Ten thoughts about coal import parity pricing

Some perspectives about the ‘Rotterdam plus’ formula and methods for calculating the wholesale market energy price.

Media brought this subject to the surface again as the National Anticorruption Bureau (NABU) served notices of suspicion to several officials because of the import parity formula for coal pricing. The first emotional and political statements didn’t provide us an answer as to whether the NABU decision is solidly grounded and how the case can be resolved. Hence this matter requires pure economic pragmatism.

First of all, let’s remember why Ukraine introduced the ‘Rotterdam plus’ formula. On November 27, 2014, after unit three decommissioning at Zaporiz’ka Nuclear Power Plant, with reserves missing, we saw a chain reaction of rotating blackouts throughout the country. Under such conditions, Ukraine had to import energy and coal from Russia during the active phase of the military conflict in Donbas. It was happening under crippling terms and political pressure. Then there was the economic blockade of temporarily occupied territories Ukraine relies upon for anthracite mines. To understand the issue better, here’s what Ivan Plachkov, the former minister of energy said (from an interview with Economichna Pravda’ in November this year):

“After coal supplies from the ORDLO (temporary occupied territories) reduced and a ‘special period’ was introduced for the energy market, from mid-2017 the situation with coal supplies stabilized and gained a positive dynamic. Did the introduction of the import parity mechanism for coal influence it? I think, yes. For the last year people haven’t shown interest in the subject of coal stock size, except for some rare cases; society is starting to become comfortable with the ‘everything’s going to be alright’ future.”

So, the main consequence of ‘Rotterdam plus’ was the stabilization of Ukrainian energy systems.

Secondly, before the implementation of the formula, the tariff was imposed in a manual mode, there were no rules for steal coal pricing within the tariffs for thermal plants. Manual mode paves the way for corruption. The ‘Rotterdam plus’ method uses the import parity principle as a base for pricing. For the reason that all the anthracite mines remained in the occupied territories, this coal became a scarce commodity in Ukraine. In such a climate, orientation for import parity as a price making method for scarce commodity is the only objective method.

Price setting with the import parity approach is based on market principles so it excludes corruption. This is because no official influences the coal commodity exchange price decided in the leading European coal hub ‘Amsterdam-Rotterdam-Antwerpen’ — it was used for the so-called ‘coal component’ determination within the tariffs for thermal power plants.

Thirdly, prices may fluctuate, which could influence the result of ‘Rotterdam plus’ formula in Ukraine. Nevertheless, even this factor was taken into account — the methodology of ‘Rotterdam plus’ considers not the current spot price but the average price for a year. This allowed to cushion fluctuations and make predictions. On top of all, this formula has ensured that the coal price in Ukraine is lower or equal to the market price. If there hadn’t been parity, price making would have been based on the last bid of the Ukrainian mines. It’s clear that with limited resources, the coal price would have been the highest.

Fourthly, the National Commission for State Regulation of Energy and Public Utilities didn’t invent the import parity principle, of course. The great majority of countries use it, and those who aren’t — well, it’s their loss. Eurocoal is in firm agreement. The association’s representatives gave examples of the two main policies for coal pricing. On the one part, Great Britain refused import parity at one time, and it led to the destruction of the local coal industry. But there are Turkey and China where import parity made the launch of a support system for the local industry possible. By the way, Britain backed off and returned the import parity to provide objective coal pricing.

Euracoal’s Secretary General Brian Ricketts made some comments about the import parity formula in September 2018:

“The import parity principle isn’t a Ukrainian invention, it is implemented all over the world. Germany and Britain have introduced it. There are a lot of examples in the world where this method is used, and you’ve chosen a benchmark to determine and make pricing with the import parity.”

Fifthly, the ‘Rotterdam plus’ formula allows to cover import expenditure, even though it does not necessarily require imports itself— it sets a price point for Ukrainian mines. Coal-steam plants produce a large part of the energy in Ukraine, thus, coal mining is very necessary. Because energy pricing in Ukraine is connected to international prices for energy resources, it creates significant opportunities for coal mining expansion.

Sixthly, before the implementation of the import parity method, the authorities imposed the tariff in a manual mode. Subventions covered the stated and market price difference. The low price for coal from state mines and chronic funding gap led to lost revenues. The import parity methodology allowed to reduce the losses and to increase coal production. For instance, state mines received 5.4 billion UAH in two years (from March 2016 till March 2018) as additional income thanks to implementing the import parity method.

Seventhly, what will happen if a Ukrainian coal miner proposes a thermal plant to buy raw materials for a price higher than the import parity? The answer is very simple — a plant will buy coal from an importer. So the national mines need to curb their appetite — they need to moderate the price to sell the product. This is how market-based pricing works.

Eighthly, if the one wants to raise investment for expanding coal mining, one needs transparent pricing which stimulates investors. This is what pricing based on the import parity does.

Ninthly, the question of so-called ‘plus’ — which is considering expenses for coal transportation — sparked a lot of discussions. They say, why should we take these costs into account if we talk about Ukrainian coal. The answer takes us to classics of market relations which says that all of the players should be on the same footing. If this ‘plus’ is not considered, coal importers will be discriminated against — transportation costs wouldn’t be included. And we can’t ignore importers’ economic interests. For example, last year Ukraine imported 5.6 mln tons of coal which were vital for Ukrainian thermal plants’ functioning. On the other hand, ‘plus’ played into the hands of Ukrainian coal miners — if transportation costs hadn’t been taken into account, their tariff would have been lower for this ‘plus’ amount.

Tenthly and finally, it was the IMF who insisted on import parity introduction. This method applies to gas and coal markets. Regarding gas, it even has a separate term — ‘Dusseldorf Plus’. The IMF wouldn’t have given us the tranches we received in 2016-2017 if there were no such methodology.

In order to summarize, I can say that the decision to introduce the import parity method for determining the coal element in thermal plant tariffs was rational because it gave price points based on international prices for market agents, and crucially reduced the risk of subjectivity in price making. The use of import parity was methodologically correct, transparent and it excludes ‘manual mode’ hazards. It was an important transition period leading to the market relations that came into force since July 1 as a part of energy market reform. I think it will be very useful for NABU experts to learn about these arguments during the Rotterdam plus case investigation. If they can accept them impartially and through the economic prism, I guess they can drop the case and transfer it to the archives. And then NABU can move to investigations which constitute a crime.

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