by Volodymyr Smelik, Vladyslav Smelik and Dmytro Sakharuk

Ukraine shows great potential for the development of new cogeneration plants, particularly for industrial sites and the district heating sector. Here Volodymyr Smelik, Vladyslav Smelik and Dmytro Sakharuk give guidance on how projects could be steered through the permitting and licensing regime.

Ukraine has ideal conditions for cogeneration. At present approximately 85% of the heat energy generated in Ukraine is by municipal boilers constructed during the Soviet Union era for local district heat supply. The majority of these municipal boilers consume natural gas, which represents 75% of the nation’s total fuel consumption. Notably, more than 20% of the natural gas that Ukraine annually consumes is burned for heating. Industrial users consume 66% of the natural gas; these users may also be interested in implementing cogeneration.

The Institute of Engineering ThermoPhysics of the National Academy of Sciences of Ukraine believes that the existing municipal district heat supply infrastructure allows for the introduction of cogeneration at a total capacity of 5000—8000 MW and for existent generation for industrial users up to 1000 MW.

Ukraine procures natural gas mainly from Russia. After Russian Gazprom substantially increased natural gas prices in 2006—2007, the Ukrainian government took steps to decrease the country’s dependency on natural gas as a fuel source by increasing consumption of Ukrainian coal. However, due to the low quality of coal and problems with its transportation, natural gas remains the main fuel burned for heating in Ukraine.

COGENERATION PAST AND PRESENT

The first cogeneration projects were implemented in Ukraine after 2005, when the Cogeneration Act was adopted by Parliament. In 2006, tax benefits were introduced for investment in energy-saving projects, including cogeneration. So far, because of certain contradictions within the tax law, these incentives have failed to significantly increase the number of cogeneration projects. The government, however, has been working to remedy the situation. In July 2008, Ukraine’s Prime Minister instructed the Ministry of Fuel and Energy to develop a state program for the development of cogeneration in Ukraine. At present, there are seven working cogeneration projects in Ukraine. Many other projects are in the process of development. Among the most prominent are:

  • a 27 MW cogeneration plant to be located in the Ivano-Frankovsk region of western Ukraine. This will utilize (as its fuel exhaust) heat generated by the seven gas turbines at the Bogorodchany compressor station of the Soyuz gas pipeline
  • a 13 MW cogeneration plant to be located in the Kiev region of central Ukraine. This will produce electricity, heat, cooled water and carbon dioxide for a Coca-Cola bottling facility
  • a 45 MW cogeneration plant that will be located in the Odessa region of southern Ukraine. This will be constructed by the National Nuclear Electricity Generating Company, Energoatom.

Implementing cogeneration projects in Ukraine is not easy, especially if such projects are based on the municipal district heat supply infrastructure. Since 2007, Squire Sanders has provided legal assistance on the construction of two combined heat and power (CHP) projects in Ukraine. The most important issues for investors in such projects are:

  • how to structure a project involving municipal/state property
  • the types of permits an investor must have to construct and operate a CHP
  • determining what price to sell CHP heat and electricity.

MUNICIPAL AND STATE PROPERTY

As noted above, district heat supply systems owned by municipal authorities and, on rare occasions, by state bodies, are very attractive for implementing cogeneration projects. However, because of numerous legal restrictions, constructing cogeneration projects based on municipal or state property is a much more complicated task than structuring projects based on private property.

Investors have a variety of strategies to choose from in order to implement cogeneration projects based on municipal or state property — such as leasing, concession, and purchase or privatization. Other strategies include entering into a joint activity agreement without establishing a legal entity; establishing a joint venture (a new legal entity); or a management agreement. Each has its advantages and disadvantages. The strategy selection depends on a number of factors including the type of property, the investors’ plans and the municipal or state authorities involved. Key features are described below.

Leasing — the easiest way to proceed

At present, leasing of municipal or state property is the easiest and most common strategy used by investors in Ukraine. However, an investor should know that the leasing of state or municipal property must be done on a competitive basis that requires participation in special tender procedures. Relationships between an investor and the municipal or state authorities are governed by a lease agreement that must correspond to standard lease agreements adopted by the respective state or local authorities.

One of the important issues that must be addressed in a lease agreement is who owns the improvements made to a leased property. This issue is critical for projects providing construction of CHP in the course of the modernization of existing power producing facilities.

Concession — does not protect investors very well

Concession is very similar to leasing. However, it is permitted in only a limited number of cases. As a rule, concession benefits state or municipal authorities more than it does the investor. For example, authority remains with an owner who gives concession for reconstruction and improvements. An investor may receive compensation only for reconstruction and improvements.

However, if an investor increases the value of the property given into concession by more that 25% or creates a new property, that investor has the right to purchase the property after termination of a concession agreement.

Purchase — only through privatization

Purchase of state or municipal property is subject to relatively complicated privatization rules. It may offer an investor control, but due to uncertainties in both the legislation and the politically-charged privatization process, it is likely to be considerably more difficult. As a rule, state or municipal property is privatized on a competitive basis, either through an auction (the best price wins) or a tender (the proposal with the best terms wins). However, in certain circumstances, direct sale/purchase is allowed.

Privatization strategies are not applicable in all cases because Ukrainian legislation prohibits privatizing certain types of state property or enterprises — for example, heat distribution networks and infrastructure. In some regions of Ukraine, local authorities have also prohibited sale-purchase of municipal enterprises and other municipal entities.

LLC — preferred option for joint ventures

Entering into a joint activity agreement with state or municipal authorities or establishing a joint venture is another option. Because incorporation and formation of the governing structure are simpler than they would be for a joint stock company, the most suitable form of joint venture is a limited liability company (LLC). To acquire control in an LLC, the investor must possess at least 50% plus 1% participatory interest in a company.

Management agreement — not well tested

Theoretically, an investor may implement a cogeneration project under a management agreement entered into with a municipal or state authority. However, the practice of using such agreements has not been developed yet in Ukraine, and its applicability to a given project must be considered on a case-by-case basis.

PERMITS TO CONSTRUCT AND OPERATE CHP

Construction and operation of CHP in Ukraine requires obtaining numerous permits, authorizations and licenses. As it is not possible to fully describe them in this article, we will address just those that are the most important, unusual or difficult to obtain.

Allocation of land for construction of CHP

Ukraine classifies land as private, municipal or state land. There are no difficulties with purchasing or leasing private land zoned for construction purposes. However, only about 10% of land in Ukraine is private, and only 20% of that land is zoned for construction. As a result, most land for construction is taken from municipal and state land that is currently agricultural.

At this time, allocation and rezoning of municipal and state land for construction is perhaps the biggest problem that investors face. Allocation and rezoning are complicated and time-consuming procedures. In addition, any purchase or lease of municipal or state land is subject to three major restrictions:

Land auctions. Only the winner of a land auction may buy or lease state or municipal land (there is no land auction requirement for private land). Land auctions were introduced in December 2007, but at the time of writing no procedure for conducting an auction has yet been adopted, and no state or municipal land has been sold or leased.

Moratorium on alienation and rezoning of agricultural land. The Land Code prohibits alienation and rezoning of private land plots designated for agricultural crop production. Neither individuals nor legal entities may transfer title to such land plots (except by inheritance) or rezone them into construction and other uses. In effect since January 2007, the temporary ban will continue until certain land reform legislation is adopted by Ukraine’s parliament.

Foreign national’s restriction. Agricultural land may not be acquired by foreign nationals, foreign legal entities or Ukrainian companies with a foreign owner. Non-agricultural land may be purchased by foreign nationals or entities, but only if it is situated within a settlement (e.g. a city) or, if outside such a boundary, through acquiring real estate construction.

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Drafting and approval of CHP construction design
Construction design of CHP must be developed by a contractor licensed in Ukraine. If developed by a non-Ukrainian designer not licensed in Ukraine, the design must be adjusted to Ukraine standards by a designer licensed in Ukraine. Ukraine’s construction standards frequently do not comply with EU standards, so adjustments can be quite extensive and therefore expensive.

Acceptance of completed CHP

Operating a completed CHP is prohibited until it is accepted under procedures provided for in Ukrainian law; therefore, the usual transfer from contractor to client is not possible in Ukraine. Acceptance is a two-stage process involving Ukraine’s Working Commission and State Commission, who both have to qualify a completed construction as safe and ready to use.

The Working Commission and State Commission consist of a developer, a general contractor, a designer and representatives of various state authorities. Both check to ensure the compliance of the completed construction with the construction design, as well as with architectural, sanitary, fire safety, ecological and energy-saving regulations. The acceptance process must be completed within 30 days of the construction’s completion (with a possible extension to 60 days). Because a developer cannot use a completed CHP before acceptance, this time period must be taken into consideration in the project schedule.

Qualification of CHP

CHP plants may be qualified or not qualified. Qualification is conducted by the National Agency on Efficient Consumption of Energy Resources. The main purpose of qualification is to confirm that a CHP complies with efficiency requirements provided in the Cogeneration Act.

Qualification only matters for determining who CHP-generated electricity may be supplied to. Owners of non-qualified CHP plants may generate electricity for their own needs or supply direct to particular customers. Owners of qualified CHP plants have the right to supply electricity to a wider spectrum of customers. In addition, they may supply electricity to the wholesale market and to local distribution companies.

Licensing regime

The National Energy Regulatory Commission of Ukraine (NECU) is a licensing authority in the world of cogeneration. An owner of a CHP may need to receive several types of licenses in order to secure the right to generate and sell electricity and heat. The type and number of licenses depends on how the consumers of the generated electricity and heat may be classified.

PRICING CHP HEAT AND ELECTRICITY

As a rule, tariffs on heat and electricity generated by CHP are regulated by the NECU. However, which tariffs are regulated depend on the following criteria: the type of energy (heat and/or electricity) that is generated; the type of activity planned, including generation and/or transportation and/or supply; and the anticipated consumer, such as the wholesale electricity market (WEM), individual business or the general population.

The NECU regulates tariffs on electricity generated by CHP if a company sells that electricity to the WEM or to the population. In such cases, the price of electricity may not exceed a tariff approved by the NECU. In the case of direct supply of electricity, the tariff is not regulated by the NECU and may be defined by the parties in a power supply agreement.

The NECU regulates tariffs for heat generated by CHP in all cases. However, in the case of direct supply of heat, the price may be higher or lower than approved by the NECU. This is prohibited in the case of heat supply to the population.

If a company plans to generate heat for its own consumption and electricity for sale or vice versa, it must apply to the NECU for approval of both heat and electricity tariffs. This is because the tariff approval procedure adopted by the NECU does not provide for separate approval of tariffs.

The NECU approves tariffs for a one-year period, and applying for approval is a complicated procedure. A company must submit a number of documents, including the Tariffs Calculation and Investment Program which must be approved beforehand by the Ministry of Fuel and Energy of Ukraine. Therefore, preparation of documents required for tariff approval needs to begin well in advance.

SUMMARY

Cogeneration has great potential in Ukraine, despite the challenges outlined. Cogeneration is supported by the state and driven by the economy — given the current cost of Russian gas and oil, only those who decrease their heat and electricity expenses will survive. Our experience shows that cogeneration projects in Ukraine, while difficult, are not impossible if handled by experienced and knowledgeable professionals.

Volodymyr Smelik, Vladyslav Smelik and Dmytro Sakharuk are corporate lawyers in the Kyiv (Ukraine) office of global law firm Squire, Sanders & Dempsey.
Email: vlsmelik@ssd.comvsmelik@ssd.com and dsakharuk@ssd.com