Indexation Formula for Natural Gas Procurement in Ukraine

Due to the high volatility of natural gas market prices, it is almost impossible to adequately plan the purchases for the year ahead, so contract prices need to be regularly updated. This fact creates uncertainty for the contracting authorities, as well as room for unfair competition and corruption. We offer an indexation formula which uses the European gas prices as a benchmark for procurement prices and calculate the potential economic effect of this formula on the Ukrainian gas procurement market.

Problems with the Public Procurement of Natural Gas

Natural gas procurement poses a number of challenges for the contracting authorities (CAs), suppliers and controllers. Due to price volatility it is almost impossible to adequately plan the purchases for the year ahead, so prices need to be regularly adjusted. After the heating season starts, CAs find themselves in a weak position in price negotiations since they almost never have storage for accumulating stocks, and if the contract is cancelled the new procurement would take at least one month due to the existing public procurement regulations. The new version of the Law on Public Procurement, which was recently adopted by the Ukrainian parliament, addresses this problem by allowing CAs to have a new contract fast in case the previous contact was cancelled because of the supplier.

CAs often lack reliable data on market dynamics. There are cases when unreliable price references are provided by specialized agencies to support higher price claims of suppliers. As a result, CAs bear administrative responsibility if they do not have proper justification for changing contract prices when controlling agencies initiate an audit.

Natural gas suppliers may also find themselves in a situation of unfair competition. Since it is possible to win an open auction (i.e. by quoting a considerably lower than market price) and later raise the price to the market level with an additional contract, honest businesses might feel demotivated to participate in the procurement process. They cannot be sure if the contract price can be changed later because there is no proper legal mechanism to assess the need of such an adjustment.

Previous research shows that every third contract of natural gas purchase was amended with an additional contract at least once, usually raising the price for the customer (Shapoval, Memetova, 2017). Additional contracts are indeed used 1) as a tool for price overstatement by the supplier, 2) as a loophole for corruption, and 3) as a way to get a market price for a supplier who used dumping to win the auction (Gribanovsky, Memetova, 2017).

International Drivers of Gas Prices in Ukraine

Since 2016, the EU has been the only official exporter of natural gas to Ukraine. According to PwC, Ukraine imported 14.1 billion m³ in 2017, which is 44% of total gas consumption – the remaining 56% are extracted locally. In Ukraine, the prices for industrial consumers are not regulated, while the household prices are set by the government. Today, the average price on the unregulated gas market is in line with the prices in neighbouring countries – the Baltic states, Poland, Slovakia and Hungary (PricewaterhouseCoopers Advisory LLC, 2018).

European prices are formed on the large marketplaces. The two biggest hubs, Dutch TTF and British NBP, by far outweigh their competitors (ACER Market Monitoring Report, 2017). However, the third-biggest hub, German NCG, is the closest to the Ukrainian border, so its prices often become the benchmark for private traders. In some cases, NCG is the official benchmark for gas price – for instance, the purchase parity import price in Ukraine in 2017-2018 was based on this hub’s index.

In order to assess the impact of the European natural gas prices on procurement prices in Ukraine, we used the Month+1 futures hub prices from TTF, NCG and Austrian VTP CEGH. Procurement prices were extracted from the analytical module of ProZorro (the Ukrainian e-procurement system which CAs are obliged to use at all levels). We excluded irrelevant procurements and selected the contracts which had information on the volume procured. We calculated the average daily prices weighted by volume. Our dataset covers the time period from January 1, 2017 to December 31, 2018.

Figure 1: Natural gas prices at ProZorro and European hubs

Source: ProZorro data, hubs data

As one can see in Figure 1, hubs prices are highly correlated, so they cannot be used as independent variables within a single model. Thus, we decided to take the NCG Month+1 price as a benchmark for explaining the relation between internal procurement prices and international market prices.

NCG Impact on Procurement Prices in ProZorro

In the period of low business activity on natural gas markets, especially in summer, few contracts are awarded. One might have noticed from Figure 1 that this leads to higher variance in daily prices caused by random factors. Therefore, in our model we decided to use the weighted average of weekly prices instead.

Figure 2: Weekly gas price fluctuations in ProZorro and NCG

Source: ProZorro data, Pegas (https://www.powernext.com/futures-market-data)

Our econometric estimation shows that the NCG Month+1 price influences procurement prices with a lag of 7 weeks. In other words, the price at the German hub becomes relevant for the Ukrainian procurement market after almost 2 months on average.

Figure 3: Correlations between procurement prices and NCG Month+1 with different lags

According to the model, the weighted average gas price in ProZorro is more dependent on the NCG Month+1 gas price than on the reservation price in ProZorro. Thus, a UAH 1 increase in the reservation price adds UAH 0.41 to the final price, while each additional hryvnia of the NCG price leads raises the final price by UAH 0.63 in 7 weeks if the price growth trend is not taken into account.

Potential Cost-Saving Using the Price Indexation Formula

The Price Indexation Formula

As European gas prices strongly influence prices on the internal Ukrainian market, it is obvious that they should be included into the indexation formula, as well as exchange rate fluctuations. After consultations with stakeholders, the Ministry of Economic Development and Trade of Ukraine (MEDT) decided to adjust the initial formula proposed by the KSE and included price fluctuations on the Ukrainian Energy Exchange (UEEx) with a small weight into the formula in order to stimulate UEEx development.

The final formula was officially published in December 2018. This formula is not compulsory for any contract authorities, though it is recommended for use by the smaller public entities who do not have the in-house analytical capacity to make a realistic price assessment during negotiations with the suppliers.

where:

• CP – new price in UAH for 1000 m3 of natural gas (including value-added tax, VAT)
• PCP – current price in UAH for 1000 m3 of natural gas (including VAT) before adjustment
• K(cur) – average National Bank of Ukraine (NBU) UAH/EUR exchange rate for 5 days before the price change
• K(base) – average NBU UAH/EUR exchange rate on the day of the previous price adjustment (contract signed)
• NCG(avg) – average of daily NCG Month+1 index during 20 previous trading days before the day of price amendment, EUR per MW-hour
• NCG(base) – NCG Month+1 index on the day of the previous price amendment (contract signed), EUR per MW-hour
• VAT – rate of value-added tax, which is currently 20% in Ukraine
• CV – heating value of natural gas in MW-hour/1000 m3 on the date of the price adjustment
• UEEx(avg) – weighted monthly average natural gas price of UEEx (including VAT) on the day of price amendment
• UEEx(base) – weighted monthly average natural gas price on the UEEx (including VAT) on the day of the previous price amendment (contract was signed)

Thus, the formula includes current gas price, exchange rate changes, changes in NCG index and UEEx index.

Estimation of Potential Cost-Saving for Contract Authorities

The simplest yet time-efficient way to empirically verify the hypothesis of potential cost-saving after the introduction of the price indexation formula in the gas market is a retrospective analysis of the contracts which had already been signed.

The basic principle of estimation is comparing actual prices with the potential prices calculated based on the price indexation formula. For this, we collected a dataset of natural gas procurement contracts covering the time period from August 2017 to the end of August 2018. This period includes both short-term contracts signed for the heating season or its part (usually signed in August-September, sometimes in January-February) and middle-term contracts which are active for at least one year (usually signed in December-March). We took into account all the additional contracts to these contracts signed before January 1, 2019.

Supply schedules and prices of additional contracts are not readily available in a machine-readable format, so we kept only contracts with the total value higher than UAH 1 million. These are 27.5% of all contracts but they cover 79.3% of the total value of natural gas procurement in Ukraine. The final dataset contains prices of additional contracts and monthly supply schedules.

Our earlier analysis of all the contracts on the shorter time scale showed no correlation between prices and volumes in gas procurement contracts (Shapoval, Memetova et al., 2017), therefore our results can be extrapolated to all the gas contracts.

The biggest gap between actual and indexation prices would be in November 2017, averaging UAH 623. However, until the end of the year the gap reduced threefold to UAH 170.

Figure 4: Monthly increase of gas procurement prices

Source: bipro.ProZorro, ProZorro API

We combined the supply schedules with the prices found in the additional contracts in order to estimate potential savings. Obviously, the highest savings were observed during the heating season. However, in September they were negative (see Figure 6). Thus, while the market prices of natural gas started rising in August, actual procurement prices lagged behind until the end of September-October.

Figure 5: Monthly cost savings in case of applying price indexation formula

Source: bipro.ProZorro, ProZorro API

In total, for contracts of over UAH 1 million, potential cost savings from applying the price indexation formula would have been equal to UAH 120.25 million. If these estimations are extrapolated to all the contracts, this figure would reach UAH151.6 million. This is a rather modest sum in relative terms – only 2.7% of the total contract value. However, using the formula is expected to assist smaller CAs who often lack the knowledge of market dynamics to negotiate the optimal price more effectively and limit their dependence on the suppliers’ estimates.

Besides, the parties concluded the contracts without taking into account the opportunity of using the indexation formula. Therefore, actual cost savings might be lower, first of all because the suppliers’ auction strategy would be different. In particular, the dumping strategy with subsequent price increase through additional contracts would become useless. If the formula is used, a lower starting price would mean a lower increase in absolute terms (UAH per 1000 m³), because the formula calculates the change in relative terms (in per cent). For example, if the market price grows by 15% during the indexation period, the starting price can also be raised by only 15%.

Conclusion

The application of the price indexation formula for natural gas procurement may have a positive impact on the public procurement market. We recommend taking into account the prices of the European hubs adjusted by exchange rate fluctuations.

Had the price indexation formula been used for additional contracts in gas procurement in 2017-2018, the average price would have declined by UAH 623, potentially allowing CAs to save UAH 151.6 million.

Formula pricing would raise the negotiation power of customers (CAs) before the start of the heating season. This is especially true for the smaller ones which are not able to professionalize procurement processes. Natural gas price indexation within clearly defined boundaries will create more favourable conditions for fair competition by eliminating the stimuli for dumping at the auction stage.

References

• ACER Market Monitoring Report, 2017 .
• Gribanovsky Olexiy, Memetova Inna, 2017. “Additional contracts as a result of price dumping” (in Ukrainian).
• Order of CMU 187 of March, 22 2017, http://zakon.rada.gov.ua/laws/show/867-2018-%D0%BF#n127 (in Ukrainian).
• PricewaterhouseCoopers Advisory LLC, 2018. “Ukrainian gas market: Discovering investment potential and opportunities”.
• Shapoval Natalia, Memetova Inna, 2017. “Additional contacts in Ukraine: causes and methods of prevention” (in Ukrainian).
• Shapoval Natalia, Memetova Inna, Gribanovsky Olexiy, Tchmil Olexandra, 2017. “Three Sources of Losses in Natural Gas Public Procurement” (in Ukrainian).

Data Sources

• CEP, 2019. Source code of the project [github repository] https://github.com/cep-kse/natural_gas_formula.
• EUStream, Energy content at Budince. [web page] https://tis.eustream.sk/TisWeb/#/?nav=bd.gcv.
• PowerNext, 2017. Futures market data. [web page]. Retrieved from https://www.powernext.com/futures-market-data.
• ProZorro, 2014-2020. Ukrainian public procurement data. [bi system] http://bi.prozorro.org.