Overview of Licensing Regime for the Use of Subsoil in Ukraine in 2007
By Irina Paliashvili
RULG - Ukrainian Legal Group, P.A.
Ukraine has two alternative
regimes for the use
of subsoil: the Licensing
Regime and the production sharing
agreements regime (PSA Regime).
This article is devoted exclusively to
the Licensing Regime, including its
legislative and practical aspects in
2007 and the prospects for its development
in 2008, with special emphasis
on its applicability to foreign investors in the oil and gas sector.
There are serious and on-going flaws in the legislative basis
for the Licensing Regime, as well as in its practical application.
Despite these flaws, the Licensing Regime exists and has been
used by domestic and international companies in Ukraine with
varying degrees of success.
The Licensing Regime is regulated by subsoil legislation, which
includes: the 1994 Subsoil Code (Subsoil Code) and the 2001 On Oil
and Gas Act of Ukraine (Oil & Gas Act) (we omit the laws regulating
other types of subsoil resources) and is spelt out in various subsequent
regulations. Therefore, a standard law-based legislative basis, albeit
outdated and at times ambiguous and conflicting, does exist for the
Licensing Regime (hereinafter – Standard Legislative Basis).
Since 2004, however, the Parliament of Ukraine (Rada) has
suspended the Standard Legislative Basis through annually adopted
laws on the State Budget (Budget Acts), and stipulated an annual ad
hoc system for the Licensing Regime based not on laws, but on regulations
adopted annually by the Government (the Cabinet of Ministers)
of Ukraine (GOU). Over the years, this temporary measure has
in practice evolved into an entirely new system of its own. In sum, the
Standard Legislative Basis for the Licensing Regime is being replaced
annually by regulations (Regulation-Based System).
In practice, this replacement takes place through a two-step
process: (1) the Standard Legislative Basis is suspended, usually at
the end of the year, by the Budget Act for the next year; and then
(2) in the first quarter of the next year, the GOU adopts licensing
regulations for the particular year, which remain in effect only
through to the end of the particular year. Of course, this ad hoc Regulation-
Based System, creates a high degree of unpredictability and
makes the oil & gas sector much more prone to political influence
and dependant on the composition, orientation and discretion of
the GOU at the moment.
Unfortunately, for 2008 we do not see the much-needed return
to the Standard Legislative Basis as likely, because the Budget Act for
2008 once again provides for the suspension of the Standard Legislative
Basis and renews the flawed Regulation-Based System.
The Licensing Regime is regulatory rather than contractual
because under it, an investor applies to the State for a permit (license)
to use subsoil (Subsoil Permit), which is the primary document
authorizing subsoil use. A Subsoil Permit is issued by a state
body authorized to issue Subsoil Permits (Licensing Body). Over
the years, the Licensing Body has changed several times, and the
current Licensing Body is Ukraine’s Ministry for Protection of the
Natural Environment (Environmental Protection Ministry). Issuance
of the Subsoil Permit must be accompanied by an agreement
between the Licensing Body and the subsoil user on the conditions
for using subsoil (Licensing Agreement), which is considered to be
an integral part of the relevant Subsoil Permit.
It should be noted that Subsoil Permits are issued separately for
exploration (Exploration Subsoil Permit) and for production (Production
Subsoil Permit).
Under the Regulation-Based System, Subsoil Permits are generally
sold through auctions (Auction Procedure). In certain special
cases determined by the GOU, Subsoil Permits are instead granted
without an auction being held (Non-Auction Procedure).
It is important to note that in addition to a Subsoil Permit,
which is obtained for the use of a specific subsoil area pursuant to
subsoil legislation, a requirement also exists to obtain a license allowing
to generally carry out a certain type of activity, such as exploration
or production. The licensing of types of activity in various
industries is regulated by the On Licensing Certain Types of Economic
Activity Act of Ukraine.
We have identified the following notable trends in the Regulation-
Based System for 2007 as compared to 2006, which we categorize
as (1) positive; (2) general; or (3) negative.
(1) Positive Trends
• The respective GOU regulations established clearer (but still not
sufficiently clear) provisions with regard to converting an Exploration
Subsoil Permit into a Production Subsoil Permit: if certain
conditions are met the holder of an Exploration Subsoil Permit has
the right to obtain a Production Subsoil Permit without an auction.
• The possibility of obtaining a single Exploration-Production Subsoil
Permit is more directly implied in the respective GOU regulations.
• The grounds for reformulating (transferring) a Subsoil Permit have
been expanded and some new possibilities have appeared for investors,
provided that certain conditions are met. These possibilities include
reissuing a Subsoil Permit for the benefit of a new joint venture
company (JV) or for the benefit of a subsidiary or parent company.
(2) General Trends
• The list of the cases when an existing Subsoil Permit can be suspended
or cancelled has been significantly revised and expanded.
• Compared with 2006, the list of grounds for applying for a
Subsoil Permit under a Non-Auction Procedure has increased from
10 to 13 and some grounds have been restated.
• The deposit payable at an auction for a Subsoil Permit increased
from 5% to 20% of the starting bid for such Subsoil Permit.
• The auction participation fee in 2007 is no longer refundable
to applicants (a 50% refund was stipulated in 2006).
• The deadline for filing an auction application has been reduced
from 30 to 15 days, and the deadline for making the official
auction announcement has been reduced from 45 to 30 days, with
both deadlines counting from the date the auction is held.
(3) Negative Trends
Historically, issuance of Subsoil Permits under the Licensing
Regime in Ukraine has been very politicized, and this has been especially
true in the last few years, and specifically in 2007. In reality,
only the least attractive and most expensive oil & gas areas were
allowed to be auctioned. Subsoil Permits for remaining areas have
been granted through “exceptions” to the Auction Procedure. Not
surprisingly, even those few auctions that did take place in 2007 either
did not attract any bidders, failed to sell any Subsoil Permits, or sold
very few Exploration Subsoil Permits, and no Production Subsoil
Permits were offered at all. The analysis of the Auction Procedure in
2007 shows that it is not sufficiently transparent and allows for baseless
cancellation of an auction or withdrawal of some Subsoil Permits
from an auction. In addition to the regulatory flaws, the practical implementation
of the Auction Procedure in 2006-2007 was inconsistent,
ambiguous, and deeply flawed. This resulted in highly publicized
scandals, which caused the President of Ukraine to issue a Decree in
the fall of 2007 suspending all future auctions.
Another negative trend was that in 2007 the GOU declared unlawful
the traditional method by which foreign investors participate
in the use of subsoil, to wit, through joint activity agreements with
Ukrainian holders of Subsoil Permits (JAAs). In general, JAAs are
possible under Ukrainian civil legislation, and, in particular, the Oil
& Gas Act recognizes the tie between JAAs and oil & gas exploration
and production by mentioning it in various contexts. At the outset,
it should be noted that JAAs do not represent a sufficiently solid and
risk-free legal basis for long-term investment in the oil & gas sector
because of a number of general legal concerns and risks. In addition,
JAAs do not allow foreign investors to acquire any rights to Subsoil
Permits held by local partners.
In practice the Licensing Body had always recognized JAAs, and
even encouraged foreign investors to invest in oil & gas projects specifically
through JAAs. The GOU was well aware of this practice and accepted
it by never raising any objections. However, in 2007, the GOU
adopted an inconsistent and contradictory approach towards JAAs.
Following instructions issued by the GOU, the State Tax Administration,
Ministry of Economy, Ministry of Justice, Ministry of Finance
and Ministry for Fuel and Energy came to the unanimous — but unexpected
— conclusion that the GOU considers the use of JAAs to
invest in oil and gas exploration and production to be unlawful. Obviously,
the GOU’s inconsistent, hostile and hypocritical position with
regard to JAAs creates substantial risks for foreign investment in the
oil & gas sector and raises doubts about the GOU’s true intentions.
Finally, another major negative setback in 2007 has been the
GOU’s open interference in the gas market. The Budget Act for 2007
and later GOU Resolution No. 31 dated 16 January 2007 introduced
restrictions on the sale of natural gas extracted in Ukraine. Companies
in which the State owns a majority stake are now required to sell
their natural gas exclusively to NJSC Naftogaz Ukrayiny at a price
approved by the National Commission for Regulation of the Electric
Power Industry, i.e. at low prices set by the State. It is important to
note that these restrictions apply not only to gas owned by companies
in which the State owns a majority stake, but also to gas owned
by their privately-owned JAA or JV partners. For example, if a foreign
investor happened to have a JAA with such a state-controlled
company, the share of extracted gas belonging to this foreign investor
would also be subject to these restrictions, and the foreign investor
would be forced to sell its share of gas to Naftogaz Ukrayiny at an
artificially low, regulated price.
As a result of the above restrictions, 2007 saw gas prices in Ukraine
set not by the free market, but by the State. Predictably, these restrictions
outraged the investment community and resulted in litigation —
while the GOU openly ignored the protests and court decisions. Unfortunately,
the Budget Act for 2008 contains the same restrictions, so
we expect that in 2008, this issue will again end up in the courts.
In 2007 the GOU and President of Ukraine made a number of
declarations about developing the energy sector, improving its legal
basis and attracting foreign investment in this sector. Unfortunately,
to date these good intentions have not been implemented. In practice,
in 2007 the GOU continued to carry out hostile policies against
investors and cultivated an unpredictable, contradictory and arbitrary
regime for investment in the energy sector. It remains to be seen
whether the new-elected Parliament and the new GOU introduce
serious positive changes in the energy sector and good intentions are
implemented in practice.
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