subsidy reform proposals_20.07.16

Analysis of subsidies system for HUS payment and proposals on its reforming

Draft document for discussion

Minister of Regional Development, Construction and Housing and Communal Services of Ukraine, International Finance Corporation

July 20, 2016

Analysis of subsidies system for HUS payment and proposals on its reforming (Draft document for discussion)

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Content

1. Conclusions ................................................................................................................ 3

2. Review of the current system of subsiding of the citizens for HUS payment ........ 4

2.1 Procedure and volumes of subsidy accrual for HUS payment ......................... 5

2.2 Administration of subsidies granting ................................................................. 9

2.3 System of subsidies transfer ............................................................................ 10

2.4 System of subsiding in the context of reform of energy efficiency in residential sector ........................................................................................................... 12

2.5 Advantages and disadvantages of the existing system .................................. 14

3. Role of central authorities in the subsiding system ............................................... 15

4. Target characteristics of subsidy system ................................................................ 17

5. Proposals on reforming of subsidies system .......................................................... 18

5.1 Transition to cash settlements in the system of transfer of subsidies to utilities (amended RCMU No. 20) ................................................................................. 20

5.2 Automation of administration of the subsidies system .................................. 21

5.3 Monetization of subsidies ................................................................................ 21

5.4 Other initiatives on optimization of subsidies volume ................................... 23

6. Annex 1. Glossary .................................................................................................... 25

7. Annex 2. Algorithm of subsidies payment for HUS ................................................ 26

8. Annex 3. Size of subsidy for typical HH ................................................................... 27

9. Annex 4. Key parameters of the model for forecasting the need in funding subsidies ............................................................................................................................. 28


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1. Conclusions

Since May 2015 in Ukraine began to operate the new simplified procedure for granting subsidies that became an important step in the conditions of transition to market and economically feasible prices for housing and communal services (offsetting the rapid rise of HUS tariffs for vulnerable households) . However, the results of the system functioning over the last year have shown that it does not meet modern conditions, and creates significant risks both for public finances and HUS market. Key shortcomings of the current system are:

Administrative severity and non-transparency (including the lack of implementation of modern IT

solutions);

Excessive costs of the state budget – the subsidy is granted on the basis of official income of

citizens, which can be much less than real. That is why not all HHs receiving subsidies actually need

it;

Settlements on subsidies is made not in cash (netting) that distorts the market relations between

industry players and demotivates the end-user to save on HUS bills.

Implementation of the reforms in the field of HUS industry and energy efficiency directly depends on the system of subsidies. The success of any of these reforms is impossible without appropriate reforming of the system of subsidies.

In addition, we estimate that the annual accrual of subsidies already in 2017 can reach UAH 118 bln (or 15.7% of the state budget). Such volumes of subsidies funding may not be affordable for balancing the public finances in the medium term and require actions in the following areas:

increase of official income of the population (economic development and legalization of the

economy);

energy efficiency and decrease in HUS consumption (primarily heating and gas supply);

gradual reduction of state support for HUS payments through subsidies system (review of

calculation methodology or formula).

Minsoc and Minfin play a key role in the functioning of the subsidy system. Minregion, Minenergo, MEDT and NEURC are not directly responsible for functioning of the system of subsidies but the fulfilment by these authorities of the function assigned on them largely depends on this system (and vice versa). Therefore, reforming of subsidies should be realized with their active participation.

It is assumed that reforming of the subsidy system will occur in two phases:

The preparatory stage at which the Government must approve the Concept and the

correspondent Action Plan;

Implementation of appropriate measures in accordance with decisions adopted by the

Government.

Preliminary list of measures that was developed by the Working Group includes:

Transition from clearing to cash payments in the system of transfer of subsidies to utility

companies;

Automation of subsidies system administration;

Monetization of subsidies (subsidies transfer to the card accounts of the citizens with special

regime of operation);

Other initiatives on optimization of the amount of subsidies accrued (more details are given in

Chapter 5).


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2. Review of the current system of subsiding of the citizens for HUS payment

Currently, Ukraine has a system of granting subsidies to citizens for HUS payment, which was developed in

the mid-90s of the past century. Since October 1994, the Government of Ukraine began a gradual increase

in tariffs for housing services to the level of full reimbursement of their actual cost. Prior to increase the

payments of the population were covering in general only 4% of the prime cost of services, and the

remaining 96% was covering the state from the state budget to the companies that provided them. In 1994,

the government subsidies to enterprises-service providers accounted for 75% of the state budget deficit.

If as of February 1, 1995 payment of the population was 20% of the prime cost of services, on July 30, 1996

it accounted for 80% already. Accordingly, the share of subsidies in the state budget deficit reduced from

above 75% to 24%.

The program of housing subsidies was introduced in 1995 by the decision of the Government of Ukraine to

help poor families in HUS payment at the new increased tariffs. Subsidies in their initial implementation

were identified as non-monetary form of help to families in payment for dwelling administration, cold and

hot water supply, gas, heating, waste and electricity, solid and heating (liquid) fuel. The right to a subsidy

had any family, if its expenses for the above services exceeded 15%. The difference between the amount

of charges of the family for HUS and established share of aggregate income of the family was paid directly

by the state to enterprises-service providers. In 1997 from 2.6 to 3.5 million of families were receiving

subsidies depending on the month of the year.

The main reason for increasing tariffs and introduction of subsidies for HUS in the mid-90s was the

announcement on increase of natural gas prices and the need for major repairs of residential buildings and

upgrading or replacement of water and heating supply of such buildings.

As you can see, 20 years ago the situation was somewhat similar. The level of tariffs after the increase

reached 80% of the economically feasible cost of services. Savings as a result of the tariff increase should

have been directed to the modernization of housing and replacement of communications. However, the

set goals were not achieved. On the one hand, because of the constant increase in energy prices and,

consequently, for HUS, and periodic devaluation of the national currency, which entailed higher prices for

imported energy, and on the other hand, due to imperfection of tariff setting and the Program of housing

subsidies, which did not promote energy efficiency. The main principle of this system was minimization of

the consumer participation in the calculations.

In the years 2015-16 the system of subsidies has become an important social shock absorber during a sharp

increase in energy tariffs. It allowed subsidy recipients to pay only a small proportion of HUS bills. However,

the current results of the system functioning have shown that it does not meet modern conditions, and

creates significant risks and inefficiencies for both the public finances and for the HUS market. Obviously,

it should be essentially changed. This requires changing attitudes as to the functioning of the system of

housing subsidies and institutional and macroeconomic conditions in which this system evolves.

In most countries the subsidies are intended for the poorest sections of the population. In Ukraine in 2015

about 30% of households received a subsidy. In 2016 it is forecasted that in the conditions of decline in real

incomes of the population subsidies for HUS payment from the state budget will receive more than half of

households. In this situation, the subsidies can be too great burden on the budget and gradually transform

from direct into indirect way of subsidizing the Naftogaz. Thus, the population has no motivation to reduce

energy use, as it is only involved in calculating the subsidy, and is not a recipient.


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2.1 Procedure and volumes of subsidy accrual for HUS payment

The key parameters that affect the calculation of the subsidy are:

official income of household members;

size of minimum cost of living (LU “On State Budget of Ukraine” for the correspondent year);

base rate of payment for HUS (RCMU No. 1156 of July 27, 1998);

tariffs for services set by NEURC or local authorities;

social standards of consumption of HUS (RCMU No. 409 of August 6, 2014).

According to the current algorithm of subsidies calculation, its size does not depend on the actual consumption of HUS, and is based on social rates determined by the resolution of the CMU No. 409 of 06.08.2014. On the basis of social rates and operating tariffs households’ payment for HUS (social bill) is calculated.

The subsidy is calculated as the difference between social bill and mandatory payment of the household, which in turn are calculated on the basis of the household members’ income. The subsidy is granted only in the case when the social bill for HUS exceeds the required mandatory payment of HH.

A simplified scheme for calculating subsidies is given in the picture below; the complete scheme is shown in Annex 2.

Diagram 2.1. Simplified algorithm of calculation of subsidies amount

Source: RCMU No. 848, RCMU No. 409, RCMU No. 1156, Working group analysis

The approach to granting subsidies based on social rates of consumption simplifies administration (see section 2.2). However, lack of a direct link between consumption and size of subsidies leads to excessive accrual of subsidies (especially in conditions of warm winter like in the heating season 2015/16). The Government envisages return of excessive subsidies to the state budget (RCMU No. 319 of 27.04.16) and an appropriate order is currently in process of development. In terms of efficient use of public funds, this approach is justified in the current conditions but should be replaced in the medium term, because, in fact, demotivates the population to save the resources.

On the other hand, if the population is given the opportunity to use subsidies savings for other purposes, it will create incentives for savings and additional financial resource for the implementation of energy efficiency measures (e.g. if this funds will be used for upgrading their own homes).

Assessment of the needs in funding HUS subsidies

Ukraine has a large-scale program of state subsidies for HUS payment. During the 2015-16 heating season subsidies received ~ 4.9 million of HHs (33% of the total amount) and on the average subsidy covered 90% of bill for HUS. It is expected that at the end of 2016 there may be ~ 8 millions HH (~ 55%) of recipients of subsidies. A significant increase in subsidies was caused by shock from a significant increase in energy tariffs in the years 2015-2016.


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In 2016 the need for funding HUS subsidies can reach UAH 85.2 billion, which is 12.8% of the state budget. In 2017 the need can rise to UAH 118.0 billion (15.7% of the state budget). Key assumptions used for forecasting the subsidies financing needs are listed in Annex 4.

Diagram 2.2. Forecast of volumes of subsidies to the population (under current conditions)

*forecast is made based on import price for natural gas of USD 190 for ths. m3

Source: budget of Ukraine, Working group analysis

The mentioned subsidies funding volumes may not be suitable for balancing the public finances in the medium term. The need for subsidies can be reduced by the following three components:

increase of official income of population (economic development and legalization of the economy);

energy efficiency and economy in consumption of HUS (primarily heating and gas);

gradual reduction of state involvement in paying HUS through subsidies system (review of

calculation methodology or formula).

In addition, external factors such as the price for natural gas on the international market (according to the Memorandum with the IMF Ukraine should quarterly adjust tariffs for gas and heating according to the import price of gas, which is set in a foreign currency) may largely influence the total amount of subsidies. The diagram below shows the possible impact of gas prices on the amount of subsidies.

Diagram 2.3. Impact of import price for gas on the needs in subsidies financing, UAH bln

Source: Working group analysis

Amount of accrued subsidies considerably depends on seasonality. The largest expenditure of HUS is centralized heating and gas supply for heating. Therefore, the amount of subsidy accrual in winter is several


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times higher than the corresponding amount in the summer. This factor has been further enhanced due to increase in energy tariffs in April 2016.


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Diagram 2.4. Forecast of accrual of subsidies by months in 2016-17, UAH bln


Compared with the summer months, in winter increases the number of recipients (see. diagram below),

and the amount of subsidies, which on average receives HH (see Annex 3).

Diagram 2.5. Forecast of number of HHs-subsidy recipients for months in 2016-17, ml.


The key housing and utility services, which consumption is subsidized by the state, is supply of natural gas

and heat (thermal energy) for production of which, main source is natural gas (up to 80%).

Diagram 2.6. Forecast of the subsidies needs on HUS for 2017, UAH mln.


Calculation of amount of subsidy for the typical household is given in Annex 3.


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2.2 Administration of subsidies granting

System of administration of subsidies covers relations between many organizations and authorities: Minsoc, Minfin, local governments and organizations that provide HUS, Pension Fund, tax authorities and households. This requires the exchange and processing of a significant volume of information.

Despite the simplification of system of granting subsidies from May 2015, its administration requires considerable resources of social protection authorities. Old methods of administration do not allow public entities to timely and qualitatively analyse key indicators and make appropriate management decisions, including due to lack of use of modern IT technologies. Appointment or transfer of subsidy to household due to changes in key parameters, in fact, can be carried out during ~2 months.

Introduction of modern IT-solutions will allow solving the key problems of the administration of subsidies:

Reduce the need for human resources and to minimize the human factor;

Increase the speed, transparency and quality of decision-making on subsidies granting;

Strengthen cooperation among involved parties on check of the reliability of information;

Timely provide central governments with analytical information for making strategic decisions.

Subsidies for HUS payment is assigned to HH to one of its members. For this it is necessary to submit to the local social protection authority only two documents – application (contains information about a household, housing, etc.) and a simplified income statement. Then, in 15 days the social protection authorities receive the information from the Pension Fund, SFS bodies, etc. required for data validation and subsidies designation. All other information necessary for subsidies granting (on provision of HH with living space and utilities) shall be provided to HUS organizations within 5 days. After receiving the mentioned information, social protection authorities shall, within 10 days, take the decision on granting (not granting) of subsidy and inform citizens in writing of the decision taken.

Diagram 2.7. Scheme of subsidies administration

Source: resolution of the CMU, data of the Minregion

Subsidies granting and monitoring of their intended use is carried out by structural units of local authorities on social protection.

In addition, in non-standard cases, subsidies may be designated on the basis of decisions of local authorities or commissions that they form for this purpose. The decision in such cases is made taken into account acts of examination of material and living conditions of HH.

During the verification of data on citizens who have received the subsidy, the Minfin revealed cases of provision of false information and other violations caused by the simplified procedure of subsidies granting.


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In this case, the calculation by social protection authorities of subsidies stops and HH returns subsidy received in excess.

A simplified approach to subsidies granting has the following problems:

Does not take into account the income of citizens obtained from unofficial sources and not

declared. Thus, the state grants subsidies to the part of the population whose actual income allow

to pay for HUS;

Low level of process automation, not allowing a limited number of social protection workers to

perform verification of income and financial status of applicants for subsidies. Also, there is no

possibility to quickly track unscrupulous recipients of subsidies, especially in the conditions of a

growing number of people who need state support.

Since May 2015 subsidies system operates with the following changes:

Restrictions on economic status of persons applying for a subsidy were cancelled, except for one-time purchases in excess of UAH 50 ths;

Subsidy granting for 12 months for all categories of recipients was introduced (including those consumers of gas and DHC, whom previously subsidy was granted only for the heating season);

Subsidies for the next period in case of absence of changes in the household are designated

automatically. For this social protection authorities collect the necessary information and within

10 days take the decision on subsidy granting.

2.3 System of subsidies transfer

The current system of transfer of subsidies is complex and is inefficient in practice:

a significant proportion of payments is made in the form of offsets, which distorts the relationship

between entities in the field of HUS (stimulates calculation entities to accumulate obligations, and

not to their timely implementation);

blurred responsibility of the consumer and the state, represented by numerous bodies, for

timeliness and completeness of payment for services rendered;

the system demotivates people to save and implement energy saving measures.

Clearing (offsets) system for subsidies was introduced by the Resolution of the CMU No. 20, which actually violates the requirements of the Budget Code of Ukraine concerning the prohibition of offsets.

Diagram 2.8. Type of calculations on subsidies depending on services (forecast for 2017)

Source: data of State Statistics Service, Working group analysis

The diagram below shows the calculation scheme for accrued subsidies for centralized heating services. Clearing payments for accrued subsidies for gas, water and electricity supplies are carried out under similar algorithms.


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Diagram 2.9. Scheme of settlements for thermal energy and gas for DHC

Source: RCMU No. 217, No.20, Order of the Minenergo and Minfin No. 493/688, data of the Minregion, Working group

analysis

Transfer of subsidies (by offsetting) from the budget to enterprises of DHC, further settlements of DHC with NJSC “Naftogaz of Ukraine” and the latter with the budget as payment of taxes, creates significant risks to the financial condition of the DHC as the receipt of payments from the subsidy depends directly on the availability of the correspondent commitments on the whole netting chain. In addition, existence of mutual settlements stimulates settlement entities to accumulate commitments and not to timely implement them.

Description of clearing settlements system (on example of heat supply enterprises):

DHC may participate in mutual settlements with accrued subsidies for HUS and commitments for gas or electricity consumed on the basis of the Common Decision Protocol (CDP);

State budget makes settlements of HUS subsidies with taxes from Naftogaz, Ukrtransgaz and Ukrgazvydobuvannia based on CDP;

From February 2016 (after introduction of changes to the Resolution of the CMU No. 217 in December 2015) mutual settlements for HUS subsidies also influence the proportion of “real” money, which is transferred to Naftogaz and remain in DHC. If there is a debt budget before the DHC, the latter do not have funds to pay for gas, and the more debt of DHC to Naftogaz, the smaller share of “real money” they receive from the application of the adjustment coefficient;

The chain of settlements may have more parties but it starts with DHC and ends with Naftogaz, Ukrgazvydobuvannia or Ukrtransgaz. Also, DHC may have several “chains”, on which settlements are made and signed CDP or netting on one “chain” can be divided into several CDPs. This complicates the administration of the system and makes calculations non-transparent.

For the mutual settlements commitments must be available between the parties of settlements. If at any stage of the chain there are no relevant liabilities, netting is not carried out.

Frequency and timing of settlements are not regulated. Provided that all parties are interested in making mutual settlements, it is delayed for about 1 month after end of the month in which services were provided. This is because all parties have to agree on their commitments and sign CDP. But, in practice, any party (Treasury, Naftogaz or enterprises) need not sign CDP and then, netting does not happen at all. Existing legislative regulation and system of settlements do not determine those responsible for settlements. This,


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in turn, leads to late payment of bills by enterprise, for example, for consumed gas to Naftogaz and charging penalties and fines to the enterprise.

Diagram 2.10. Term of making mutual settlements on subsidies regarding payment for consumed gas

Source: RCMU No. 20, Working group analysis

Under conditions where the cost of subsidies in 2017 will reach more than UAH 100 billion, there may be a situation when entities of HUS field will not have required number of commitments for offsets making. This will lead to further accumulation of debts to NJSC “Naftogaz” and increase of the liquidity gap of HUS enterprises. Moreover, when except NJSC “Naftogaz” on the market will operate other operators of gas supply, settlements with them will be impossible.

One of the current problems is that the social rate of accrual of subsidies in some cases exceeds the actual consumption of services. The existing mechanism for the return of “excessive” subsidies envisages the following: if the amount of subsidy exceeds the bill for HUS, the service provider accepts it as payment for services for subsequent periods. However, after the heating season:

The amount of unused subsidies for centralized heating services payment shall be returned by

service providers to the budget in full on the basis of the act of reconciliation;

The amount of unused subsidies for payment of individual heating services equivalent to 100 m3

of natural gas or 150 kW*h of electricity is counted as payment for services in the next accounting

periods;

The other part of the unused amount of the subsidy for the services of individual heating payment

are returned by the service provider to the budget based on the act of reconciliation prepared

with a division of social protection (such a measure, on the one hand, may be interpreted as more

efficient use of budget funds and, in fact, demotivates consumers to save energy consumption).

The subsidy for the purchase of liquefied natural gas, solid and liquid stove fuel is provided directly to the public in cash. Subsidies for managing multi-apartment house and adjacent area (elevators maintenance and their energy supplies, cleaning of adjacent areas, garbage disposal, management costs, etc.) are transferred in cash to housing maintenance organizations, management companies or condominiums.

2.4 System of subsiding in the context of reform of energy efficiency in residential sector

Energy efficiency reform should be based on three main components: reforming of heating enterprises, establishment of the Energy Efficiency Fund and monetization of subsidies.

Monetization of subsidies is a component that will affect both the heating sector reform (it will allow to strengthen payment discipline and improve the financial condition of heat supply enterprises) and the establishment and operation of the Energy Efficiency Fund by creating the source of its content and incentives for implementation of energy efficiency measures for the public.


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Diagram 2.11. Components of energy efficiency reform


Lack of motivation of recipients of subsidies for energy efficiency measures

The current system of subsidies does not create financial incentives for households in their implementation of measures to improve energy efficiency. In fact, it distorts the main motive of the population to conserve energy: the relationship between the actual consumption of HUS and their cost specified in the accounts for payment for services.

Currently, subsidies receive more than 1/3 of all households in Ukraine, which actually are not motivated to reduce energy consumption. This problem is particularly acute for multi-storey buildings where energy efficiency projects should be approved by the consent of 75% of co-owners. This can be a major obstacle to implementing energy efficiency projects for such buildings.

The impact of subsidies on the financial condition of the DHC

After approval of changes in December 2015 to the Resolution of the CMU No. 217 of June 18, 2014, the status of payments of the state on HUS subsidies affects the number of “real” funds that enterprises receive from the public. In case of delayed payment of subsidies the providers of services have arrears to suppliers of natural gas and electricity. With the growth of the debt, according to the correction coefficient share of funds received from the public in favour of suppliers reduces.

Obstacle to creation of a free market of gas and heat

In addition, with the existing system of transferring subsidies from the state budget for provision of subsidies for payment of HUS, heating companies are tied to Naftogaz as the single supplier of energy resources. This means that settlements on subsidies can occur only if Naftogaz is a supplier of gas. If DHC goes to another supplier – it loses income from subsidies.

Given the desire to create a free market of natural gas, this procedure of clearing payments for subsidies actually limits for enterprises of DHC possibility to optimize operating costs and to choose gas supplier.

Heating companies that use alternative energy sources are not able to make settlements for subsidies. Thus, the existing scheme of payments for subsidies creates significant barriers for development of market of alternative energy sources.


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2.5 Advantages and disadvantages of the existing system

Key advantages and disadvantages of the existing system of subsidies are provided in the table below.

Table 2.1. Advantages and disadvantages of the existing system

Advantages Disadvantages

The size of the subsidy depends directly on the size of the family income. The higher the income, the lower the subsidy granted

Recipient of the subsidies may be a person with large but “grey” income

Increased total percentage of payments and, accordingly, the revenue of enterprises of DHC and Naftogaz

Does not encourage the consumer to economical consumption of resources as

subsidy recipient cannot use the saved subsidy

The concept of system envisages the creation of effective incentives to conserve resources:

the amount of the subsidy is fixed, that is why with a decrease in consumption,

payment over subsidy is reduced;

consumption over the established social rate is not covered by subsidies;

mandatory fee is not paid in full when the value of actually consumed services

less than the mandatory fee.

Current social rates for calculating subsidies are too high relative to actual

consumption. As a result – excessive subsidies are accumulated in the accounts

of DHC

Clearing payments adversely affect the liquidity of the DHC. First, DHC under

such conditions can only pay for gas or electricity. Second, in case of delayed

transfer of subsidies the DHC receives a smaller share of “real” money through

the adjustment coefficient

Allowed the most vulnerable sections of the population to relatively smooth

experience a sharp increase in energy prices

Clearing encourages market participants to the formation of “extra”

commitments to make as many settlements as possible

The existing system entails significant risk for the formation and development

of free market of natural gas and alternative energy sources

“Blurs” responsibility of the parties for untimely performance of obligations



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3. Role of central authorities in the subsiding system

The system of subsidies includes relationship between many levels of executive authorities. The key government body is the Ministry of Social Policy and local units of social protection. Minsoc together with local authorities is responsible for the calculation and assign subsidies to households, which applied for subsidies. Another authority in the system is the Ministry of Finance, which is responsible for transferring funds to local budgets in amounts of accrued subsidies (currently in the form of clearing) to enterprises of the DHC and verification of recipients of subsidies.

Minregion, Minenergo, MEDT and NEURC are authorities that form the policy governing the relationship between the key stakeholders of the HUS market (utilities and Naftogaz) and are responsible for creating conditions for the normal functioning of the HUS market and, therefore, interested in reforming the subsidy system.

Diagram 3.1. Interrelations in the subsidy system

*payment for subsidies in the form of clearing


Table 3.1. Key tasks of CEB within the system of subsidies granting

Minsoc Local social bodies Minfin Minregion, Minenergo,

NEURC, MEDT

Develops a system of subsidies granting

Performs monitoring, collection and analysis of information on the purpose and use of subsidies

Assigns subsidies to HH

Checks legality of subsidies granted

Calculates the amount of subsidies for HH

Checks data provided by subsidy recipient for calculating subsidies

Keeps records provided and used subsidies

Main budget funds administrator

Transfers the subsidy funds for the payment of subsidies to local budgets

Provides verification and validation of information on subsidy recipients

From policy and regulate relations between key stakeholders of HUS market

Set tariffs on utilityservices

Calculates social rates of consumption of resources

The goal – creation of capacity for HH to pay for HUS

The goal – provision of possibility to get subsidies by HH

The goal – ensuring of adequate funding of subsidies granting

The goal – provision of quality services and profitability of utility enterprises and NJSC “Naftogaz”


In conditions when ~5 million of households (> 30% of the total number in the country) receive subsidy and the lack of modern IT-solutions, social protection authorities lack manpower. This negatively affects the speed and quality of data validation to calculate subsidies.


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The Minfin is assigned with function of provision with funds of subventions system to pay for accrued subsidies. In terms of limitation of budgetary resources clearing settlements were introduced for most of the subsidies that are made through accounts in the Treasury.

Minregion, Minenergo, MEDT and NEURC are not directly responsible for the functioning of system of subsidies but the performance of the functions assigned on these authorities largely depend on the quality of functioning of the system of subsidies. Therefore, reforming of subsidies should be carried out with their active participation.


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4. Target characteristics of subsidy system

Subsidies as a tool to stimulate population to conserve energy

The system of subsidies should be directed to help the most vulnerable segments of the population to provide acceptable living conditions, but it should not completely remove the issue from households on reduction of energy consumption and HUS payment. The population should be interested in reducing the volume of consumed resources and, therefore, reduce bills for HUS. Otherwise, the subsidy system becomes inefficient and causes excess costs of the state budget.

Payments for subsidies must be made with “real” money rather than clearing

Subsidies granting in cash form and not through offsets, will allow increasing the liquidity of the sector of HUS. For enterprises-service providers it is critical given that in 2017 the number of households-subsidy recipients may exceed 50% of all households in the country. In this case, half of the income of HUS providers will be in the form of clearing that companies will not be able to freely use it.

One of the main advantages of cash payments for subsidies is creation of normal economic relations between market participants. They (especially NJSC “Naftogaz”) will no longer have the incentive to accumulate mutual obligations, which are essential condition for the preparation of mutual protocols and making clearing payments involving budget. This, in turn, will help to remove mutual obligations of the components associated with mismanagement and corruption.

Subsidies should be transferred to the population and not to utilities (monetization of subsidies)

An important feature of the new subsidy system should be a change of recipient of funds for subsidies. Now consumer does not actually “feels” subsidy because it is automatically transferred to the accounts of service providers.

If the subsidy will be transferred to the account of the consumer, he/she will see the real amount of consumed services and will be interested to minimize their consumption. The consumer will be able to use own saved funds or subsidies funds at own discretion. This is significantly different from the current concept where excessive subsidies simply “hang” on the accounts of the DHC and regional gas companies before the end of the heating season as obligations to consumers.

Change of the funds recipient for the subsidy will lead to simplification of the system and settlements between the parties. This will allow to “remove” the state of relations “population – service providers.” In this case, the responsibility of each of the members: of the state to the population for the timely provision of subsidies, population to utilities for timely payment of services received is increased.

Automation of administration of subsidies and verification (modern IT solutions)

The system of administration must be automated through the use of advanced IT solutions (transfer of information into a single electronic database). This will allow to address the following issues:

Minimization of the human factor in the decision taking on granting or not granting subsidies;

Speed up of consideration of filed application and taking the decision on the designation of

subsidies;

Reduction of the need for human resources;

Creation of a consolidated database on all subsidy recipients and beneficiaries that will allow to

improve among others the budget planning process of costs for subsidies.

Introduction of verification system should minimize the subsidy granting to part of the population that does not have the right to it. The purpose of verification will be confirmation of the mentioned level of income by subsidy recipients and other parameters for calculation of subsidies. Thus, the state budget will be able to save a significant amount of money.


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5. Proposals on reforming of subsidies system

It is assumed that reforming of the field will take place in two stages:

The preparatory stage at which the Government must approve the Concept and the Action Plan;

Implementation of the relevant actions.

Expected timetable of reform and key initiatives developed by the Working group is presented in the Diagram below (more details on the initiative are presented below in the section).


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Diagram 5.1 Expected schedule of reform



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5.1 Transition to cash settlements in the system of transfer of subsidies to utilities (amended RCMU No. 20)

Refusal from use of the mechanism of settlements and signing of common protocol decisions (CDP) is an important and necessary step to monetize subsidies. It will also solve multiple problems of the financial condition of the DHC and improve budgetary discipline:

Firstly, the cash flow from subsidies will not depend on the availability of commitments that will create transparent and simpler relations in the field;

Secondly, settlements between entities will no longer require the signing of CDP that can accelerate time of subsidy granting by budget by nearly 1 month;

Thirdly, cash payments make it possible to clearly establish those responsible for transferring funds. Obligation of the budget on transfer of the funds in certain terms will allow to solve the problem of fiscal discipline. Besides, Treasury obligations to publish in open access information about the timing and amount of transferred subsidies will allow to carry out control in the system.

Thus, refusal from clearing settlements (RCMU No. 20) will become one of the reasons for solving the issue of improvement in fiscal discipline and implementation of market relations in the HUS field.

Subsidies to the population will come from the budget to the HUS providers in cash and will be credited to a special account under the Resolution of the CMU No. 217. On the diagram below sample of settlements for DHC is specified:

Diagram 5.2. Scheme of payments in the heat sector after refusal from clearing payments

Source: RCMU No.217, data of Minregion, Working group analysis

To implement such a system changes to the following legislative acts are needed:

Amendment of Resolution of the CMU No. 20 for cancellation of mutual settlements based on CDP

Amendment of Resolution of the CMU No. 217 for introducing a mechanism for the allocation of

the funds for subsidies

The expected time of implementation of the action - September-October 2016.

The main risk of introducing such a system of relations in the field is that it may need up to UAH 10 billion of additional liquidity of the state budget in the winter (equivalent to semi-monthly volume of subsidies). Therefore, the Minfin should ensure funding sources.


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5.2 Automation of administration of the subsidies system

Ultimately both benefits and subsidies should be targeted, and therefore there should be a single database of their recipients:

1. Creation of a single system of personal accounts (including within the project “Modernization of

population social support system” carried out with the assistance of the IBRD)

2. Conducting verification procedures, adjustment of the number of subsidy recipients

Ensure the operation of a single system of personal accounts will allow to create a single database of persons entitled to benefits and subsidies that will have a significant positive effect:

Such database will contain all necessary information for state control over the legality of subsidies

granting (subsidy recipients’ rights to receive it) and for automatic calculation of subsidies;

Due to the availability of database in regions – simplify bureaucratic mechanisms and optimize the

costs of social protection authorities;

Provision of accounting of cash flow for subsidies will give opportunity not only to control it but

also more reliably predict and plan future expenses.

Such measures should be implemented by the Minsoc together with the Minfin. At this, draft regulatory and legal acts of the Minsoc should be created that regulate the activity of such a single system of personal accounts (databases), its relevant technical regulations, etc.

To implement the measure, in addition to the introduction of the automated system, it is necessary to create a legislative framework for its effective functioning.

The expected term of implementation of the action – 2-nd quarter 2017

5.3 Monetization of subsidies

Monetization of subsidies is the introduction of money transfer system in accordance with the intended subsidies to special bank accounts of consumers. This approach will introduce direct relationship between the supplier and the consumer for all types of housing services, will establish clear areas of responsibility and will give the public incentives to save energy and implementation of energy efficiency measures. However, the transition to monetization for all recipients cannot be made in a short time period because of the need to open a large number of accounts. This process can take 2-3 years.

A special bank account of the recipient of subsidies provides for the possibility of use of the funds only for 2 measures – payment for HUS or payment for energy efficiency measures. At that, the priority is the HUS payment, and in the absence of debt – measures on energy efficiency. Thus, this will ensure proper use of the funds.

Subsidies monetization mechanism envisages involvement of commercial banks (post offices – in areas where there is no access to the bank). Subsidies monetization scheme is given below.


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Diagram 5.3. Proposed scheme of monetization of subsidies with restricted use during payment for housing and utilities services


A necessary condition for the implementation of monetization is to create a single point of personal accounting (single base) of subsidy recipients and coordination of the timing of transfer of subsidies from budget with deadline for payment of HUS.

Also, for the effective functioning of the system it is necessary to conduct explanatory work with the population and HUS enterprises. The population should receive information about a new mechanism of payment for HUS (population will have to pay for HUS from the special account of subsidies and additionally pay their own money, if necessary). For HUS providers it is necessary to develop recommendations for a single payment document (receipt) to establish the precise form of reflection of the amount of money the consumer has to pay himself and amount the state provides.

The Ministry of Social Policy, the Ministry of Finance and the National Bank of Ukraine (by consent) should be responsible for the implementation of such a system.

Expected term of implementation of all necessary preliminary steps for start of monetizing – 2-nd quarter 2017. After that, 2-3 years will be needed to ensure that all households have opened special bank accounts for subsidies granting.


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5.4 Other initiatives on optimization of subsidies volume

The current system of public subsidy was intended to soften the sharp rise in energy prices and, consequently, the tariffs for HUS in the period of their increase. In future it is necessary to develop and adopt a long-term plan of optimization of the amount of subsidies that should put aim to reduce the state budget expenses in the long term and to accustom people to the rational use of energy and other HUS.

The developed plan should be supported by a strong communication campaign which will be aimed to explain the necessity of energy efficiency measures, rational use of energy and causes of a gradual reduction in the size of subsidies.

The amount of subsidies should be gradually reduced

An important part of system reform is a gradual reduction in the size of the subsidies. This is a key element of the new system of subsidies, which should address two issues: to become one of the main incentives to reduce energy consumption and allow gradually reduce the state budget expenditures.

There are several options that would allow it to implement:

Reduction of consumption rates, which will result in reduction of the size and terms of the

subsidies;

The gradual increase in the mandatory payment of the household;

Introduction of correction coefficient size of subsidy – after several years of receiving subsidies,

the total size of subsidy gradually decreases according to the above ratio. A more detailed example

of the operation of step-down ratio is presented below.

Conventionally, application of adjustment coefficients is as follows: HH applies for subsidy and receives it in full. Starting from the 4th year subsidy gradually begins to decrease by a certain factor: 4th year - ratio of 0.95, 5th year – 0.9, 6th year – 0.85, and so on up to a certain limit ratio (rates and terms can be agreed).

Diagram 5.4. Example of use of decreasing coefficient


In applying these coefficients population will be stimulated to implement energy efficiency measures and will have time to implement them. In turn, the state will actively create conditions for the implementation of such measures. One of the tools should become the Energy Efficiency Fund, which will provide financial resources to the population in the form of grants or loans.


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Application of two-rate tariff for heat energy

Introduction of two-rate tariff for central heating is one of the ways to reduce the need for subsidies. With two-rate tariffs the population will pay for the service of central heating not only during the heating season but throughout the year. During unheated season subsidy for heat will not be charged. At the same time, during the heating period, the fee for the services of central heating will be reduced; accordingly, social rate of payment will be reduced. Thus, the saving of the state budget for the subsidies expenditures will be possible. More detail savings are presented below on example of forecast of expenditure on subsidies for 2017, subject to availability of only one-rate tariffs or only two-rate tariffs for central heating. The annual savings on subsidies may reach in this case ~ UAH 1.9 billion.

Diagram 5.5. Forecast of subsidies cost for CH on condition of only one-rate or only two-rate tariffs, UAH bln


Use of seasonal ratios during calculation of subsidies for CH and gas heating

One of the options for optimization of payment on subsidies is the proposal of NJSC “Naftogaz” for the application of additional seasonal correction ratio when calculating the social rate of natural gas for heating.

According to the proposal, it is planned to apply to it adjusting factor to social rate of consumption of gas depending on the month in which services are provided.

Table 5.1. Possible values of adjusting season ratio depending on the month in which services were provided

Month October November December January February March

Ratio 0,4 0,6 0,9 1,0 0,9 0,7

Source: data of NJSC “Naftogaz”

It is proposed to exclude April from the heating period. The advantage of this approach is that the use of low adjustment ratios at the beginning of heating season will allow to almost completely avoid overpayments on accounts of customers in this period.


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6. Annex 1. Glossary

Term/abbreviation Definition

CDP Common Decision Protocols

CEB Central executive body

CH Centralized heating

Clearing Settlements between entities in the form of offsets

CMU (Government) Cabinet of Ministers of Ukraine

CWS Cold water supply

ЕЕ Energy efficiency

DHC District Heating Company

HH Household(s)

HUS Housing and utilities services

HWS Hot water supply

IBRD International Bank of Reconstruction and Development

LU Law of Ukraine

MEDT Ministry of Economic Development and Trade of Ukraine

Minfin Ministry of Finance of Ukraine

Minenergo Ministry of Energy and Coal Industry of Ukraine

Minregion Minister of Regional Development, Construction and Housing and Communal Services of Ukraine

Minsoc Ministry of Social Policy of Ukraine

Local social authorities

Local authorities for social protection of the population

NBU National Bank of Ukraine

NEURC National Energy and Utilities Regulatory Commission

NLA Regulatory and legal act(s)

RCMU Resolution of the Cabinet of Ministers of Ukraine

SFS State Fiscal Service

VRU Verkhovna Rada of Ukraine


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7. Annex 2. Algorithm of subsidies payment for HUS

Diagram 7.1 Algorithm of calculation of subsidies for HUS

Source: Resolution of the CMU, information of the Minregion

It should be noted that for calculating the heat consumption as part of social HUS bill, regional expenditure coefficients of heat energy (in the case of centralized heating) or fuel (in case of individual heating) apply. These coefficients are set by the Resolution of the CMU No. 409 of 06.08.2014.


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8. Annex 3. Size of subsidy for typical HH

For typical households of three people living in the apartment of 50m2 or house of 70m2, heated by gas, limit HH income at which the subsidy is granted makes ~ UAH 12-14 thousand depending on the type of home (apartment or house) in winter and ~ UAH 7 thousand in summer.

Further are given calculations for a typical household – the average income in Ukraine for HH – UAH 5000, the average household size - 2.6 persons, the area of apartment - 50m2 or house - 70 m2).

Diagram 8.1. Social bill of typical household in winter, UAH


Tariffs for services and social rates affect the amount of subsidies straightforward: the higher the index, the greater the amount of subsidies given to household. The main impact on the subsidy size creates social charges for heating, because under the rates that take effect on July 01, 2016 its share will reach> 60% of all social HUS bills.

At the backdrop of a sharp rise in energy tariffs in the years 2015-16, the Government sharply increased spending on subsidies to the population and simplified the procedure for obtaining subsidies for HUS payment. In 2015 over 30% of total accrued amount for heating was paid by subsidies. This figure can potentially rise to 50% by the end of 2016.

The amount of subsidies that a typical household in Ukraine will receive (after the increase in tariffs for heat and hot water from July 1, 2016) is shown in the Diagram below.

Diagram 8.2. Subsidy to typical households, UAH



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9. Annex 4. Key parameters of the model for forecasting the need in funding subsidies

Table 9.1. Key parameters of model for forecasting the need in funding the subsidies

Key assumptions

2016 2017 2018

Import gas price, USD 190,0 190,0 190,0

National currency rate, UAH/USD 25,5 27,2 27,8

Annual inflation rate 15,1% 8,1% 5,2%

Interest of two-rate tariffs for CH in the country 15,0% 15,0% 15,0%

Minimum cost of living, UAH 1399 1544 1611

Tariff for gas (set after the heating season), UAH/ths. m3 6879,0 7497,4 7729,1

Tariff for CH for the heating season, UAH/Gcal 1469,23 1605,77 1667,24

Tariff for HWS (set after the heating season), UAH/m3 84,03 92,05 96,15

Tariff for electricity upon consumption up to 100 kW*h, UAH/kW*h

0,57 (0,71)* 0,90 0,94

Tariff for electricity upon consumption up to 600 kW*h, UAH/kW*h

0,99 (1,29)* 1,68 1,75

Tariff for electricity upon consumption over 600 kW*h, UAH/kW*h

1,56 (1,64)* 1,68 1,75

Social standards according to RCMU No. 409 of 06.08.14 (amended of 30.04.16)

Output data

Annual volume of accrual of subsidies, UAH bln. 85,2 118,0 120,9

Number of HHs receiving subsidy at the end of the year, mln. 8,1 8,1 8,0

Percentage of HHs receiving subsidy at the end of the year (of total number of HHs)

54,0% 53,4% 52,9%

* х.х – tariff for electricity from 01.03.2016 (х.х) – tariff from 01.09.2016


subsidy reform proposals_20.07.16

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