Ukraine
Technical Assistance Report-State-Owned Enterprises-Fiscal Risk Management

This Technical Assistance Paper on Ukraine highlights that good progress has been made in improving the disclosure and management of fiscal risks since the embedding of fiscal risks in the Budget Code in December 2018. The mission refined the financial model to analyze risks relating to Naftogaz that had been developed on the October 2018 mission. Despite updating the assumptions, the modelling still shows that the anticipated loss of transit gas revenue will have a significant negative impact on the Ukraine budget from January 2020. Appropriate mitigating action could ameliorate this negative impact, but there will still be a significant reduction in the inflows to the budget from Naftogaz. The next steps recommended by the mission include that Naftogaz, Ukrainian Railways and Energoatom models should be discussed with the State-owned Enterprises (SOE) and refined and that coverage should be expanded to include other major SOEs.

Abstract

This Technical Assistance Paper on Ukraine highlights that good progress has been made in improving the disclosure and management of fiscal risks since the embedding of fiscal risks in the Budget Code in December 2018. The mission refined the financial model to analyze risks relating to Naftogaz that had been developed on the October 2018 mission. Despite updating the assumptions, the modelling still shows that the anticipated loss of transit gas revenue will have a significant negative impact on the Ukraine budget from January 2020. Appropriate mitigating action could ameliorate this negative impact, but there will still be a significant reduction in the inflows to the budget from Naftogaz. The next steps recommended by the mission include that Naftogaz, Ukrainian Railways and Energoatom models should be discussed with the State-owned Enterprises (SOE) and refined and that coverage should be expanded to include other major SOEs.

Executive Summary

Good progress has been made in improving the disclosure and management of fiscal risks since the embedding of fiscal risks in the Budget Code in December 2018, including:

  • Development of a resolution setting out procedures for assessing different fiscal risks, which was being considered by the Cabinet of Ministers of the Ukraine;

  • An order to establish sanctions where required information is not submitted has been drafted but has not yet been submitted for approval;

  • The electronic system for gathering SOE data is now operational;

  • An action plan for enhancing fiscal risk management over the medium term (including creating a fiscal risk register (Q2 2020), and a fiscal risk management committee in the MoF (Q2 2021)) has been developed.

The second annual fiscal risk statement is due in September with the 2019 budget. This is an important opportunity to build on the achievement of the first Fiscal Risk Statement (FRS) in 2018, with a more comprehensive FRS.

The mission refined the financial model to analyze risks relating to Naftogaz that had been developed on the October 2018 mission. Despite updating the assumptions, the modelling still shows that the anticipated loss of transit gas revenue will have a significant negative impact on the Ukraine budget from January 2020. Appropriate mitigating action could ameliorate this negative impact, but there will still be a significant reduction in the inflows to the budget from Naftogaz. Moreover, Naftogaz was experiencing an immediate cash deficit at the time of the mission, which will require decisive action to resolve quickly to avoid a gas shortfall during winter.

A simplified version of the model was also applied to Ukrainian Railways and Energoatom.

  • Ukrainian Railways is anticipated to realize losses and experience a significant cash shortfall over the medium term, resulting in the company being a draw on the budget. Finding a sustainable solution to these challenges is necessary to allow the company to continue providing the rail services necessary to enable economic growth.

  • In the case of Energoatom, even without significant increases in the electricity tariffs charged by the company, it is expected to remain profitable and continue contributing toward the budget. That said, the impact of different approaches to covering the deficit of the Universal Service Supplier and the gap between the feed-in and market tariffs for the green market could change this outcome. Moreover, the company’s planned borrowing could be inadequate to meet its cash outflows resulting in a cash deficit. However, the company has the capacity to sustain more debt to meet its liquidity requirements. Collecting additional information from both companies would allow for more detailed exploration of relevant scenarios.

The models do not represent a final view on the magnitude of the risks examined but instead provide a basis for future modelling of key risks. The models should be periodically updated as new macroeconomic forecasts are prepared, and to reflect policy changes and other developments, such as the subsequent capital raising by Naftogaz.

The next steps recommended by the mission include that Naftogaz, Ukrainian Railways and Energoatom models should be discussed with the SOEs and refined and that coverage should be expanded to include other major SOEs (e.g. Ukrenergo, the State Food and Grain Corporation and coal mining companies). The authorities were also encouraged to incorporate information from the stress testing and scenario analysis into the September 2019 FRS.

Table 1.

Ukraine: Proposed Plan for Implementation of Recommendations

article image

I. Introduction

1. Having established a Fiscal Risks Management Department (FRMD) within the Ministry of Finance (MoF), the Ukrainian authorities have been taking steps to improve their disclosure and management of fiscal risks. The authorities reported the following progress that had been made since the last Fiscal Affairs Department (FAD) Technical Assistance (TA) mission on Fiscal Risks, which took place in October 2018:

  • In December 2018, the amendments to the Budget Code were adopted by the Verkhovna Rada. The amendments establish the legal basis for fiscal risk management, including assigning the MoF powers to collect information and monitor fiscal risks and develop mitigating measures as well as requiring that the relevant line Ministries submit the requisite information;

  • Consultations on the draft overarching resolution, setting out the procedures for assessing the different types of fiscal risks, had taken place with the relevant Ministries and, during the mission, the resolution was being considered by the Cabinet of Minister of the Ukraine (CMU);

  • The authorities were in the process of developing a draft order which will provide for administrative sanctions to be instituted where the required information on fiscal risks is not submitted;

  • The electronic system for gathering the state-owned enterprise (SOE) data was operational;

  • The MoF were in the process of preparing inputs on fiscal risks for inclusion in the Budget Declaration, which was to be finalized in May 2019; and

  • An action plan had been developed for enhancing fiscal risk management over the medium term.

II. Improving Current Practice

A. Draft CMU Resolution on the Procedures for Assessing Fiscal Risks

2. The draft resolution prescribing the procedures and responsibilities for analyzing the major fiscal risks and identifying possible mitigating actions was being considered by the CMU. The resolution covers the key areas of fiscal risk, with the exception of risks associated with the debt portfolio. The authorities reported that these are already adequately addressed under a separate resolution. With respect to the macroeconomic risks, there was still insufficient distinction between actions to strengthen the analysis and monitoring of potential risks and the potential mitigating actions to respond to an underperforming economy, such as implementing growth stimulating reforms or ensuring that there is an appropriate fiscal and/or monetary policy response.

B. Draft Order on Administrative Sanctions

3. The draft order sets out the procedures for preparing and considering a case report and applying administrative sanctions and appealing such decisions.1 The order is based on the Administrative Code of the Ukraine on Administrative Offences and is a requirement in terms of the amendments to the Budget Code that were approved by the Verkhovna Rada.

4. The individuals with ultimate responsibility for submitting accurate and timely information on fiscal risks have not been clearly defined, which allows for evasion and may create enforcement challenges. The draft order makes reference to officials of central and local executive authorities, social insurance and pension funds, financial institutions, state-owned enterprises and business entities where the state has majority ownership. The authorities said this is based on the wording used in article of the Administrative Code relating to fiscal risks.

5. The sanctions should be sufficiently onerous to ensure adherence in cases where information is willfully withheld. The authorities reported that the fines that may be imposed amount to around EUR 100 where information was not submitted and around EUR 150 where regulatory measures were not implemented. This may be a sufficient penalty where the omission occurred through negligence. However, the authorities should ensure that there are adequate sanctions in the event that fiscal risk information was purposely not provided, possibly for the purposes of concealment or other ulterior motives. Usually, the provision of accurate company information would be a key fiduciary duty of the directors, with failure to do so including such injunctions as being prohibited from serving in a similar capacity for a substantial period of time.

C. Budget Declaration and Fiscal Risk Statement

6. The MoF intends to include a general overview of fiscal risks as part of the Budget Declaration, with a more detailed Fiscal Risk Statement (FRS) to be produced in September for inclusion in the Budget documents. The Budget Declaration sets out the Government’s fiscal strategy over the medium-term. In future, including the detailed FRS as part of the Budget Declaration would provide the basis for these risks to be taken into account as part of the fiscal strategy as well as informing the framework within which the detailed expenditure decisions that will be set out in the Budget documents are made. The Budget documentation could then include an assessment of the potential risks that could materialize during the upcoming fiscal year.

7. Having published their first FRS in 2018, the authorities are well positioned to be able to include a comprehensive FRS in September as part of the budget documents. Given the limited time remaining before the finalization of Budget Declaration (scheduled to be in mid-May) as well as some challenges collecting the data as the Budget Code amendments were only approved in December, no more than a qualitative discussion of fiscal risks will be possible in the Budget Declaration. A draft overview of fiscal risks that could be included in the Budget Declaration setting out the main sources of fiscal risks arising from the macro-economy, debt and state guarantee portfolio, SOEs and financial sector was provided is included as Annex I.

D. Action Plan for Enhancing Fiscal Risk Management

8. The MoF have developed an action plan for enhancing fiscal risk management over the medium term. The key elements of the plan are as set out in Box 1.

Key Elements of the Fiscal Risk Management Plan

  • The deadline for the development and submission to the CMU of the draft resolution on the procedures for assessing fiscal risks relating to the macroeconomic situation, SOEs, public private partnerships (PPPs), government guarantees, extra-budgetary funds and local borrowings to be extended from the second quarter (Q2) of 2018 to Q2 2019, as the VR only adopted the Budget Code amendments in December 2018;

  • Annual analysis and inclusion in the Budget Declaration of a general assessment of fiscal risks and their impact on the State budget indicators;

  • Annual preparation of information on fiscal risks and their impact on the State budget indicators in the planned budget period;

  • Creation of a register of fiscal risks for the purposes of monitoring and mitigation by Q2 2020;

  • Development of models for stress testing of SOEs that pose the highest fiscal risks using the electronic system by Q3 2020;

  • Strengthening the institutional and analytical capacity of the MoF and other public authorities in managing fiscal risks through training on an ongoing basis;

  • Creation of a fiscal risk management committee at the MoF by Q2 2021; and

  • Implementation of an electronic system for monitoring the extended set of fiscal risks by Q4 2021.

9. As progress on elements of the action plan are already at an advanced stage, some of the targeted deadlines could be brought forward. As already mentioned, the Budget Code amendments establishing the legal framework for fiscal risk management were adopted in December 2018 and implementation is already underway. Despite the delay in adoption, the authorities already published a first FRS in 2018. During the course of the mission, models for stress-testing the financial projections of Ukrainian Railways (UZ) and Energoatom were developed and the existing Naftogaz financial model was updated. Including the results of the stress-testing for select SOEs in the September FRS would improve transparency although disclosure of the results would need to be accompanied by a careful discussion so as not to adversely impact on perceptions of the financial position of the entities and to articulate the actions the government is taking the strengthen SOE performance. The authorities underlined that their intention is that this analysis be automated as part of the electronic reporting system.

10. Accelerating progress in strengthening fiscal risk management requires high-level support and a clearer assignment of responsibilities. The draft CMU regulation setting out the procedures for assessing and mitigating fiscal risks clearly defines the responsibilities of the respective Line Ministries. However, there is still a need for the MoF to analyze the inputs received from the Line Ministries and quantify the likely impact on the key budget indicators; for instance, translating the changes in the macroeconomic indicators into the implications for the revenue and expenditure forecasts. For several risks, it may make sense for these responsibilities to lie with the existing departments in the MoF, for example revenue risks could be analyzed by the revenue forecasting department; debt portfolio and guarantee risks could continue to be assessed and monitored by the debt department, with the FRMD performing a coordination role. However, in other case where functions are not well-defined, the FRMD may need to play a stronger role2. Fast-tracking the creation of the fiscal risk management committee could assist in this regard as well as fostering greater internal collaboration in developing the FRS. Besides enhancing capacity through training, ensuring an appropriate balance between the responsibilities and the staffing of the FRMD will also assist.

E. Scenario Analysis and Stress-Testing

11. The MoF’s capacity to assess the fiscal risks arising from SOEs is being improved through scenario analysis and stress-testing. During the October 2018 short-term expert (STX) visit, a model that would allow the authorities to undertake scenario analysis and stress test the SOE financial projections was developed and applied to Naftogaz. A simplified version of the model was applied to Ukrainian Railway and Energoatom during the mission. The authorities were trained in the use of the model, with the intention that they would be able to expand the coverage to include other macro-critical and high risk SOEs and that the analysis could be incorporated into the next FRS.3 A detailed guideline for the model has been developed and is included as Annex II.

12. The data used in the models was drawn from the financial plans of the SOEs, which will allow for automation. All of the SOEs are required to submit financial plans. The financial plans include an income statement, balance sheet and cash flow statement and information on capital expenditure, borrowings and payments to the budget. Actuals for the preceding financial year (2017), budget and actuals for the current year (2018) and forward looking projections covering the next 5 years (2019–2023) are provided. In addition, quarterly breakdowns are provided for the upcoming financial year (2019). The reporting in the financial plans does not always correlate exactly with International Financial Reporting Standards (IFRS), which can make it difficult to reconcile the data. Further, some discrepancies were noted, which should be discussed by the authorities with the SOEs:

  • The detailed breakdown of operating expenditure for the three entities could not be reconciled to the operating expenditure reported in the summary income statement in the financial plan; and

  • The detailed information relating to obtaining and repaying funds could not be reconciled to the liabilities reported in the summary balance sheet for the entities. Specifically, in the case of UZ, the total long term liabilities of UAH 30 billion exceeded the total long term liabilities of UAH 21 billion reported in the summary balance sheet as at the end of 2018.

13. The model outputs still need to be validated with the SOEs. The results generated using the financial model were compared with the financial plans that had provided by each of the SOEs. Table 2 below summarizes key issues that were noted and which should be discussed with the respective SOEs.

Table 2.

Ukraine: Key Issues to be Discussed with the SOEs

article image

14. The impact of changes in macroeconomic parameters as well as SOE specific factors were assessed. The model allows for the impact of changes in a range of factors (scenario analysis) or a single factor (stress test / sensitivity test) to be assessed. As a minimum the outcomes under the upside and downside macroeconomic scenarios produced by the authorities can be compared to the outcomes under the baseline scenario. The macroeconomic changes that were considered are summarized in Table 3. In addition, the impact of SOE specific scenarios can be modelled (e.g. impact of the termination of the transit gas contract with Gazprom at the end of 2019). These are discussed further below.

Table 3.

Ukraine: Summary of Key Macroeconomic Assumptions for Baseline, Stress and Reform Scenarios

article image

15. The model can be used to strengthen fiscal risk management. It allows the MoF to determine the factors that are most likely to have a significant impact on a SOE’s performance and the government budget. This can provide an entry point for policy discussions on the priority risks requiring decisive corrective action and appropriate actions that are most likely to contribute toward mitigating such risks.

Naftogaz

16. The anticipated loss of transit gas revenue will have a significant negative impact on the budget from January 2020. Taking appropriate mitigating action (for instance, by implementing the reforms considered in the reform scenario) could ameliorate this negative impact, but there will still be a significant reduction in the inflows to the budget from Naftogaz. The key assumptions underpinning the baseline, stress and reform scenarios are summarized in Table 4.

Table 4.

Ukraine: Summary of Key Assumptions for Baseline, Stress and Reform Scenarios

article image

This could be increased to 90 percent to match the stress scenario if current policy is likely to be continued indefinitely.

17. Naftogaz was currently experiencing a significant cash deficit, which required decisive action to resolve quickly. Left unaddressed, the shortfall being experienced at the time of the mission could compromise the company’s ability to pump gas for storage in anticipation of the winter peak in demand. Options that were discussed included undertaking an international bond issuance, loans from international financial institutions, loans from state-owned banks or recapitalization by the government. However, the company has little capacity to take on additional debt, given the anticipated fall in revenue and profitability in the upcoming financial years. Nevertheless, in July 2019, Natfogaz managed to raise capital through two Eurobond issuances in the amount of EUR600 million and USD335 million.

Figure 1.
Figure 1.

Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Naftogaz (UAH million)

Citation: IMF Staff Country Reports 2019, 359; 10.5089/9781513521657.002.A001

Ukrainian Railways

18. UZ is anticipated to realize losses and experience a significant cash shortfall over the medium term and will continue being a draw on the budget. Only under the reform scenario, is the company projected to generate an operating profit, but after taking into account financing costs, the company is still expected to realize a net loss even under this upside scenario. The level of borrowing projected in the financial plan is inadequate to cover the cash outflow arising from the losses and the planned level of capital expenditure. In any event, the company’s weak financial performance means that it is not able to sustain such debt. The anticipated impact on the budget does not include any potential recapitalization that may be required to keep the company liquid. Table 5 summarizes the key assumptions under each scenario.

Table 5.

Summary of Key Assumptions for Baseline, Stress and Reform Scenarios Applied to Ukrainian Railways

article image
Figure 2.
Figure 2.

Projected Cash Shortfall (2018–21) under Baseline, Stress and Reform Scenarios for Ukrainian Railways (UAH million)

Citation: IMF Staff Country Reports 2019, 359; 10.5089/9781513521657.002.A001

Figure 3.
Figure 3.

Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Ukrainian Railways (UAH million)

Citation: IMF Staff Country Reports 2019, 359; 10.5089/9781513521657.002.A001

19. With additional data, additional scenarios could be considered.

  • UZ indicated that although they are incurring costs to maintain the entire rail network, only around half of the network is used to generate almost all of the revenues. The financial impact of decommissioning the underutilized network could be assessed.

  • According to UZ, freight rail services are cross-subsidizing the passenger rail services, which are loss-making. However, whereas there has been a significant reduction in freight rail services due to a change in the structure of the economy and conflict with Russia, passenger rail services have been increasing. The impact of this structural shift could be determined and implications of increasing passenger tariffs or compensating UZ for the costs could be analyzed.

  • Where freight rail tariffs are regulated, UZ reported that the tariffs are not cost reflective. The impact of migrating toward cost reflective tariffs could be evaluated.

  • The rolling stock is currently nearing end of life.

20. Finding a sustainable solution to UZ’s financial challenges is important for enabling economic growth. Underpricing of rail services has stunted the development of other forms of transportation, leaving Ukraine dependent on the rail system. For instance, 70 percent of cargo is transported by rail, due to the road network in Ukraine being relatively underdeveloped compared with other peer countries. Ageing rolling stock and inadequate maintenance results slows train speeds, results in breakdowns and is expected to soon result in a reduction in UZ’s capacity, which would have a negative impact on the economy.

Energoatom

21. Even without significant increases in the tariffs charged by Energoatom, the company is expected to remain profitable and continue contributing toward the budget. The authorities are currently liberalizing the wholesale energy sector. Should the introduction of a wholesale market result in an increase in the tariffs at which Energoatom can sell its electricity, this will have a significant positive impact on the company’s performance and its contribution to the budget.

22. However, an inadequate level of borrowings relative to the company’s cash outflows is expected to result in a cash deficit. Most of the cash deficit arises as the result of the company’s capital expenditure and changes in the working capital. Energoatom has the capacity to sustain more debt: its gearing and debt cover ratios remain acceptable even under the stress scenario.

23. Additional information would enable an assessment of the impact of different approaches to covering the costs of quasi-fiscal activities. It is not yet clear how the Universal Services Supplier (USS) will be compensated for the shortfall between the cost of purchasing electricity in the market and the lower, regulated retail tariff at which they will be able to sell the electricity. Similarly, there will be a gap between the cost of purchasing renewable electricity at the approved feed-in tariffs and the market price. One option that has been mooted is that Energoatom would be responsible for covering these costs. Energoatom are proposing that these costs would get spread across all generators. To assess the impact, an estimate of the total amount of such costs would be required.

Table 6.

Summary of Key Assumptions for Baseline, Stress and Reform Scenarios Applied to Energoatom

article image

Capital expenditure of UAH 10 billion was assumed in 2019 as no assumption was provided in the financial plan.

Figure 4.
Figure 4.

Projected Cash Shortfall (2018–21) under Baseline, Stress and Reform Scenarios for Energoatom (UAH million)

Citation: IMF Staff Country Reports 2019, 359; 10.5089/9781513521657.002.A001

Figure 5.
Figure 5.

Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Energoatom (UAH million)

Citation: IMF Staff Country Reports 2019, 359; 10.5089/9781513521657.002.A001

III. Recommendations

  • Recommendation 1: Discuss the financial models and outputs and possible mitigating actions with Naftogaz, UZ and Energoatom (within 3 months).

  • Recommendation 2: Expand the financial model to include other major SOEs (e.g. Ukrenergo, the State Food and Grain Corporation and coal mining companies) (within 6 months).

  • Recommendation 3: Incorporate information from the stress testing and scenario analysis in the Fiscal Risk Statement that forms part of the Budget Documentation for the 2020 financial year (within 6 months).

  • Recommendation 4: Finalize the CMU resolution setting out the roles and responsibilities for fiscal risk assessment and reporting (within 3 months)

  • Recommendation 5: Strengthen the capacity of the FRMD and institutionalize coordination within the MoF, with the Ministry of Economy (MoE) and SOEs (1 year).

  • Recommendation 6: Integrate the model with the new electronic system for receiving period updates of information from SOEs (6 months).

The mission reiterated the advice of previous FAD and STX4 visits to gradually expand the fiscal risk analysis and disclosure to a broader range of risks and to deepen analysis over time.

Ukraine: Technical Assistance Report-State-Owned Enterprises–Fiscal Risk Management
Author: International Monetary Fund. Fiscal Affairs Dept.
  • View in gallery

    Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Naftogaz (UAH million)

  • View in gallery

    Projected Cash Shortfall (2018–21) under Baseline, Stress and Reform Scenarios for Ukrainian Railways (UAH million)

  • View in gallery

    Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Ukrainian Railways (UAH million)

  • View in gallery

    Projected Cash Shortfall (2018–21) under Baseline, Stress and Reform Scenarios for Energoatom (UAH million)

  • View in gallery

    Projected Impact on the Budget (2018–21) under Baseline, Stress and Reform Scenarios for Energoatom (UAH million)