction of mineral resources from deposits that have national importance and are included in the State Fund of mineral deposits; transportation of oil, petroleum products via main pipelines, transportation of natural and oil gas via pipelines and its distribution; supply of natural gas according to regulated, unregulated tariffs; storage of natural gas in quantities which exceed the level established by the licensing conditions. Article 8 of the Law of Ukraine On Licensing Certain Types Of Business Activity provides that an entity should conduct some type of licensing underlying economic activity according to the licensing conditions set up for this type of activity. In this regard, the National Electricity Regulatory Commission (NERC) as the licensing authority in oil and gas complex, developed, approved and published a number of Licensing conditions for economic activity in oil and gas complex. Violation of licensing conditions by the licensee (the entity that is licensed to conduct a certain type of business) could lead to revocation of its license. Given the above mentioned, we can conclude that the Law of Ukraine On Licensing Certain Types Of Business Activity involves such element of transparency in oil and gas sector as the approval by the independent extradepartmental state body (NERC) and the publication of the licensing conditions on business activities concerning oil transportation, transportation, distribution, supply and storage of natural gas General conclusions about legislative level to ensure transparency in oil and gas industry Ensuring transparency in the oil and gas industry does not belong to the legally set up principles of state policy in the petroleum industry; and informing the society about the situation in the specified field is not mentioned among the objectives of state regulation of oil and gas relations The legislation of Ukraine stipulates the mechanism of state control over economic activities in the petroleum industry, however it:

14 13 does not allow direct involvement of the society to state control; does not establish the obligation of public authorities to inform the society about the results of state control over economic activities in oil and gas industry. provide sufficient information on the situation in the oil and gas industry, particularly on the volumes of extracted and transited oil and gas and generated by them financial flows The following elements of transparency in oil and gas industry are present: possibility to involve industrial and scientific organizations, as well as experts and consultants to participate in the work of the Permanent Interdepartmental Commission concerning conclusion and implementation of production sharing agreements, foreseen by the Law of Ukraine On Production Sharing Agreements. However, the obligatory participation of these individuals and organizations in the work of the Interdepartmental Commission is not stipulated, as well as procedure of such participation and scope of authorities of given individuals and organizations. Also, today in Ukraine the development of oil and gas mineral resources on the basis of production sharing agreements is of little importance; opportunity for citizens and their associations to participate in activities on rational use and protection of mineral resources (including oil and gas fields) by providing assistance to local Councils of Deputies and specially authorized bodies of executive power, provided by the Code of Ukraine On Mineral Resources. However, the volumes of such assistance are not specified and there is no mechanism for its practical implementation The legislation of Ukraine does not provide a comprehensive mechanism that would determine object, subjects and mechanism of public control in the petroleum industry. Foreseen in the legislation of Ukraine citizens' rights in oil and gas industry are somewhat fragmented, do not create a single clear system and do not

15 14 2. Real sector of hydrocarbons extraction in Ukraine. Since 1998, the national Joint Stock Company Naftogaz of Ukraine (hereinafter NJSC Naftogaz of Ukraine ) plays the leading role in oil and gas sector of Ukraine. It is 100% state-owned company and was established on the basis of the former Joint Stock Company Ukrgazprom and a number of oil and gas sector enterprises. The Naftogaz of Ukraine cons owns shares in the authorized capital of companies SC Ukrgazvydobuvannya, OJSC Ukrnafta, SJSC Chornomornaftogaz, which provide oil, gas and gas condensate production. NJSC Nadra of Ukraine also works in oil and gas sector and deals with survey and exploration of gas and oil. Extraction of hydrocarbons is carried out mainly by companies, where Naftogaz of Ukraine owns shares in the authorized capital: subsidiary Ukrgazvydobuvannya (71% of national production), state joint stock company Chornomornaftogaz (6% of national production), OJSC Ukrnafta (16% of national production). Besides these companies, some private companies (See List), which formally hold licenses, conduct exploration and production of hydrocarbons, but their share in total oil and gas production does not exceed 7%. It means that the state represented by the respective entities, posses the dominant positions in energy production. However, in the oil segment the state has no control over OJSC Ukrtnafta, and accordingly does not control oil production. NJSC Naftogaz of Ukraine is a 50%+1 shareholder of OJSC Ukrnafta that under Ukrainian law does not give decisive rights on enterprise management and now it is basically managed by private shareholders. As of , the subsidiaries of the Naftogaz of Ukraine conducted production of hydrocarbons at 233 oil and gas fields, which are in research-commercial and commercial production, including: Ukrgazvydobuvannya deposits; OJSC Ukrnafta - 90 deposits; SJSC Chornomornaftogaz - 10 deposits Licenses for deposits development and mining. The Law of Ukraine On Oil and Gas stipulates the procedure for granting special licenses on use of oil and gas mineral resources, the basic principles of holding tenders for sale of licenses, sets licenses validity periods and sets up demands on transparency of auctions holding. In particular, the Law defines that: special licenses on use of oil and gas mineral resources are provided on a competitive basis according to the procedure set up by the Cabinet of Ministers of Ukraine; competition on granting a special license on use of oil and gas mineral resources is considered as completed if attended by at least two participants; a prerequisite of participation in the competition is the delivery of full and accurate information by the applicants about themselves according to the approved procedure of the tender; with the announcement of the competition specially authorized central executive body of geological survey and management of mineral resources rational use shall publish the following information: validity period of a special license on use of oil and gas mineral resources; detailed description necessary for

16 15 this type of special license on use of oil and gas mineral resources, on the natural environment, landscape and geological structure of oil and gas areas which are provided for use; detailed description of equipment and facilities provided for use under the terms of the special license on oil and gas mineral resources; approximate volume of capital investments to be undertaken at the initial and subsequent stages of the special license validity period on use of oil resources; the size of the fee for obtaining a special license on use of oil and gas resources; in case of industrial development of oil and gas mineral resources all necessary documentation on technological, chemical, geological, physical and other parameters of oil and gas to be extracted shall be published as well; at the request of competition participants specially authorized central executive body of geological survey and management of mineral resources provides under the current legislation information pertaining to the areas of oil and gas mining, which is provided for use; by the conclusion of agreement on conditions of use of oil and gas mineral resources conditions, released as conditions of competition, may not be altered. Second part of Article 16 of the Code of Ukraine On Mineral Resources also determines that special permits for subsoil use within specific areas are granted to specialized companies, institutions and organizations, as well as citizens who are qualified, have logistical and economic opportunities for subsoil use. In addition, the Code contains a list of compulsory payments for subsoil use and their distribution to the state budget of Ukraine. Under the Law On Oil and Gas the Cabinet of Ministers adopted the the procedure and general conditions of competition on obtaining a special license on use of oil and gas mineral resources (Resolution No of ) and established the Interdepartmental Commission to determine the winners for special permits (Resolution No of ). Since 2005, the order of conducting auctions for the sale of special permits for subsoil use has been adopted by the Cabinet of Ministers of Ukraine annually. In 2008 and 2009 Auctions Procedures were adopted by the Resolutions of the Cabinet of Ministers of Ukraine No. 525 of and No. 609 of , respectively. Also the Methodology for determining the initial selling price on an auction of a special permit for subsoil use was adopted by the Resolution of the Cabinet of Ministers of Ukraine No of which determines that the initial selling price of a permit is a part of the cost of reserves and resources of mineral deposits or areas of subsoil, which is calculated according to the Methodology for determining the value of reserves and resources of mineral deposits or areas of subsoil, approved by the Resolution of the Cabinet of Ministers of Ukraine No of August 25, Not focusing on the analysis of objectivity of parameters, assumptions and estimates included in the methodical documents, we can generally state that the legislation provides clear mechanism for calculation of the initial cost of a permit for subsoil use. Moreover, in terms of creating favourable conditions for development of the oil industry, fee for obtaining a permit should not be an obstacle for starting oil exploration or

17 16 production, since the state and society get much greater economic benefits from taxes and duties on extracted resources that are paid by oil sector enterprises. Thus, although the legislation of Ukraine, that regulates exploration and mining of mineral resources, needs improvement, in general it creates necessary conditions to ensure transparent procedures for sale of permits for subsoil use and equality of access to such rights for the enterprises and individuals through auction mechanism of selling licenses, where the necessary conditions for transparent implementation are met. However, at the same time it is necessary to note significant gaps and contradictions in the legislation of Ukraine, which does not allow considering it as an effective tool to protect the public interest, including: Laws of Ukraine on State Budget for years provided annual provision, according to which the sale of special permits to use the subsoil is carried out on auctions, except cases determined by the Cabinet of Ministers of Ukraine; Article 16 of the Code of Ukraine On Mineral Resources contains a provision providing that special permits to use the subsoil are usually granted on a competitive basis in accordance with the procedure, established by the Cabinet of Ministers of Ukraine. Thus, it is directly envisaged exceptions from a legal mechanism that creates the conditions for transparent and equitable access to mineral resources of Ukraine. But the nature, scope and duration of possible exceptions are not envisaged in the law, which allows the Cabinet of Ministers of Ukraine to regulate subsoil use actually in manual mode by issuing subordinate legislation. The main shortcoming of Ukrainian legislation in the regulation of use of mineral resources remains its frequent change. For example, from 2004 and to the second half of 2008 the above legislation that regulates subsoil use had not worked, since its main provisions were suspended annually by the Law of Ukraine on the State budget. The whole legislative mechanism that created the conditions for transparent and equitable access to mineral resources of Ukraine and thus protected the interests of Ukrainian citizens as owners of the subsoil and natural resources had been cancelled for 4 years, instead, the authority to determine procedures for granting licenses relied on the Cabinet of Ministers of Ukraine. Thus, the transition from the practice of transparent legal regulation of this sphere to manual control by issuing subordinate regulations had been carried out. For instance, the Cabinet of Ministers of Ukraine by the Resolution No. 480 of approved the Procedure of granting special permits for mineral resources. This Procedure, among others, specified 13 cases of possibilities to obtain a permit for subsoil use without an auction, which created wide opportunities for frauds and prevented involvement of strategic foreign investors in this sphere. The situation of frequent changes of legislation on subsoil use contains some dangers both for augmentation of domestic production, and for filling the revenue of the country s budget through payments for special permits and payments from oil production. In the absence of a permanent and transparent mechanism for sale of special permits, and, respectively, for control over conditions of granting special permits to users of mineral resources, it is impossible

18 17 to assess neither level of effectiveness of subsoil use nor effectiveness of state policy for subsoil use. In terms of strategic development of the sector, annual changes in the procedure and requirements for granting permits for mineral resources, along with complex and insufficiently transparent mechanism for their granting are the main factors that hinder the entry of foreign investments and companies in the hydrocarbon sector of Ukraine. Without this, domestic companies with lack of financial capacities to implement intense projects of exploration and extraction of oil will not be able to fully use the potential of national mineral resources Oil production Oil deposits in Ukraine. According to the Ukrainian State Geological Institute (USGI), the State balance of mineral reserves includes oil and gas condensate reservoirs in an amount of million tons. Estimation of oil reserves by Naftogaz of Ukraine in accordance with the standards of Society of Petroleum Engineering has shown that explored oil deposits by the state monopoly amount to only million tons. Geological data on the availability of medium and large oil deposits in specific areas differs significantly. This shows the existing zone of uncertainty in one of the most important from a strategic perspective sector for state and society. Due to a number of objective and subjective reasons, adequate conditions for work in Ukraine both for domestic and foreign companies which have relevant technologies and experience in exploration and development of deep and offshore hydrocarbon deposits, as well as sufficient funds for investment in production projects in Ukraine has not been created. Among the main reasons of the current situation are the following: lack of permanent regulations on subsoil use (regulations on terms and conditions of subsoil use, as well as on amount and order of obligatory royalties for the State Budget vary significantly every year); imperfect and opaque mechanism of granting and obtaining licenses on exploration and development, which are now given in the manual mode, not on transparent competitive basis; imperfect conditions of licensing for obtaining grants on subsoil use, including obtaining at the beginning a separate license for exploration, and only then, almost on equal terms with all other applicants, obtaining a license to develop the explored

19 18 deposit; sometimes it happens that the license is granted to an investor who has neither experience in extraction nor funds to develop the deposit Base volumes of oil extraction. The volume of oil extraction (including gas condensate) in Ukraine has been million tons annually in the current decade, while the annual demand of the Ukrainian economy, on different estimations, amounts to million tons. Such an imbalance between domestic needs and production capacities makes Ukraine's economy dependent on imported oil and petroleum products, which in turn imposes increasing demands on transparency and efficiency of functioning of this strategically important for the state sector. Moreover, in recent years a clear tendency to production decline has been marked: from the peak level of 4.4 million tons in 2007 to 4.2 million tons in 2008 and 3.9 million tons in The main companies of oil and gas condensate extraction in Ukraine in 2009 as well as in previous years were: - OJSC Ukrnafta - 72%; - SC Ukrgazvydobuvannya - 19%; - SJSC Chornomornaftogaz - 1.7%. The remaining 7% of oil extraction falls on private companies, the biggest of them is Ukrainian-British joint venture Poltava Oil and Gas Company which produces about 5% of Ukrainian oil Sale of equity production oil on the domestic market. Since 2006 the Laws of Ukraine On the State budget have determined each year that the public enterprises 2 monthly sell crude oil and gas condensate of equity production exclusively on stock exchange auctions on the terms prescribed by the Cabinet of Ministers of Ukraine. In order to enforce this norm of the law, it is also stipulates that transfer of crude oil, gas condensate, natural gas, including oil (associated) and liquefied gas is not allowed under the contract with commission merchant; give and take processing; other transactions that do not involve transfer of ownership on these raw materials. Pricing of Ukrainian oil is not based on the international market principles. Based on data of the price fluctuations on the Ukrainian Interbank Currency Exchange, prices for domestically produced oil during 2009 ranged within $ per ton (excluding VAT), while the market price of Urals oil during the year amounted to $ per ton 3. Of course, this estimation is significantly simplified and ignores difference in the basic conditions of oil sales as well as difference in oil quality in favour of the majority of Ukrainian oil sorts which are lighter and contain less sulphur in comparison with Urals oil that means it is easier to produce more light oil products, sale of which is the most profitable. Thus, even without considering these factors, the 1,5-2 difference in oil prices is significant and demonstrates the lack of effectiveness of the internal crude oil market functioning, which does not allow adjusting the price of oil, extracted by OJSC Ukrnafta, to market value. This situation leads to a shortfall in tax payments to the State Budget of Ukraine and profit margin is transferred by private companies from oil extraction industry to downstream sector. 2 То It means companies, where state share in the authorized capital exceed 50 percent, companies, where more than 50 percent of the shares (shares, stocks) are in the authorized capital of other companies were the state a shareholder is and controlling interest owns, and subsidiaries, representative offices and branches of such companies and associations, parties of agreements of joint activities and / or the persons authorized by cooperation agreements concluded with participation of these companies F D5A45?art_id= &cat_id=35884

20 Gas production. While in 1991 it was extracted 24.4 bcm of natural gas in Ukraine, during crisis 90-s the level of production fell to 18 bcm. Since 2001 there has been a trend to increase production. In 2009 Ukraine produced bcm of natural gas, in particular, enterprises of NAK Naftogaz of Ukraine extracted bcm or 90.7% of the nationwide production. Independent gas extracting companies have had the highest rate of increase in production from 0.6 bcm in 2000 to bcm in But it should be noted that these statistics may be distorted. Accounting system of gas produced in Ukraine is constructed so that there is a possibility to design gas produced by subsidiaries of the Naftogaz of Ukraine as gas produced by private companies. They sell it further to industrial customers and not householders. In 2009 gas production by enterprises of NAK Naftogaz of Ukraine was: - SC Ukrgazvidobuvannya bcm; - OJSC Ukrnafta bcm; - SJSC Chornomornaftogaz bcm. According to the National program Oil and Gas of Ukraine till 2010 adopted in 1995 and completed in 2001, national gas production in 2010 would reach 24.5 bcm in the base-case scenario. According to the Energy Strategy of Ukraine until 2030 national gas production will reach 23.2 bcm in 2010, 26.1 bcm in 2020 and 28.5 bcm in However, in 2010 enterprises of NAK Naftogaz of Ukraine planned to extract bcm, including: - SC Ukrgazvidobuvannya bcm; - OJSC Ukrnafta bcm; - SJSC Chornomornaftogaz - 1,1 bcm. Thus since 2010, Ukraine will have the trend of falling gas and oil production by enterprises of NAK Naftogaz of Ukraine and private companies will not compensate this decline. In case of not taken drastic measures, this trend will intensify in coming years. New gas agreements between Ukraine and Russia on a substantial increase in purchases of Russian gas for Ukraine economy will also have long term negative impact on the development of domestic production, as funds that could focus on strengthening own energy independence will be spent on the purchase of additional volumes of imported gas. Among reasons of insufficient development of domestic production there should be determined following: lack of clear state policy and practical steps to attract foreign investments in exploration and development of new oil and gas deposits on the territory of Ukraine; lack of national priorities to increase own oil and gas production volumes, instead strategic decisions are taken the to increase purchases of imported energy resources; significant depletion (over 75%) of extractive reserves in major oil and gas deposits; insufficient growth of explored hydrocarbon reserves; lack of large deposits among explored fields during recent years; insufficient financing of exploration works, including through attracting foreign investments; problems with the timely obtaining of special permits for mineral resources and land allocation to exploration and drilling of wells; economically insupportable tariff on domestic gas, which greatly reduces the effectiveness of public mining companies. As for the latter position it should be noted that in 2009 differentiated prices for natu-

21 20 ral gas for private households were applied. These prices were introduced on December 1, 2008 by National Electricity Regulatory Commission s (NERC) Decree No of After NERC approved such gas prices for households, the average level of natural gas prices was determined at UAH per 1000 cubic meters. Actual gas prices for households in January - December 2009 amounted to UAH per 1000 cubic meters ($76.5 according to average exchange rate of the NBU for UAH/USD). Effective in 2009 ceiling price for natural gas for thermal power utilities has been unchanged from December 2008 and is UAH per 1000 cubic meters (inclusive of VAT; target fee on approved tariff for natural gas; cost for its transportation, distribution and supply; and cost of its storage) ($112 according to average exchange rate of the NBU for UAH/ USD). But it is still unknown at what price Naftogaz of Ukraine purchased gas produced by its affiliated companies, joint stock companies and independent gas producers (according to unofficial information, the level of prices, on which gas is purchased at the SC Ukrgazvydobuvannya is $ 48 per 1000 cubic meters). At the same time, the average price of imported gas, which varied monthly during the year from $ (September minimum) to $ (March maximum) per 1000 cubic meters, was $260 per 1000 cubic meters. Such a difference in prices on domestic and imported gas does not stimulate the development of national gas production. Given the foregoing, the trend of reducing domestic gas production, which has been marked since early 2010, may have a long-term nature unless social-populist approach is not revised. In the future this may lead to reducing of the domestic gas supply to households and automatically result in partial filling of its deficit by imported gas at a much higher price, which naturally can cause social tensions. In recent years, subsidiaries of Naftogaz of Ukraine have also considerable problems in obtaining permits for special use of natural resources. In particular, this occurs because since 2006 some provisions of the State Budget of Ukraine have contradicted with the norms of the Code of Ukraine On Subsoil Assets and the Law of Ukraine On Oil and Gas which specify the procedure for granting such permits. The explorer of any hydrocarbon deposit may not get a permit to use this deposit because an order of granting such permits should be determined by the Cabinet of Ministers. These innovations also affected the effectiveness of works because permits obtaining by enterprises of Naftogaz of Ukraine has become much more difficult. The Cabinet of Ministers sometimes selectively granted special permits to state enterprises, but it didn t work as expected because of obstruction in allocation of land by local authorities which requested either sponsorship or other (not envisaged by legislation) financial expenses. Many private companies, which received special permits, mostly limited themselves to minimal investment in field support, not to mention compliance with all requirements that have been put forward with granting a permit. Responsible executive authorities did not find effective methods of solving this problem.

22 21 3. Payments to the State budget from oil and gas production. The main tax, which has been levied among general taxes and fees on extraction companies in Ukraine, is a rental payment for hydrocarbons. In the Law of Ukraine On Rental Payments For Oil, Natural Gas And Gas Condensate it is determined that rental payments for hydrocarbons are national mandatory payments paid from the value of the volume of oil, natural gas and gas condensate extracted in Ukraine. Article 7 also stipulates that rental payments are based on: volumes of extracted oil, natural gas and gas condensate; geological conditions of their extraction and sales price. The Law envisages methodology and formula of rent calculation, however, it is suspended annually and the order of calculation and amount of rental payments has been adopted every year by separate laws. From the second half of 2008 to the end of 2009 the order and amount of rental payments was established by the Law No. 309-VI On Amendments to Some Legislative Acts of , according to which entities, which extract hydrocarbons on the basis of special permits for subsoil use, make rental payments for oil and gas condensate to the State Budget of Ukraine (according to the procedure stipulated by the Cabinet of Ministers of Ukraine) in the amount of: UAH (~$180) per ton of crude oil produced from fields that are fully or partially deposited on the depth up to 5000 m; UAH (~$65) per ton of crude oil produced from fields that are fully deposited deeper than 5000 m. For rental payments for oil and gas condensate approved in this paragraph a corrective ratio is applied, which is calculated by the Ministry of Economy of Ukraine for each reporting (tax) period. Oil extracting companies in Ukraine pay also other taxes, fees and mandatory payments to the state budget on general grounds, the main of which are VAT, income tax, fees for exploration works, royalty fees. In general, we can state that Ukraine has a permanent mechanism of payments to the state budget for extraction of oil and gas condensate. However, regulation of this type of taxation of oil extracting companies has been carried out manually, and not by permanent legislation. Annual suspension of the Law of Ukraine On The Rental Payments For Oil, Natural Gas And Gas Condensate with common procedure of calculation and payment of rental fees and establishing, instead, new rates and calculation procedure of rental payments every year show flaws in state regulation of the oil industry taxation. In this case tax regulations has been applied not on a permanent methodological basis but through the chaotic adoption of separate laws that adversely affect the development of the oil extraction industry because long-term (strategic) planning of financial and business activities or investment projects under uncertainty in tax laws is impossible. Total amount of revenues in the budget of Ukraine from rental payments for extracted hydrocarbons made in 2009 for gas mln UAH (~$100 mln), for oil mln UAH (~$274 mln).

23 22 4. General conclusions about the level of transparency in the subsoil use and sale of extracted hydrocarbons Since mid-2008 in Ukraine a legal procedure for granting special permits (licenses) for subsoil use has been established, which creates conditions and opportunities for ensuring transparent and equitable access to Ukrainian mineral resources and thus protects the interests of citizens of Ukraine, as owners of the subsoil and natural resources. However, the legislation provides the legal basis for exclusion from general procedure of granting permits for subsoil use which questions the validity of the existing legislative framework and retains the risk of returning to the practice of manual control by issuing additional regulations. The legislative does not envisage a mechanism of public monitoring of the transparency level of decision-making in the field of granting permits for subsoil use and their compliance with current legislation Tax regulation of oil extracting sector needs improvement to move from adoption of separate laws to calculation of rental payment for oil extraction based on permanent methodological basis in order to create favourable conditions for development of oil companies and attracting foreign investment Terms of the sale of equity production oil on the domestic market are non-market because of the limited number of potential buyers of this oil along with existing restrictions on domestic oil exports and impossibility for foreign companies to participate in the auctions, because during the auction any company has no guarantees to obtain a permit for following oil exports outside the territory of Ukraine and there is no mechanism in Ukrainian legislation to obtain a permit in advance to export oil Price difference between imported gas and domestic gas is such that discriminates national gas producers from public and private sectors. As a result, national production has been not stimulated; the trend of growth in gas production during the current decade has been changing to decline Political and administrative restraint of domestic gas prices leads to loss of potential revenues to the budget. Low gas prices for household consumers and thermal power utilities do not stimulate energy saving.

24 23 5. Testing of level of readiness by extractive sector companies to work according to EITI reporting templates. After adoption by the Government of Ukraine Resolution No of September 30, 2009 and the relevant Statement on joining the Extractive Industries Transparency Initiative (EITI), the Center NOMOS within the Association EnergyTransparency, supported by the International Renaissance Foundation, implemented the project: Transparency level determination of oil and gas companies via adapted EITI template in the framework of the Association EnergyTransparency. One of the goals of this project was dissemination of EITI international experience and testing the readiness of extracting companies to accept rules of transparency according to designed reporting template. Letters with appropriate explanations and argumentations as well as an offer to fill in reporting template (according to Samples, given in the Annexes 2) were sent to corresponding entities. The rationale included following statements: mineral resources of Ukraine belong to the property of the society, are in the people/state ownership and of great national economic significance, and in accordance with the fundamental right to know (Part 2 of Article 19 of the International Covenant on Civil and Political Rights of , Part 1 Article 10 Convention on Human Rights and Fundamental Freedoms of ) Reasoning. a) Article 34 of the Constitution of Ukraine stipulates the right of everyone to freely collect, store, use and disseminate information orally, writing or otherwise on one s own choice. Part 1 of the Article 9 of the Law of Ukraine On information envisages that all citizens of Ukraine, legal persons and public bodies are entitled to have right on information that provides free opportunity to obtain, use, store and disseminate information necessary for exercising their rights, freedoms and interests, objects and functions performance. Based on this, access to requested information is necessary for citizens of Ukraine in order to exercise their constitutional rights on information; b) the requested information does not belong and can not belong to information, which under Article 37 of the Law of Ukraine On information can t be provided for review; c) the requested information is socially significant in the sense of Article 30 of the Law of Ukraine On information, and the public right to know this information dominates the right of the holder for its protection. Social significance of the requested information and priority of the public right to receive it is confirmed, in particular, by provisions of such regulations: Code of Ukraine On Mineral Resources, Article 4 of which states that mineral resources are the exclusive property of the citizens of Ukraine ; Law of Ukraine On Oil and Gas, whose Article 10 provides that ownership on the natural resources of oil and gas within the territory of Ukraine and its territorial waters and exclusive (maritime) economic zone belong to Ukrainian people ; The Energy Strategy of Ukraine till 2030, approved by the Decree No. 145 of the Cabinet of Ministers of Ukraine of , which, inter alia, states that: The purpose of the social state, which, according to the Constitution of Ukraine, Ukraine is, should be comprehensive welfare of citizens. One the key element of

25 24 welfare in civilized countries is to provide citizens with heat and electricity. The Constitution of Ukraine stipulates the right of citizens to have adequate standard of living and safe and healthy environment, which obliges a state to create appropriate conditions for economic development. The realization of these objectives should be guarantied by comprehensive, reliable and environmentally safe satisfaction of people needs and social production in energy products. The Energy Strategy also states that functioning of the fuel-and-power sector s facilities has strategic importance for the state; The Decree of the President of Ukraine of No On Decision of the National Security and Defence Council of Ukraine of December 9, 2005 On the state of Ukraine's energy security and the basic principles of state policy for its procurement, whereby the inefficient use of fuel and power resources, unsatisfactory financial situation of fuel-and-power sector and shadow turnover of financial resources in the energy sector are determined as the main threats to energy security of Ukraine; Resolution of the Cabinet of Ministers of Ukraine No of , according to which domestic gas is a resource, which has a determining effect on the overall level and price dynamics, as well as on products and services that have significant social value; Also the fact that substantial part of the state budget of Ukraine, through which social programs and social payments are funded, is composed of incomes generated from activities of extraction of primary energy resources, point out the necessity of transparency and information accessibility for the society. Based on the foregoing, it can be concluded that the requested information should be open. According to the Article 29 of the Law of Ukraine On information, access to public information is provided, among others, by giving it directly to citizens interested in, public authorities and legal entities, and limiting the right for obtaining open information is prohibited by the law. Providing with the requested information will indicate that the company complies in reality with European approaches in organizing its work on the principles of transparency, efficient use of resources and countering corruption. It was noted that the reporting under EITI template will be carried out annually according to appropriate procedure, which will be worked out in the partnership Government - NGO Coalition - entities The testing results of Oil & Gas extracting companies. Altogether in the framework of the project 67 requests were prepared and sent to oil and gas extracting companies, which, according to the List, have licenses on hydrocarbons extraction. Although the list was carefully checked out, nevertheless 10 requests were returned back by UKRPOSHTA because their recipients moved to other addresses. As of April 30, 2010 three responses were received which proposed to address to their parent companies. 54 respondents ignored requests to provide information about their activities in the field of hydrocarbon extraction according to EITI methodology. During the telephone survey of the reasons of such neglect it was found out the following. 1. EITI reporting template is considered by management of companies as additional to existing reporting forms, including tax reports. Against the background that Ukraine has one of the most cumbersome tax reporting systems in the

26 25 world, introduction of another form is regarded as an additional burden that is unwanted. According to Paying Taxes Pricewaterhouse Coopers. The Global Picture, in 2009 Ukraine occupied 183rd place in World Ranking because of a number of tax payments, the total number of which totalled 147. (For comparison: Kyrgyzstan takes 178th position, Azerbaijan - 76th, Georgia - 59th, USA - 30, Kazakhstan and the Netherlands 21st, Sweden 3rd). 2. The decision on Ukraine s accession to the EITI was taken by the previous government and under another president, the position of the new government and a new president is unknown. Hence, the reluctance of the part of businesses to be proactive exists until the government decides on this issue. 3. Companies are not required to provide information according to EITI reporting template because under current legislation this is the prerogative of government agencies, not companies. Given the redundant number of different reporting forms, company management is unwilling to take on additional commitments, especially as EITI is voluntary in nature. 4. Shares of some companies are listed on international stock exchanges (including London), so such company meets certain international standards of transparency and requires no additional ones. 5. Requested information is available on companies websites in the annual financial statements, confirmed by an auditor. The last reason is untrue. First, most companies from the List do not have web pages. Second, in cases the sites are available, their informative context leaves much to be desired. Third, an attempt to fill out an EITI reporting template for Naftogaz of Ukraine using only the official financial report approved by the auditor, failed due to lack of information (see Annexes 2). In fact, the only available information is about the volume of extracted hydrocarbons. Disaggregated information on tax payments and other obligatory payments is not public. Important notice - the attitude of foreign companies operating in the mining sector to the issue of transparency in general and EITI in particular. Ukraine is not positioned by investors as a state rich on raw materials, but its mineral wealth is of interest to oil and gas companies. Investors believe the Ukrainian market is quite promising. Business in Ukraine is perceived as a game with the minimum rules set up at the legislative level, which gives a high chance of winning. Investors are ready to use any possibilities provided by imperfect legislation. They are looking for how to effectively lobby own interests in state agencies and through high-ranking officials who can influence decision-making regulating the conditions of business in the Ukrainian oil and gas extraction sector. The need for lobbying and qualitative legal services is largely a tool to minimize the corruption burden on business. Those who can not achieve this minimization leave Ukraine. At the same time, those companies that work in Ukraine are not too concerned about issues of transparency/opacity. One of the examples is the company that came to Ukraine to develop hydrocarbons on the Black Sea shelf. Despite the fact that its parent company joined the EITI in West Africa, a subsidiary structure in Ukraine has not declared intention to join the Initiative.

27 26 General conclusions. The legislative imperfection, inconstant legislation in hydrocarbon and mineral resources sector, redundant number of different reporting forms, government indifference to the EITI and high level of corruption are not conducive to promoting the Initiative in Ukraine at the level of economic entities. The level of transparency of companies of hydrocarbon extraction sector in Ukraine is close to zero (opaque), except two companies whose shares are traded on international exchanges. Ignoring perception of the EITI among entities is correlated with negative index dynamics of corruption perceptions in Ukraine. According to Ranking Transparency International , Ukraine fell from 84th position in 2002 to 146th in Few foreign companies or joint ventures operating in the oil and gas sector of Ukraine are not a model of transparency and are forced to prefer the opaque rules, adapting to current realities in Ukraine in order to profit from the activity.

28 PART ІІ. 27 Analysis of progress in transparency of natural monopolies activities responsible for pipeline transportation of hydrocarbon resources in Ukraine.

29 28 Given the Statement of the Government of Ukraine and the Cabinet Minister s Resolution No of September 30, 2009 on joining of Ukraine to the Extractive Industries Transparency Initiative (EITI) and signing by the Government the Brussels Declaration of 23 March 2009, taking into account the provisions of the Brussels Protocol on multilateral technical meeting on the gas on June 29, 2009 ( To set a clear commitment to increase transparency in the sector. Ideally, it should include an agreement of Ukraine to join EITI, but at least it should include a commitment to regular and timely public reporting on key financial indicators.), Center NOMOS, according to project goals, on December 1, 2009 sent targeted requests for information by filling in a sample form of the adapted EITI reporting templates. Taking into account that the mineral wealth and main pipelines (transit potential) of Ukraine are weal of the whole society, are state owned and of great economic importance (Article 4 of the Code of Ukraine On mineral wealth and Article 7 of the Law of Ukraine On Pipeline Transport ) and according to the fundamental right to know, displayed inter alia, in Part 2 of Article 19 of the International Covenant on Civil and Political Rights of , in part 1 of Article 10 of the Convention on Human Rights and Fundamental Freedoms of the , the Center Nomos, as a Project Contractor, referred to three entities responsible for pipeline transportation of energy resources ( Ukrtransgaz - Statemonopole company in gas transporting, Ukrtransnafta - State-monopole company in oil transporting, Naftogaz of Ukraine - holding company-monopoly, responsible for pipeline transportation of hydrocarbons) 4 to provide basic information as regards to the appropriate organization. In particular, it was noted in the letters of request:... We send you an adapted reporting template on EITI methodology with the request to complete it according to the financial report for The provided information will be used to compile the test report with the purpose of its public presentation and sending the generalized analysis to the Secretariat of the Cabinet of Ministers of Ukraine (Plenipotentiary of the Cabinet of Ministers on Initiative implementation). This report will include generalized (summarized) information. When considering our request for information (by filling in adapted reporting template on EITI methodology) please note the following: a) Article 34 of the Constitution of Ukraine stipulates the right of everyone to freely collect, store, use and disseminate information orally, writing or otherwise on one s own choice. Part 1 of the Article 9 of the Law of Ukraine On information envisages that all citizens of Ukraine, legal persons and public bodies are entitled to have right on information that provides free opportunity to obtain, use, store and disseminate information necessary for exercising their rights, freedoms and interests, tasks and functions performance; Based on this, access to requested information is necessary for citizens of Ukraine in order to exercise their constitutional rights on information; 4 According to the Article 5 of the Law of Ukraine On natural monopolies, transportation of oil and gas via pipelines is provided by the natural monopolies, catalogue of which is being compiled and kept by the Anti-monopoly committee of Ukraine. Therefore, the Anti-monopoly committee of Ukraine determined following economic entities (subjects of natural monopolies) in the oil and gas complex, which enjoy monopoly on the national market ( amc.gov.ua/amc/control/uk/publish/article?art_id=42754&cat_id=59366): - in the sphere of using pipelines for oil and oil products transportation NJSC Naftogaz of Ukraine represented by JSC Ukrtransnafta ; - in the sphere of using pipelines for gas transportation NJSC Naftogaz of Ukraine represented by SC Ukrtransgas.

30 29 b) the requested information, in our opinion, does not belong and may not belong to information, which under the Article 37 of the Law of Ukraine On information can t be provided for review. Furthermore, even if the requested information is classified as restricted information, the Article 30 of the Law of Ukraine On information directly implies that confidential information could be extended if the information is socially significant, what means that it is either the subject of public interest or the public right to know this information dominates the right of the holder for its protection. In this case, the social significance of the requested information and priority of the public rights to receive it are confirmed by: provisions of such regulations: Law of Ukraine On Pipeline Transport, where Article 7 states that cross-country pipelines have important national economic and defence values; The Decree of the President of Ukraine of No On Decision of the National Security and Defence Council of Ukraine of December 9, 2005 On the state of Ukraine's energy security and the basic principles of state policy for its procurement, whereby the inefficient use of fuel and power resources, unsatisfactory financial situation of fuel-and-power sector and shadow turnover of financial resources in the energy sector are determined as the main threats to energy security of Ukraine; The Energy Strategy of Ukraine till 2030, approved by the Cabinet of Ministers of Ukraine on No. 145, which emphasizes the exceptional importance of oil and gas transit facilities for Ukraine and notes that functioning of the fuel-and-power sector s facilities has strategic importance for the state; the fact that substantial part of the state budget of Ukraine (by which social programs are funded and social payments carried out) is formed at the expense of economic activities in the oil and gas industries of Ukraine (i.e., at the expense of funds generated from mining activities and transit of primary energy sources). Based on the foregoing, it can be concluded that the requested information should be open. According to the Article 29 of the Law of Ukraine On information, access to public information is provided, among others, by giving it directly to concerned citizens, public authorities and legal entities, and limiting the right for obtaining open information is prohibited by the law. In addition, delivery of the requested information by your Company will indicate that in practice it follows the European approaches in organizing its work on the principles of transparency, efficient use of resources and countering corruption. In case you refuse to provide the requested information (or part of it), please specify the reasons and cite legal grounds for such refusal (in particular, please indicate, what is the basis for conclusion that interests for non-disclosure of requested information dominate fixed by laws of Ukraine priority right of citizens and their associations to receive relevant information of social significance). Similar requests in more general terms were sent in October 2007 to a number of oil and gas sector entities (NJSC Naftogaz Ukraine, SC Ukrtransgaz, JSC Ukrtransnafta, SC Ukrgazvydobuvannya, JSC Ukrnafta, SSC Chornomornaftogaz, SC Naukanaftogaz, CJSC UkrGazEnergo, CJSC RosUkrEnergo ), some of whom were

31 30 among the current recipients. Thus, it allows drawing conclusions either on responses or lack of them on progress / regress of transparency at the corporate level in the monopole companies. Status (progress-regress) of the information transparency was evaluated by the transparency index (i T) on a 5-point scale where 0 - ignoring of the request for information, 1 - rejection to provide information; 2 - formal (meaningless) information, 3 - partial (fragmentary) provision of information, 4 - substantial information, not executed according to the sent template, 5 - full requested information pursuant to the sent template.

32 TABLE COMPARATIVE ANALYSIS OF RESPONDENT RESPONSES ON REQUESTS TO PROVIDE IN- FORMATION, BASED ON EITI SAMPLE FORM, IN 2009 COMPARED WITH 2007 INFORMA- TION REQUESTS (PROBATIONARY ASSESSMENT OF TRANSPARENCY OF NATURAL MONOPOLIES RESPONSIBLE FOR TRANSIT OF HYDROCARBONS) Respondent Reasons used to prove rejection in providing an answer to requested information in 2007 Juridical analysis of used reason by Respondent in 2007 Juridical analysis answers in 2009 Overall conclusion regarding transparency NJSC Naftogaz of Ukraine і) requested information belongs to commercial secret of the NJSC Naftogaz of Ukraine according to Order #596 on іі) according to Article 30 of the Law of Ukraine On information : confidential information is data which belongs or used by any person or entity and can be unveiled by them according to their will and on their terms. (the letter of the Chairman Deputy G. Yurieva, on ) Ukrainian legislation (in particular, article 36 of the Economic Code of Ukraine and Article 505 of the Civil Code of Ukraine) provides for very wide rights for entities to classify information as confidential (in particular, entities, generally, independently designate regime of access to technical, organizational, commercial, production and other information that they posses; Ukrainian legislation doesn t require to officially recognize that information of any kind belongs to commercial secret and doesn t require state registration of what is commercial secret / confidential information; there is no legal procedure to classify any kind of information as confidential). At the same time, part 11 of Article 30 of the Law of Ukraine On information stipulates that confidential information may be unveiled without its owner permission if this information has social significance that means this information falls under public interests and the right of the society to know this information prevail over the owner right to protect it. In the request it was provided grounds for social significance of requested information and was explained why this information falls under public interests. But Respondents didn t give any clear explanations, according to which criteria they concluded that interests for non-disclosure of requested information (even if it is confidential) prevail over the highpriority right of citizens and their associations to have access to relevant information of social significance. As of January, 30, 2010, the official answer on the request from to provide information by filling the form of EITI, included in the request, was absent. The registry approved by phone they had got a request, provided its registration number ( on ) and main performer who was a chief of the department. At the same time, it should be noted that from NJSC Naftogas of Ukraine the letter, signed by the first Deputy of the Chairman of the Board, was sent to another NGO which was very positive regarding the issue of transparency ( 1/12-55 on ). In this letter was noted: We think that partnership between NGOs and NJSC Naftogas of Ukraine will allow improving transparency image of the NJSC Naftogas of Ukraine for people through awareness of people about production, transportation, and consuming of natural gas. So, we can conclude that management of oil and gas sector has signs of disorganization. і Т2007 = 1 і Т2009 = 0 Regress accompanied by misbalancing of corporate management system, arbitrary interpretation of existing legislation, insufficient competence of performers, inadequate legal background.

33 Respondent JSC UkrTransNafta Reasons used to prove rejection in providing an answer to requested information in 2007 і) The right on information according to International Covenant on Civil and Political Rights on and Convention for the Protection of Human Rights and Fundamental Freedoms on concerns only individual but not an entity. іі) According to p. 3, 4, 6 of Article 32 of the Law of Ukraine On information, a request to provide spoken or written information means a call to provide spoken or written information about activities of legislative, executive or judiciary authorities of Ukraine. JSC UkrTransNafta doesn t fall under any of such bodies and, therefore, is not obliged to provide information to other entities about its activities except public authorities. ііі) There are no evidences that Centre NO- MOS is a legal entity. (a letter of the Deputy of the Chief Executive R.Borshch 05-01/367/6050 on ). Juridical analysis of used reason by Respondent in 2007 In the request in was mentioned that this information was requested in the framework of the project Transparency of revenue in oil and gas sector and would be placed in relevant Center s summary materials. So, it was emanated directly from the request that this information would be bring to people in order to satisfy their right to know. In order to ensure access to information that is not subject to mandatory disclosure or has not been officially unveiled, the Law of Ukraine On information provides (Article 32) such instruments as: a) information request for access to official documents (petition demanding the possibility to become acquainted with official documents). However, the legislation of Ukraine does not determine whether the official document means a document prepared by a public authority, or as documents prepared by legal entities. Therefore it is impossible to unambiguously answer the question whether the legislation of Ukraine provides for the obligation of a legal entity to satisfy the received information request for access to official documents; In case of any doubts, Respondent may apply to the state registrar with request to provide extract from the United State Register of Legal Entities and Individual Entrepreneurs of Ukraine, which provides information, particularly, for state registration of legal entity and its leader (the corresponding procedure envisaged by the Provisions on procedures for providing information from the United State Register of Legal Entities and Individual Entrepreneurs of Ukraine, approved by Decree of the State Committee of Ukraine on Regulatory Policy and Entrepreneurship on ). Neither Law of Ukraine On information, nor any other legislation envisage obligation of the legal entity, which makes a request for information, provide additional documents about it. Juridical analysis answers in 2009 As of January, 30, 2010, the official answer on the request from to provide information by filling the form of EITI, included in the request, was absent. The registry approved by phone they had got a request, provided its registration number ( 2084/6 on ) and main performer who was a chief of the department. Overall conclusion regarding transparency і Т2007 = 2 і Т2009 = 0 Regress accompanied by arbitrary interpretation of existing legislation, insufficient competence of performers, inadequate legal background.

34 33 Respondent Reasons used to prove rejection in providing an answer to requested information in 2007 Juridical analysis of used reason by Respondent in 2007 Juridical analysis answers in 2009 Overall conclusion regarding transparency SC UkrTransGaz According to unofficial information, the answer was prepared but not sent. Ignoring of request As of January, 30, 2010, the official answer on the request from to provide information by filling the form of EITI, included in the request, was absent. The registry approved by phone they had got a request, but had not provided its registration number and name of main performer. Later it was informed that the request had not been charged to anybody to execute. і Т2007 = 0 і Т2009 = 0 Information surdity and muteness accompanied by ignoring of existing legislation, legal negativism, incompetence and official negligence. The overall conclusion. The status of transparency in the oil and gas sector has not been improving but, in general, even worsening. A certain level of information transparency in the oil and gas sector was provided in 2007 by affording access to information from the executive branch, although affordable access was incomplete from a number of departments. For example, following the analysis of the requests for information in 2007, the Ministry of Fuel and Energy (Minister Yuri Boyko) received the results of testing і T2007 = 0, while the State Statistics Committee (Chairman - O. Osaulenko) got і Т2007 = 4, and the State Tax Administration (Head - A. Brezvin) і Т2007 = 5. (Mentioned departments are positive exceptions against the other respondents which received scores, usually located in the interval 0-2.) Despite the removal of non-transparent operators from the gas system in 2008, signing of the Brussels Declaration and expressing intentions of Ukrainian accession to the EITI in 2009, oil and gas sector has not become more transparent. And lack of transparency was observed not only in relation to civil society, but also in relation to state authorities. The latter was confirmed by the facts of not providing (or partial providing) of information from the respective entities on the requests not only of NGOs but also of the Secretariat of the President of Ukraine (2009); by public controversy between the leaders of the respective entities and the Accounting Chamber of Ukraine (2009); by conflict with the State Tax Administration (2008). The fact that simultaneously with ignoring some requests a letter of support of the project to improve transparency was sent points out on the lack of proper interaction between structural units of the entity and coordination of their activity by the head. In our opinion, lack of progress in promoting transparency of functioning of the entire Ukrainian oil and gas sectors as well as the natural monopolies of these sectors results in particular from:

35 34 (1) a number of subjective factors: an arbitrary interpretation of legislation by officials of the entities, and low legal culture and incompetence of responsible agents; reluctance of the officials of the entities to provide more or less detailed information about activities of their entities (including financial aspects of such activities); unreadiness (psychological and legal) of the entities to cooperate with NGOs, including towards establishment of an effective (not fictitious) public control over the activities of the entities; avoidance of the transparent, thorough and open dialogue with the public by the entities; (2) the imperfection of the Ukrainian legislation regarding the provision of the access to information filed in the respective oil and gas natural monopolies: The Law of Ukraine On information does not contain clear provisions that would be binding on the respective business entities (legal persons) to disclose information they possess. This law increasingly focused on state agencies but not on corporate entities. For example, Article 32 of the Law provides the possibility of sending an information request for access to official documents, however, the Law has no definition of the term official document (in particular, it is not determined whether the official document only means a document prepared by a state agency, or also a document prepared by a corporate entity). In this regard, it is impossible to definitely answer the question whether the legislation of Ukraine envisages the obligation of a corporate entity (economic agent) to satisfy the received information request for access to official documents; The Law of Ukraine On natural monopolies does not provide for the obligation of the subject of natural monopolies to disclose information about its activities. Article 13 of this Law stipulates that information and reports on the activities of natural monopolies are published by the national commissions for regulations of natural monopolies (in oil and gas sector National Electricity Regulatory Commission, NERC). In other words, only indirect disclosure of relevant information is envisaged without legally specified amount of disclosure (announcement) of relevant information; The Law of Ukraine On Business Associations does not provide for the obligation of the business associations to disclose information about their activities. This law envisages (Article 10) that information on the association activities can be provided only to association members (and only limited). Article 18 of this Law provides for the mandatory audit of annual financial statements of companies with an annual economic turnover less than two hundred fifty non-taxable minimums, but stipulates that such audit is conducted every three years. This situation in the sphere of information disclosure by economic agents joint stock companies was not so much improved by the recently adopted Law of Ukraine On Joint Stock Companies : except the detailed procedures of providing information on the request of a shareholder, the law assigned in a very general nature the obligation of the public joint stock companies to disclose information, prescribed in paragraph 3 of Article 78, as well as the obligation of all joint stock companies to disclose information in accordance with the laws of Ukraine (paragraph 5 of Article 78). It is not coincidental that there is a zero level of information transparency in such problematic area of oil and gas sector as Ukrainian GTS. It is likely that this is indirect evidence of intensive degradation pro-

36 35 cesses in the oil and gas sector because of fragmentation of the management, loss of controllability, and/or external influences by opaque clan-oligarchic structures. In general, we could say that the problem of lack of transparency in the activities of oil and gas companies lies in the sphere of threats to national (including energy) security of Ukraine. The Law of Ukraine On the basis of the national security of Ukraine dated June 19, 2003 stipulates that the main real and potential threats to national security of Ukraine in the economic sphere, among others, are: the weakening of state regulation and control system in the economy; prevailing of personal, corporate, and regional interests over national interests in the activities of management structures. In the conclusion it is necessary to give a few excerptions from the IEA review mentioned at the beginning: Transparency is a key element for positioning Ukraine as a reliable transit state. <...> the structure of Naftogaz of Ukraine is another impediment to higher transparency. The company produces, buys and transports gas and oil in Ukraine, and apparently covers losses from some operations by using revenues from other activities. <...> Greater transparency has the potential to give Ukraine a better negotiating position, which will attract more support from the West. (Ukraine. Energy Policy Review. 2006, OECD/IEA, Paris, Ukraine2006-UKR.pdf, pp. 238). In case of ignoring by the Ukrainian side requirements on ensuring appropriate level of hydrocarbons sector transparency, cooperation with the IFIs can be complicated. Development of partnership with European companies seems to become more problematic, in particular on background of the government's intentions to closer integration with the outside monopolistic supplier that is not a party of the Transparency Initiative. Opacity increases distrust in the oil and gas sector of Ukraine. Its environment will remain nutritious for corruption schemes, fraudulent transactions with flushing funds from a corporate budget, inefficient and inappropriate use of material-technical and energy resources. By calculation of the corporate ratings by international rating agencies, the reluctance of the respective entities to obey the criterion of transparency (particularly EITI) will be considered, despite the adoption of the Resolution No of September 30, 2009 by the Government of Ukraine and related Statement.