Competition for innovation

Beyond formal public service institutions, what is currently lacking is a systemic approach to economic modernization and market-based incentives for innovation. Small and medium-sized firms (SMEs) are playing an important role not only in generating employment, but also in innovation and technology adoption. Fostering Higher Levels of Value Creation in the Economy Scenarios for Ukraine Yet, conditions for SMEs are particularly difficult in Ukraine. On indicators that pose important barriers for small enterprises, such as obtaining electricity or paying taxes, Ukraine remains among the worst performers worldwide, ranking 172nd and 164th respectively, out of 189 countries in the World Bank’s Ease of Doing Business Index. As one technology entrepreneur explains, “what we need is no less than a sea change in the way the country looks at SMEs. Currently there are still too many barriers for private entrepreneurs”.

Nowhere is this more apparent than in the IT sector, which according to many stakeholders could become a real backbone of the future Ukrainian economy. While Ukraine has a large pool of highly qualified programmers, many of them have been operating in the shadow economy, providing services for companies elsewhere in the world. More fundamentally, the domestic market lacks competition, and therefore pressure for innovation. While transitioning to market economy structures after independence and then to the period of high growth in the 2000s, the Ukrainian economy has moved towards a low equilibrium of high entry barriers for non-insiders, limited incentives for technology adoption, and high concentration on base commodities.

Such worrying trends can only be overcome through enhanced competition at all levels, and SMEs will have to play an important role in this. Moreover, greater internal value creation will also support the country’s growing middle class, strengthening Ukraine’s domestic market and decreasing its dependence on external factors. Even though global commodity markets are slowly recovering, even strong sectors, such as steel production, are facing increasing competition and cost pressures as emerging markets expand capacity and Ukraine’s cheap energy advantage disappears. This leads to a broader argument: fostering higher levels of value creation in the economy cannot be mandated; it is the outcome of a process of modernization that can only flourish in a supportive institutional environment. As a leading academic puts it, “the economy develops as a system; deficiencies in areas such as healthcare, public finances, pensions – although not directly linked to businesses – all go hand in hand and affect the performance of the economy.”

Being one of the most energy-intensive economies in the world, Ukraine is also highly dependent on gas imports. The country’s energy intensity is more than five times higher than that of Qatar, which has the third largest natural gas reserves in the world. Roughly half of Ukraine’s economic output is based on major gas-consuming industries, such as metals, fertilizers and power generation. Industries sensitive to the price of gas account for about 60% of GDP and half of the country’s export earnings.

At the same time, almost two-thirds of the gas consumed in Ukraine is imported from Russia, which makes it extremely dependent on this one source of energy supply. Despite more than doubling import gas prices, utility tariffs have been adjusted only marginally since 2006, which means that the government is heavily subsidizing energy consumption. In fact, domestic household utility tariffs are well below cost recovery, creating a massive fiscal burden for the government, which severely limits its fiscal space for other important public service expenditures. Energy subsidies represent approximately 6% of the country’s GDP and result not only in a structural financial loss of US$ 2.5 billion annually, but also in disincentive energy saving behavior among the population and industry.

A non-transparent energy market and artificially low prices furthermore represent a barrier for the development of domestic energy production. While self-evident, this challenge is not easily solved. Addressing energy pricing will upset the status quo that some have been benefitting from. However, it will most certainly help unlock investments, be it from domestic sources, new players entering the market, or international assistance programs.

Although the current stand-off with Russia is likely to affect Ukraine’s energy situation in the short-term, shifts in the global energy landscape provide Ukraine with new opportunities for diversifying its energy supplies. The shale gas revolution in the United States is already putting pressure on gas markets globally. New geographic options ranging from Central Asia to Iran as well as potentially de-escalating tensions in the Middle East could all put further downward pressure on energy prices. Amid these developments, Ukraine has started to explore possibilities for the development of an LNG terminal on the Black Sea coast which, according to some estimates, would allow it to tap into gas supplies from the Persian Gulf as well as from the South Caucasus.

Institutional progress, however, will be a precondition for the kind of investments required for such grand projects. Recognizing the time required to bring complex LNG infrastructure on line, it would be unrealistic to expect significant diversification of gas supplies in the near term. While Ukraine’s accession to the European Energy Community in 2011 has yet to deliver a transformative effect on Ukraine’s domestic energy market, given that implementation of policies has been slow, closer integration with the European energy market holds significant potential for Ukraine. The adoption of European legislation on market regulation could also have positive effects on investment decisions and the operations of international energy companies in the country. Possibly the greatest promise for Ukraine’s energy security lies in exploiting its domestic energy potential, in terms of both production and reduced consumption.

According to some estimates, with the right policies and investment conditions, Ukraine’s domestic conventional or shale gas production could double within a few years. Although the current crisis may taper some of the underlying premises, projections for possible shale gas extractions see Ukraine as one of the most promising markets in Europe. The Donbas Basin in Eastern Ukraine, for example, is estimated to be almost twice as big as the largest shale reserves in the United States. Before the current stand-off, several global energy companies signed agreements that could lead to multibillion dollar investments to develop Ukraine’s shale gas and offshore resources. Beyond these fossil fuels, the country also has a significant renewable energy potential, in terms of wind, solar and biomass.

While investors start developing these alternative resources, some complain that “officials have so far failed to recognize the full potential that renewable energy could unfold in the country.” As in other sectors, the barriers for entry have been particularly high and often prohibitive for small and medium-sized companies that are at the forefront of Europe’s green energy industry.

Perhaps the biggest transformation is seen in the energy sector that stood at the outset of this virtuous circle. Gas subsidies for households have progressively been phased out and replaced by more targeted support for the most disadvantaged groups. Modernization of the country’s energy production, transmission and consumption became possible with transparent pricing and market access that brought in a flurry of investments. In a more competitive environment, domestic production of conventional, offshore, and shale gas scales up quickly, as Ukraine edges closer towards energy independence. Both within and beyond the energy sector, FDI has brought new technology and knowhow into the country, as private domestic and foreign investors responded positively to signals of improved governance.

The different components of the national economy not only thrive in this more favorable and open institutional environment, but also benefit from increasing synergies and spillovers between sectors. For instance, developments in the agricultural sector trigger increasing demand for better infrastructure, machinery and fertilizers which in turn positively impacts the metallurgical, manufacturing and chemical sectors and ultimately reinvigorate domestic producers and service providers. While long considered part of the old economy, the agricultural sector has also become a key driver for Ukraine’s emerging high tech industry from chemicals and fertilizer production to bio-tech and seed development. The sector is also increasingly characterized by a wide range of small and medium-sized companies that benefitted from long awaited land reforms and a progressively more favorable business environment. Indeed, SMEs are probably the greatest beneficiaries of the reforms, as innovative entrepreneurs are encouraged to play a more active part in the country’s economy.

Domestic consumers as well as the wider services economy also become important drivers of this economic virtuous circle. A growing middle class, which is also internationally mobile, drives expectations for more efficient institutions and becomes central to the economy’s value creation. As such, this is the scenario of a fundamental political, economic and societal transformation. Ukraine is not at the crossroads anymore, it has reinvented its economic model based on a new social contract that forms a sustainable and resilient basis for its future prosperity.