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This review of competitiveness and private sector development in the Ukraine provides a solid base for policy analysis and gives recommendations with immediate relevance and applicability. It includes diagnosis and policy actions for policy makers and advisors, offering policy responses to underpin economic diversification, enhanced competitiveness and private sector development. Finally, the book applies an innovative framework to identify barriers that hinder the development of selected sectors. It offers the design and suggests ways to implement specific policies to remove those barriers, including the selection and business analysis of Ukraine's most attractive sectors in terms of competitiveness and FDI appeal.
Competitiveness and Private Sector Development UKRAINE SECTOR COMPETITIVENESS STRATEGY Competitiveness and Private Sector Development: Ukraine 2011 SECTOR COMPETITIVENESS STRATEGY This work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries. This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. This document has been financed by the Swedish International Development Cooperation Agency, Sida. Sida does not necessarily share the views expressed in this material. Responsibility for its contents rests entirely with the author. Please cite this publication as: OECD (2012), Competitiveness and Private Sector Development: Ukraine 2011: Sector Competitiveness Strategy, OECD Publishing. http://dx.doi.org/10.1787/9789264128798-en ISBN 978-92-64-12878-1 (print) ISBN 978-92-64-12879-8 (PDF) Series: Competitiveness and Private Sector Development ISSN 2076-5754 (print) ISSN 2076-5762 (online) The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law. Corrigenda to OECD publications may be found on line at: www.oecd.org/publishing/corrigenda. © OECD 2012 You can copy, download or print OECD content for your own use, and you can include excerpts from OECD publications, databases and multimedia products in your own documents, presentations, blogs, websites and teaching materials, provided that suitable acknowledgement of OECD as source and copyright owner is given. All requests for public or commercial use and translation rights should be submitted to firstname.lastname@example.org. Requests for permission to photocopy portions of this material for public or commercial use shall be addressed directly to the Copyright Clearance Center (CCC) at email@example.com or the Centre français d’exploitation du droit de copie (CFC) at firstname.lastname@example.org. FOREWORD Foreword S ince 2009, the OECD Eurasia Competitiveness Programme has supported the Government of Ukraine in advancing national economic reform through its Sector Competitiveness Review project. This report contains the conclusions of the first phase of the project, the “Sector Competitiveness Strategy”. It provides an assessment and recommendations to guide investment policy reform and support the development of high-potential sectors such as agribusiness, machinery manufacturing and alternative sources of energy. These recommendations aim to promote competitiveness, attract investment to the country and strengthen the public-private dialogue. The second phase of the Sector Competitiveness Review of Ukraine was launched in November 2011, and focuses on supporting the Government of Ukraine in the implementation of selected sector- specific policy recommendations contained in the Strategy. This phase will result in a second report to be released in 2012-13. The project is conducted in collaboration with the Government of Ukraine and financially supported by the Swedish International Development Agency (SIDA) and the Government of Poland. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 3 ACKNOWLEDGEMENTS Acknowledgements T his report is the outcome of work conducted by the OECD Eurasia Competitiveness Programme under the authority of the Eastern Europe and South Caucasus Initiative Steering Committee (referred to in this publication as the “OECD Secretariat” when policy recommendations are suggested), in consultation with the Government of Ukraine and participation of the private sector in Ukraine. Representatives of the administration of the President of Ukraine, the Verkhovna Rada of Ukraine, several Ministries, government agencies, and private sector associations in Ukraine contributed to this report. These include: ● Iryna Akimova, First Deputy Head of the Administration of the President of Ukraine; Borys Tarasyuk, Chairman of the Committee on European Integration of the Parliament of Ukraine; Andriy Klyuyev, First Deputy Prime Minister; Sergiy Tigipko, Deputy Prime Minister; Hryhoriy Nemyrya, former Deputy Prime Minister; the Cabinet of Ministries of Ukraine (Yuryi Savchenko, Head of Department on Foreign Economic Policy and International Co-operation; Mariia Nikitova, former Deputy Chief of Office of the DPM of Ukraine; Yuriy Malich, Foreign Economic Policy Bureau). ● The Ministry of Economic Development and Trade (Vasyl Tsushko, Antimonopoly Committee Chairman and former Minister; Bohdan Danylyshyn, former Minister; Anatoliy Maksyuta, former Deputy Minister; Volodymyr Pavlenko, Deputy Minister; Iryna Kriuchkova, former Deputy Minister; Oleksandr Sukhomlyn, former Deputy Minister; Viktor Panteleyenko, former Deputy Minister; Mykhailo Rusynskyi, former Deputy Minister; Olena Kucherenko, Head of Department on International Technical Assistance and Relations with International Financial Organisations; Volodymyr Panchenko, Head of Investment and Innovation Policy Department; Yuliya Khvesyk, former Head of Department on Investment and Innovation Policy; Volodymyr Zhovtukha, Head of Department for Regulatory Policy; Tetyana Zinchenko, Head of Unit, Department on International Technical Assistance and Relations with International Financial Organisations; Svitlana Kovalivska, Head of Investment Policy Unit, Investment and Innovation Policy Department; Svitlana Yatsenko, Head of Unit on Methodology of Market Analysis, Department for Development of Economic Sectors; Maksym Duda, Head of Unit, Department of Macroeconomics; Vitaliy Troyan, Chief Consultant; Lyudmyla Musina, Consultant). ● The Ministry of Agrarian Policy and Food (Maksym Melnychuk, former Deputy Minister; Valentina Zavalevska, former Deputy Minister; Yaroslav Hadzalo, former Deputy Minister; Serhiy Ivashchuk, former Head of Department for Foreign Economic Co-operation; Oleksandr Kuts, Head of Department on Economy and Management of State Property). ● The Ministry of Finance (Andriy Kravets, Deputy Minister; Oleksandr Savchenko, former Deputy Minister). COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 5 ACKNOWLEDGEMENTS ● The Ministry of Foreign Affairs (Victor Mayko, Deputy Minister; Pavlo Sultansky, former Head of the Department on Economic Co-operation). ● The Ministry of Justice (Valeriya Lutkovska, former Deputy Minister). ● The Ministry of Fuel and Energy (Volodymyr Makukha, Deputy Minister; Serhiy Pavlusha, former Deputy Minister). ● The Ministry of Transportation and Communications (Volodymyr Korniyenko, First Deputy Minister; Borys Shyyanov, Deputy Minister). ● The State Agency on Management of Corporate Rights and Property – formerly Ministry of Industrial Policy (Serhiy Syrotyuk, former First Deputy Minister; Sergiy Grishchenko, former Deputy Minister; Sergii Bilenkyi, former Deputy Minister; Volodymyr Nikitenko, Aircraft Industry Department; Alex Shubin, former Deputy Director; Platon Popkov, Foreign Economic Relations Department; Valeriy Ivanov, Head of Aircraft Industry Department; Yuriy Petrovskiy, Head of Department for foreign economic relations; Oleksandr Kiva, Vice-President of Antonov; Volodymyr Vlasyuk, Director of the State Company “Ukrpromzovnishekspertyza”; Oleksandr Nahrobovyi, Head of Department for Development of Entrepreneurship; Larysa Komarova, former Head of Department for Implementation of Strategic Investment Projects). ● The State Committee on Statistics (Vadym Pishcheyko, First Deputy Head; Tetyana Tyshchuk, Deputy Director, Department on Production Statistics); the State Agency of Ukraine on Investments and Management of National Projects (Igor Zhovkva, Head of Department for National Projects and former Chief of Staff of the Deputy Prime Minister); the former State Agency of Ukraine on Investment and Innovation (Lyudmyla Suprun, Head; Serhiy Moskvin, Deputy Head; Rostyslav Lukach, Head of Investment Department); the former National Agency on Foreign Investment and Development (Serhiy Taran, Head; Vasyl Feduk, Head of Department for Attracting Foreign Investment and Creating a Positive Investment Image); the State Agency on Energy Efficiency and Energy Saving – formerly NAER (Sergiy Dubovyk, Vice-Chairman; Vitalii Grygorovskyi, First Deputy Chairman; Mykola Kurinko, former Vice-Chairman; Oleksandr Semchenko, Deputy Head of Technical Policy Department; Oleksandr Tron, Head of Economic Policy Department; Oleksandr Grytsyk, Head of International Cooperation Division); the former National Commission of Ukraine for Regulation of Electroenergy Market (Serhiy Dunaylo, Member). ● The European Business Association (Anna Derevyanko, Executive Director; Olga Valchuk, Deputy Director); the American Chamber of Commerce in Ukraine (Jorge Zukoski, President; Oksana Panchuk, former Deputy Director); ICC Ukraine (Volodymyr Schelkunov, Chairman; Vladimir Mikhailov, First Deputy Chairman; Volodymyr Nikolaiev, Deputy Head Department on Communications; Sergiy Babak, Deputy Secretary General; Darya Revina, Head of Commission on green investments, alternative and renewable sources of energy; Olga Revina, Director of the EU Ukraine Business Council); ICPS (Olga Shumylo-Tapiola, Visiting Scholar of Carnegie Europe and former Director); the Ukrainian Chamber of Commerce and Industry (Victor Yanovsky, First Vice-President, Secretary General; Valeryi Korol, Director, International Economic Relations Department). ● The Co-Chairs of the OECD Eastern Europe and South Caucasus Initiative, Sweden (His Excellency Stefan Gullgren, Ambassador of Sweden to Ukraine; Mirja Peterson, Counsellor and SIDA Country Director for Ukraine; Olga Tymoshenko, Programme Officer, SIDA) and Poland (His Excellency Pawel Wojciechowski, Ambassador and 6 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 ACKNOWLEDGEMENTS Permanent Representative of the Republic of Poland to the OECD) were donors to the project and provided important guidance and support. The report was written under the guidance of Carolyn Ervin, Director of the Directorate for Financial and Enterprise Affairs (DAF); Anthony O’Sullivan, Head of the Private Sector Development Division, DAF; and Fadi Farra, Head of the Eurasia Competitiveness Programme, DAF. Antonio Somma, Economist, led and supervised the study. The individual chapters were prepared by a core team of policy analysts and consultants: Gregory Lecomte, Policy Analyst and Project Coordinator (grain and dairy sector, production of energy and heat based on biomass, methodology), with input from Ales Triska, General Manager of CinemArt; Dusan Triska, Professor at Prague University of Economics and former Deputy Minister of Finance of Czech Republic; Eduardo Negrete, Legal Advisor of the Investment Promotion Agency in Peru (land reform); and Jens Holm-Nielsen, Associate Professor, Head of Center for Bioenergy and Green Engineering of Aalborg University (production of energy and heat based on biomass); Gabriela Skulova, Policy Analyst (methodology); Annamaria de Crescenzio, Policy Analyst (methodology, economic overview); Clément Brenot, Policy Analyst; and Edgardo Valencia Cruickshank, Policy Analyst (machinery manufacturing), with input from Evgeny Bogdanov, Principal of A.T. Kearney; Denis Verret, Senior International Advisor and Massi Begous, Partner Stratorg (civilian aircraft manufacturing); Sergiy Rusnak, Consultant (agribusiness); Blanka Kalinova, Senior Economist (Chapter on Investment Policy Review of Ukraine, based on the OECD publication “OECD Investment Policy Reviews – Ukraine”); Wojciech Paczynski, Consultant of the Center for Social and Economic Research in Poland, held a workshop on renewable energy in the early stages of the project. The Country Capability Survey developed by the Programme was carried with the support of GfK Ukraine. The Business and Industry Advisory Committee to the OECD (BIAC) provided support for the OECD Foreign Investor Survey. The report underwent a quality review by a panel consisting of OECD experts, academic peers, and external country specialists affiliated with the OECD. The quality review focused on: 1. Methodology. Dr. Richard Pomfret, Professor of Economics at the University of Adelaide, reviewed the publication in its entirety. Alan Paic, Economist, and Ania Thiemann, Economist at the OECD, participated in review discussions. 2. Geographic specificities. William Tompson, Head of the Regional and Rural Development Unit of the Public Governance and Territorial Development Directorate, revised the entire publication in light of his expertise on former Soviet Union economies. 3. Sectors. Olga Melyukhina, Agriculture Policy Analyst in the Policies in Trade and Agriculture Division of the Trade and Agriculture Directorate, led the review of the agriculture content of the publication. Pavel Vavra, Policy Analyst in the Agro-food trade and markets Division of the Trade and Agriculture Directorate led the review of the content on dairy. Adam Brown, Senior Energy Analyst of the International Energy Agency, led the review of the content on production of energy and heat based on biomass. Andrea Goldstein, Head of Global Relations at the Investment Division within DAF, and Claire Jolly, Policy Analyst in the International Futures Programme Division of the Science Technology and Industry Directorate led the review of the content on aircraft manufacturing. In addition, the publication was reviewed in Ukraine by the Ministry of Economic Development and Trade. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 7 ACKNOWLEDGEMENTS The final report was edited and prepared for publication by Fadi Farra, Antonio Somma, Blanka Kalinova, Grégory Lecomte, Clément Brenot, Annamaria de Crescenzio, Daniel McArthur, Sergiy Rusnak, Michael Sykes, Vanessa Vallée, Emma Beer and Ed Smiley. Local research and support in Ukraine was provided by Dmytro Kotlyar, Consultant of the OECD and former Vice-Minister of Justice of Ukraine, and by Oksana Shulyar, Consultant of the OECD and former Adviser to the Head of the Parliamentary Committee of Ukraine on European Integration. Valuable administrative support was provided by Anna Chahtahtinsky, Orla Halliday, Renata Helliot-Tavares, Zara Kuruneri, Elisabetta Da Prati and Lynn Whitney. 8 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 TABLE OF CONTENTS Table of Contents Acronyms and abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 PART I Methodology Chapter 1. Approach and methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 The definition of competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Identifying sectors for intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 A prioritisation framework to select policy recommendations for the implementation phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 PART II Economic overview and findings of the Investment Policy Review of Ukraine Chapter 2. Economic overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 A country with abundant natural resources and a well qualified labour force . . . . 44 After struggling immediately following independence, the Ukrainian economy enjoyed a period of robust growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 The global financial crisis highlighted existing weaknesses. . . . . . . . . . . . . . . . . . . . 46 Economic activity relied mainly on agriculture and highly energy intensive industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Chapter 3. 2011 OECD Investment Policy Review of Ukraine – Key findings . . . . . . . . . . . . 53 General investment policy recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Suggested measures to improve the investment climate . . . . . . . . . . . . . . . . . . . . . . 58 PART III Sector-specific analysis Chapter 4. Agribusiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Sector definition and segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 9 TABLE OF CONTENTS Global trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 The role of foreign investors along the agribusiness value-chain . . . . . . . . . . . . . . . 70 Ukraine agribusiness sector at a glance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Why focus on the grain and dairy sub-sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Stakeholder consultations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Chapter 5. Focus on the grain value chain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Sub-sector definition and segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Global trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Sources of competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 The role of foreign investors in the grain value chain . . . . . . . . . . . . . . . . . . . . . . . . . 92 Key issues and policy barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Policy recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Chapter 6. Focus on the dairy value chain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Sub-sector definition and segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Global trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Sources of competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 The role of foreign investors in the dairy sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Key issues and policy barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 Policy recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Chapter 7. Energy-efficiency and renewable technologies: Focus on production of energy based on biomass . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 Why focus on production of energy based on biomass . . . . . . . . . . . . . . . . . . . . . . . . 133 Sector definition and segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Global trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Sources of competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 The role of foreign investors in the biomass value chain . . . . . . . . . . . . . . . . . . . . . . 145 Key issues and policy barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Policy recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Chapter 8. Machinery and transport equipment: Focus on civilian aircraft manufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 Why focus on civilian aircraft manufacturing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Sector definition and segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 Global trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Sources of competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 The role of foreign investors in the civilian aircraft value chain . . . . . . . . . . . . . . . . 173 Key issues and policy barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 10 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 TABLE OF CONTENTS Policy recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Conclusion and roadmap for implementation phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 A roadmap for creating a favourable business environment and attracting investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 Targeted interventions are recommended to build long-term capabilities in promising sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 Tables 1.1. Sample size of the survey questionnaire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 4.1. How are domestic agro-climatic conditions favourable to more intensive crop growing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 5.1. World grain production and harvest area, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 5.2. Black Sea ports have a cost advantage for grain exports to middle-eastern countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 5.3. Foreign companies are sizeable grain exports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 6.1. Turnover of the largest global dairy processing companies, 2009 . . . . . . . . . . . . . . 115 6.2. Quality standards for raw cow milk for food production in Ukraine and the EU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 7.1. The distribution of Ukraine’s coal mines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 7.2. Energy uses of biomass . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 7.3. Straw, wood, husk and manure as primary biomass sources are promising in Ukraine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 8.1. Aircraft industry was selected as it presents specific technology and capabilities in Ukraine and high government priority . . . . . . . . . . . . . . . . . . . 161 8.2. Segmentation of civilian aircrafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 8.3. Distribution of selected aircraft by segments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 8.4. Active fleet by carrier, Airbus vs. Boeing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 8.5. Total accidents/Total aircraft production % of key aircraft competitors . . . . . . . . 172 8.6. Active fleet by country, selected countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 8.7. Investment in the Boeing 787 programme by Japanese risk-sharing partners . . . 179 Figures 1.1. Ukraine needs to move from a factor-led economy to an efficiency-led economy . . 30 1.2. Sector Prioritisation Framework methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 1.3. Sector Prioritisation Framework, analysis for Ukraine . . . . . . . . . . . . . . . . . . . . . . . 33 1.4. Results of consultations with private and public sector representatives . . . . . . . 34 1.5. Agribusiness example: Comparison of production costs for wheat (USD per metric tonne), 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 1.6. Civilian aircraft industry example: Areas for potential FDI along the supply-chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 1.7. Dairy sub-sector example: Difficult access to finance is partly due to the weak links between farmers and processors . . . . . . . . . . . . . . . . . . . . . . . . . 37 1.8. A framework to prioritise among policy recommendations for Phase II based on the country’s strategic advantage and the areas of intervention . . . . . . . . . . . 38 2.1. Ukraine’s labour force has a high level of tertiary education . . . . . . . . . . . . . . . . . 44 2.2. Female labour participation in Ukraine is high compared to regional peers . . . . 45 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 11 TABLE OF CONTENTS 2.3. Annual inward FDI flows in the region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 2.4. FDI per capita in Ukraine is lower than in its regional peers. . . . . . . . . . . . . . . . . . 47 2.5. The share of services in GDP has expanded since independence. . . . . . . . . . . . . . 48 2.6. The current account deficit has widened . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 2.7. The evolution of real GDP has been closely linked with steel prices . . . . . . . . . . . 49 4.1. The agribusiness supply-chain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 4.2. Consumption of crop and livestock products to increase more rapidly in non-OECD countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 4.3. Agricultural production growth over the last decade was driven by non-OECD countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 4.4. Agricultural production in non-OECD countries to grow at a faster pace than OECD countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 4.5. Demand for high value added products in modern retail outlets grows as incomes rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 4.6. Price changes for selected commodities in 2005-10 . . . . . . . . . . . . . . . . . . . . . . . . . 68 4.7. Most commodity prices in real terms to remain above the last decade’s level. . . 69 4.8. FDI stock in agriculture is rising in CIS countries and South-East Europe but it is much smaller than in Latin America and Africa . . . . . . . . . . . . . . . . . . . . . 71 4.9. Arable land in selected European countries, thousand square kilometres . . . . . . 72 4.10. Production of agricultural commodities in Ukraine, millions of USD, 2008. . . . . . 72 4.11. Ukraine: Share of agriculture sector in GDP, 1999-2009 . . . . . . . . . . . . . . . . . . . . . . 73 4.12. Export structure of Ukraine, 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 4.13. Variation in production of selected commodities in Ukraine, 2006-09, index 100 = 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 4.14. Domestic consumption status and outlook for key agricultural products . . . . . . . . . 78 4.15. Annual world imports of agricultural products, status in 2009 vs. outlook in 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 5.1. Example of the wheat value chain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 5.2. Ukraine’s grain production has rebounded in recent years . . . . . . . . . . . . . . . . . . . 85 5.3. Ukraine’s production of wheat and coarse grains . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 5.4. Ukraine is amongst the top exporters of wheat and coarse grains. . . . . . . . . . . . . 86 5.5. Growth of world grain consumption is projected to be higher in non-OECD countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 5.6. Africa, Middle-East and East Asia will drive the additional grain imports over the coming decade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 5.7. Grain production costs are competitive, while yield still offers opportunity to improve efficiency of production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 5.8. Ukraine could apply more fertiliser to increase yields . . . . . . . . . . . . . . . . . . . . . . . 91 5.9. Major importers of starch and gluten, millions of USD, 2007 . . . . . . . . . . . . . . . . . 93 5.10. Percentage of farmers having difficulty in obtaining credit. . . . . . . . . . . . . . . . . . . 94 5.11. Limited access to long-term loans results in very low use of agricultural machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 5.12. Cargo handling volume is near to maximum capacity of Ukrainian ports . . . . . . 97 6.1. Cow’s milk dominates the global raw milk output . . . . . . . . . . . . . . . . . . . . . . . . . . 107 6.2. The dairy value chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 6.3. World consumption growth of dairy products driven by non-OECD countries. . . 109 12 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 TABLE OF CONTENTS 6.4. World dairy production value and structure, recent trends and forecasts, 2005-19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 6.5. Key importers of selected dairy products globally. . . . . . . . . . . . . . . . . . . . . . . . . . . 110 6.6. Annual dairy, food and meat price indices, 2002-04 = 100 . . . . . . . . . . . . . . . . . . . . 111 6.7. Millions of cows producing milk in Ukraine, 1990-2006 . . . . . . . . . . . . . . . . . . . . . . 111 6.8. Milk yield, tonnes of fluid milk per cow per year, 1990-2006 . . . . . . . . . . . . . . . . . . 112 6.9. Cost of milk production in selected countries, US dollars per 100 kg, 2007 . . . . . 113 6.10. Domestic demand for processed dairy products is expected to increase by 30% over the coming decade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 6.11. The Ukrainian dairy industry exports significant volumes of its production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 6.12. CIS countries and Middle-East already key importers of Ukrainian dairy products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 6.13. Workforce skills are seen as an area for improvement where government action is called on. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 6.14. Quality of state controls and regulation are debated . . . . . . . . . . . . . . . . . . . . . . . . 119 6.15. Milk yields in Ukraine’s large dairy farms are half of the European Union average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 6.16. Lack of financing affects the level of investments and therefore productivity. . . 121 6.17. A summary of policy options to enhance initial and VET education . . . . . . . . . . . 123 6.18. Extension programmes are an example of a policy option to develop producers’ skills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 6.19. Credit guarantee schemes are a way to foster access to finance for mid-size farmers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 6.20. Supply chain financing brings the financial means of large or foreign firms to small-scale producers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 7.1. Energy intensity, a cross country comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 7.2. Opportunities to reduce energy-intensity and to develop alternative sources of energy along the value chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 7.3. Naftogaz (100% owned by the state) dominates the gas-value-chain in Ukraine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 7.4. State-owned Naftogaz dominates exploration and production, as well as the main oil pipelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 7.5. State and private ownership of power transmission and distribution assets until mid-2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 7.6. Biomass residue supply chain for energy production. . . . . . . . . . . . . . . . . . . . . . . . 138 7.7. Structure of the global total primary energy supply, 2007 . . . . . . . . . . . . . . . . . . . . 139 7.8. Structure of world renewable energy sources supply, 2007 . . . . . . . . . . . . . . . . . . . 140 7.9. Key success factors for a bio-energy project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 7.10. Economic potential of biomass sources in 2008, breakdown by type of agricultural residue, millions of tonnes of coal equivalent . . . . . . . . . . . . . . . . . 142 7.11. Production costs of heat by straw-based boilers are lower than by gas-fired boilers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 7.12. Operating costs and profits of a hot water boiler based on wood biomass for supply of a middle-size city, thousands EUR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 7.13. Net cash-flow plan in the five first years of the project, thousands EUR. . . . . . . . 144 7.14. Fuel used for power and heat production in Ukraine, 2006 . . . . . . . . . . . . . . . . . . . 145 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 13 TABLE OF CONTENTS 7.15. Price of natural gas for utilities in Ukraine, past trends according to IMF requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 7.16. Potential opportunities for FDI along the value-chain . . . . . . . . . . . . . . . . . . . . . . . 146 7.17. Lack of public support and awareness for the biomass industry was pointed out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 7.18. Payment arrears also need to be solved to allow for investment . . . . . . . . . . . . . . 150 7.19. The quick adoption of biomass in Poland has made it a key element in the renewables landscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 8.1. Four sub-sectors were identified on the basis of their share in the national domestic turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 8.2. The aircraft manufacturing industry ranges from components to after-sales services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 8.3. OEMs play a key role in designing, coordinating suppliers, and assembling the final product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 8.4. Number of deliveries of regional turboprops, 2002-10 . . . . . . . . . . . . . . . . . . . . . . . 164 8.5. Number of deliveries of regional jets, 2002-10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 8.6. Number of deliveries of large or very large aircraft, 2002-10 . . . . . . . . . . . . . . . . . . 165 8.7. Total expected demand for civilian aircraft by segment over 2011-30 . . . . . . . . . . 167 8.8. Asia Pacific and other emerging economies will drive the growth of demand for civilian aircraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 8.9. Example of Airbus A380 global supply-chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 8.10. Surveyed entrepreneurs assessed the skill gap in the aircraft segment . . . . . . . . 180 9.1. Selected areas of interventions in the Agribusiness sector . . . . . . . . . . . . . . . . . . . 190 9.2. Selected areas of interventions in the Energy production from alternative sources sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 14 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 ACRONYMS AND ABBREVIATIONS Acronyms and abbreviations AF Agrarian Fund CAGR Compound Annual Growth Rate CCS Country Capability Survey CET Continuing Education and Training CHP Combined Heat and Power CIS Commonwealth of Independent States BIAC Business and Industry Advisory Committee to the OECD DAF Directorate for Financial and Enterprise Affairs EBRD European Bank of Reconstruction and Development ECA Export Credit Agencies EIU Economist Intelligence Unit EU European Union FAO Food and Agriculture Organization of the United Nations FDI Foreign Direct Investment FTA Free Trade Agreement GCI Global Competitiveness Index GDP Gross Domestic Product GECAS General Electric Commercial Aviation Services HO Heckscher-Ohlin IAR Industria Aeronautică Română IEA International Energy Agency IEAv Instituto de Estudos Avançados IFC International Finance Corporation IFI Instituto de Fomento e Coodernação Industrial IFPRI International Food Policy Research Institute ILFC International Lease Finance Corporation ILO International Labour Organization IMF International Monetary Fund INPE Instituto Nacional de Pesquisas Espaciais ITA Instituto Tecnológico de Aeronáutica MAPU Ministry of Agricultural Policy of Ukraine MENRU Ministry of Environment and Natural Resources of Ukraine MHCU Ministry of Health Care of Ukraine MNE Multinational Enterprise MRO Maintenance, Repair and Overhaul MSPIS Main State Phytosanitary Inspection Service OBM Original Brand Manufacturer OEM Original Equipment Manufacturer COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 15 ACRONYMS AND ABBREVIATIONS PFI Policy Framework for Investment PSE Producer Support Estimate PPP Public Private Partnership PPP Purchasing Power Parity R&D Research and Development SCUTRCP State Committee of Ukraine on Technical Regulations and Consumer Policy SDVM State Department of Veterinary Medicine SEIS State Ecological Inspection Service SEZ Special Economic Zone SES State Epidemiological Service SIDA Swedish International Development Cooperation Agency SME Small-and medium-sized enterprise SNAI Servicio Nacional de Aprendizaje Industrial SOE State Owned Enterprise SPF Sector Prioritisation Framework SSSU State Statistics Service of Ukraine TCO Total Cost of Ownership TFP Total Factor Productivity UAC United Aircraft Corporation USDA United States Department of Agriculture UNCTAD United Nations Conference on Trade and Development UNECE United Nations Economic Commission for Europe UNIDO United Nations Industrial Development Organization VAT Value Added Tax VEB VneshEkonomBank VET Vocational and Educational Training WBD Wimm-Bill-Dann WEF World Economic Forum WTO World Trade Organization 16 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Executive summary After a decade of sustained growth, the Ukrainian economy has been impacted by the global crisis The Ukrainian economy experienced a decade of robust growth from 2000 onwards. During 2000-08, real GDP grew at an annual average rate of 7%, among the fastest in Europe. Foreign direct investment (FDI) inflows to the country increased at an annual average rate of 43.8% to reach USD 10.9 billion in 2008 in nominal terms. The economic growth of the country was supported by a more efficient use of resources which led to an increase in productivity, and by external factors, including an upsurge in commodity prices, particularly steel, which is one of Ukraine’s leading exports. However, during the expansion the country failed to implement all the necessary reforms required for broad- based financial stability and durable economic growth. The recent global economic crisis affected the economy: in 2009, real GDP contracted by 15% and FDI inflows fell by 56%. The national currency, the hryvnia, dropped sharply against the US dollar and the banking sector was hit. Capital outflows culminated in emergency financing of USD 10.5 billion granted by the IMF. Following this deep recession, the country reverted to growth in 2010, albeit at a slower pace than before the crisis. Under the current policy settings, GDP growth over 2012-13 is projected to be below Ukraine’s potential. In June 2011, the World Bank projected Ukraine’s GDP growth at between 4.5% and 5% over 2012-13. The need to boost competitiveness The fact that Ukraine was among the emerging economies most affected by the crisis underscores the need for further reforms to increase the country’s competitiveness and therefore to pursue a more stable path to growth. Based on the OECD definition, competitiveness is “the degree to which a country generates, while being and remaining exposed to international competition, relatively high factor income and factor employment levels” (OECD, 1997 – according to this definition, “factor” refers to production factors). This definition contains two key elements. First, competitiveness is related to productivity, focusing on factor income or value-added from inputs. Secondly, maximising the value-added is a key feature of competitive economies. Competitive economies push idle factors producing insufficient value-added to more productive uses, attract further investment, achieve high employment levels and generate higher living standards. 17 EXECUTIVE SUMMARY However, the convergence in productivity between countries is likely to be a long process. Therefore, the stage of development of an economy needs to be taken into account to assess its current and future competitiveness. The crisis showed that the temporary drivers of competitiveness which sustained Ukraine’s recovery over the last decade – such as a global rise in commodity prices – have almost exhausted their potential, leaving the economy more vulnerable to shocks. Ukraine is also in a transition period, moving from a resource-led economy to an efficiency-led economy, according to the definition of three stages of development (X. Sala-i-Martin and E. Artadi, 2004). In this phase the nature of its comparative advantage is evolving from a cost advantage, mainly built on natural endowments and a cheap labour force, to a capability advantage. Building entrepreneurial, managerial and technical capabilities is particularly important to operate efficiently and maintain competitiveness over time. Within the framework of the OECD Eurasia Competitiveness Programme, the OECD has worked with both the government of the Republic of Ukraine and the private sector in order to enhance the country’s competitiveness and to improve its attractiveness to foreign direct investors. A country-specific “Sector Competitiveness Strategy for Ukraine” project is being carried out, based on two pillars: ● Horizontal policy: an Investment Policy Review of Ukraine, which assesses the country’s ability to comply with the principles of liberalisation, transparency and non- discrimination and to bring its investment agenda closer to recognised international standards. This work also paved the way towards Ukraine’s adherence to the OECD Declaration on International Investment and Multinational Enterprises. ● Vertical policy: a Sector Competitiveness Review of Ukraine, which analyses those sectors with important potential, which could competitively attract investments. The study presents some policy recommendations needed to lift the barriers currently hindering private sector development in the selected sectors. Horizontal policy: the role of the legal and regulatory framework The Investment Policy Review shows that Ukraine has made progress in developing a legal framework to attract FDI, but several implementation challenges continue which can affect the perspective of domestic and foreign investors, preventing the country from mobilising private investment commensurate with its economic potential and investment needs. General transparency in terms of access to investment-related information has improved, but public consultations and public-private dialogue are still limited. Investment policy implementation continues to suffer from a lack of regulatory transparency due to frequent changes in legislation, the complexity of existing measures and the absence of, or delays in issuing, implementation regulations. Recommendations include the implementation of regulations to facilitate the rapid and effective application of the law on public-private partnerships (PPPs) and the development of public-private consultations with the business community, including with foreign investors, on business-related legislation and regulations. Ukraine’s investment promotion activities have been subject to frequent reorganisation resulting in the multiplication of agencies, often with overlapping responsibilities. It is essential that the new State Agency for Investments and National Projects, created at the end of 2010, and the restructured Council of Local and Foreign Investors fulfil their main 18 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 EXECUTIVE SUMMARY tasks, notably the creation of a single-window facility for foreign investors. It is also advisable to take into account the interests and concerns of foreign investors in small and medium-sized enterprises (SMEs), which are particularly affected by frequent legislative and regulatory changes and related regulatory uncertainty. Public policies promoting principles for responsible business conduct, such as those embodied in the OECD Guidelines for Multinational Enterprises, could contribute to investment inflows, in turn supporting sustainable development. However, corruption remains the key impediment to investment and the main reason for the country’s poor ranking in available international business surveys. Vertical policy: removing barriers to investment in key sectors of the economy The Sector Competitiveness Review of Ukraine aims at both enhancing the sectoral competitiveness of the country’s economy and improving its attractiveness to foreign investors. Three initial sectors have been prioritised, on the basis of key assets and market attractiveness: ● Agribusiness, including the grain and dairy value chains. ● Energy-efficiency and renewable technologies, including the biomass value-chain. ● Machinery manufacturing and transport equipment, including the civilian aircraft value chain.1 The analysis shows that these sectors could attract domestic and foreign investments at different levels of the value chain. However, a number of specific policy barriers are currently hindering their potential. The comparative advantages of the selected sectors and the factors hampering their growth are summarised below. Grain sector Traditionally agriculture has been one of the largest components of the Ukrainian economy, contributing 8.2% of value added in 2010 and 25% of total exports in 2009.2 In the grain sector Ukraine benefits from a significant cost advantage, with production costs estimated at around half those of other European producers, such as Germany. It also benefits from proximity to growing markets such as the Middle-Eastern and African countries. The country also has the potential to increase productivity further and to use the vast areas of unused arable land, which could lead to an increase of up to 80% in grain output. These significant strengths could help the country to further consolidate its leading role as a grain producer and exporter, in a context where growing population, rising personal incomes in developing countries and increasing feeding requirements for fast- growing livestock sectors are expected to drive global grain consumption upwards in the future. Ukraine, which is already the third-largest world exporter of grain after the USA and the EU27, is expected to become a global leader in grain exports by the end of the decade, together with other key players such as Kazakhstan and Russia. However, some issues are hindering the development of the sector. Productivity is low, as a result of the limited use of high-quality inputs and the lack of investment in fixed assets, such as machinery and storage facilities, especially by small and medium-sized farms. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 19 EXECUTIVE SUMMARY Second, the quality of output does not meet the standards of neighbouring markets, impeding exports. Difficulties in accessing finance are a primary concern for small and medium-sized farmers, limiting their ability to invest in operational activities and in fixed assets which could improve productivity and quality. Thirdly, the current moratorium on the purchase and sale of land, which restricts access to the sector, has an adverse impact on both agri-finance and foreign investments, since land cannot be used as collateral by farmers, nor can it be owned by foreign individuals or foreign companies. Dairy sector Ukraine has traditionally had a robust dairy sector, although herd sizes and output have recently been decreasing. The country enjoys low production costs (47% of France’s milk production costs in 2007), a growing domestic market in the medium term, and proximity to both large, mature export markets such as the EU and developing markets such as Russia and the Commonwealth of Independent States (CIS). Rising incomes in developing countries will trigger a surge in the consumption of a diversified basket of processed dairy products, shifting the sector towards higher value-added dairy production. In order to progress up the dairy value chain, Ukraine must still overcome some important challenges, such as low-quality of output and low productivity. For example, in large modern Ukrainian farms, milk yield approximates 2.9 tonnes per cow, compared with the 3.5 tonnes in Russia and the OECD average of 4.8 tonnes. The reasons for Ukraine’s low productivity are the lack of cattle breeding skills, the low level of private investment and the high level of taxation of inputs. Moreover, high fragmentation of production significantly increases the costs of milk collection, since most households own only one or two cows, with a subsequent negative impact on the quality and safety of milk. Energy-efficiency and renewable technologies with a focus on biomass The country’s abundant agricultural and forestry waste constitutes an asset to the development of alternative energy production based, in particular, on biomass. The low energy prices Ukraine has enjoyed so far have stimulated specialisation in energy- intensive industries. However, energy efficiency in the country is, on average, one third of that in its industrialised peers. The planned convergence of natural gas import prices to European levels, agreed by the Ukrainian government under the IMF plan in 2010, should trigger a switch to alternative (non-fossil) sources of energy. The diffusion of green technologies such as biomass-based energy – which could partially satisfy rising energy consumption and replace the traditional heat and power production system – depends predominantly on the steps that the government takes to facilitate the transition to these alternative sources. Administrative barriers currently limit investment opportunities in the sector, and a national plan defining the role and objectives of biomass in the energy landscape is still lacking. One of the consequences is limited communication and low awareness among farmers, industrial companies and utilities about the possible use of biomass. Development is also held back by the lack of access to capital for most players, indebtedness of local utilities and arrears in payments by consumers. 20 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 EXECUTIVE SUMMARY Civilian aircraft manufacturing sector Ukraine has traditionally been involved in the civilian aircraft sector, having inherited a significant part of the former USSR’s capabilities in the aerospace industry. The high technical skills of the labour force, its relative cost competitiveness and the quality of its products are the main comparative advantages of the Ukrainian industry. Ukraine’s education system focuses on scientific curricula and produces a significant number of well qualified aerospace scientists and engineers compared to other emerging economies. The main Ukrainian aircraft manufacturer, Antonov, designed and manufactured the largest operating cargo aircraft in the world – the An-225 Mriya. Global demand for finished aircraft is projected to increase over the next 20 years. In OECD countries the forecast rise in demand will be driven by the need to replace outdated and fuel- inefficient aircraft. In the Asia Pacific region, both passenger travel and cargo transportation are expected to boom. The Ukrainian aircraft manufacturing sector could leverage its existing capabilities and take advantage of the favourable prospects for the industry. However, the existing governance system should be revised, since it is currently hindering competitiveness. Both the military and civilian aircraft sectors currently enjoy a national interest status with a high level of protection and control. The military aerospace sector is closely protected and controlled, and the same level of protection and control applies to the civilian aircraft sector. It does not allow for interactions with foreign investors or industrial partners, unless approved at ministerial level or higher, which virtually eliminates opportunities to implement a business-centred industrial policy. The way forward Targeted policies could be implemented to overcome the existing challenges and foster competitiveness in the prioritised sectors. In the next phase of the project, the OECD Secretariat will support Ukraine in implementing one or two specific policy recommendations per sector. Moreover, efforts will be made to develop dedicated local capabilities, enabling the government to continue the process of building a dynamic comparative advantage beyond the timeframe of the project. ● In order to improve productivity and raise the quality of output in the grain sector access to finance is required. The private sector needs to have access to credit, to invest in assets, such as machinery and storage facilities, and to purchase high-quality inputs, such as seeds and fertilisers. This could be achieved by fostering the development of instruments like supply-chain financing, leasing, and insurance to cover against risk. Easier access to finance will probably require the completion of land reform, as a prerequisite for using land assets as collateral. ● The growth of the dairy sector depends on an improvement in the quality and productivity of raw milk production. It is recommended that policy development focuses on the alignment of the available human capital with the private sector’s needs. Specific interventions include, for example, human capacity building programmes in the fields of veterinary medicine, feeding efficiency, animal husbandry skills and management. Once the quality of milk has become closer to international standards and the dairy processing sector has acquired the proper technological capabilities, the next steps COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 21 EXECUTIVE SUMMARY could include an export diversification strategy, which would entail expanding the trade base to growing regional markets. ● The development of energy production based on biomass requires a major reform of the energy sector, with the alignment of prices to market values and a review of existing payment mechanisms. At the same time, it is recommended that reforms are introduced in the area of investment policy and promotion. To facilitate the attraction of investment in sustainable energy, administrative processes should be streamlined (e.g. permits), implementing a single-window approach for investors, and creating a pre- approval process for green tariffs. A further recommendation is the design and execution of a comprehensive development plan for the production of alternative energy with an initial focus on biomass. ● The civilian aircraft manufacturing sector would benefit from a revision of its corporate governance. A reorganisation of the supervision of the sector was announced in 2010. It is necessary to use the momentum created by this announcement to shape a new governance system with separate branches for the military and civilian sectors. The civilian aircraft manufacturing part of Antonov could become a corporation and be allowed to interact with global suppliers and partners. The recommended next steps include the establishment of three public-private working groups, focusing on agribusiness, production of energy based on biomass, and civilian aircraft, respectively. These working groups will become permanent bodies in charge of designing and implementing the needed reforms for each sector, beyond the timeframe of the OECD project. Finally, it is recommended that the government of Ukraine include a sub-national dimension in its efforts to improve its sectoral competitiveness. At present, an uneven distribution of FDI persists between regions: two-thirds of Ukraine’s FDI stock is currently concentrated in six regions. A first step in this direction is the OECD Territorial Review of Ukraine, started in 2011. The Territorial Review is a national-level diagnosis providing evidence-based and detailed analyses of regional policies. Following on from this, specific efforts to develop a sub-national level strategy should also be pursued. Notes 1. The sectors were selected after a consultation phase with government experts and current and prospective foreign investors. The list was presented to the Coordination Council for OECD-Ukraine in December 2010 and validated by the key stakeholders. 2. WTO, (2011), International Trade Statistics, Trade Profiles, Statistics Database. 22 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 INTRODUCTION Introduction A s part of the OECD Eastern Europe and South Caucasus Initiative (see box on the next page), a sector competitiveness review was conducted for the Republic of Ukraine to improve sectoral competitiveness and enhance its policy convergence with OECD investment instruments. The Sector Competitiveness Report is part of a wider project following a three-phase approach over five years (2009-14): first, by developing a sector competitiveness strategy (Phase I), secondly, by implementing specific aspects of the recommended policies to address the existing constraints (Phase II), and finally, by putting in place the mechanisms to embed sustainable reform (Phase III). The aim of the first phase of the project, co-financed by the Swedish International Development Agency and the Polish government, is to enhance the country’s productivity level by identifying policy barriers that should be removed to boost the competitiveness of selected economic sectors. This report constitutes the output of the first phase of the project. It identifies the sector-specific sources of competitiveness for agribusiness, energy-efficiency and renewable technologies, and aircraft sectors and draws up a list of recommendations on how to overcome the structural weaknesses that are currently hampering growth. The report is the result of a collaborative effort with the Ukrainian authorities and representatives of the private sector. It should facilitate the prioritisation of a strategy for the country and pave the way for a series of structural reforms that could lead to sustainable long-term economic growth. The scope of this report does not extend to macroeconomic reforms; however it is helpful to underline that sound monetary and fiscal policies remain a prerequisite for putting the country firmly on the map of foreign investors, especially given the current risk-averse attitudes of most investors. The work is presented in three parts. Part I discusses the framework and methodology used to select those sectors to be the objects of the study (Chapter 1). Part II includes a broad macroeconomic analysis of the Ukrainian economy (Chapter 2) and presents the findings of the Investment Policy Review of Ukraine (Chapter 3). Part III presents in depth analyses of the agribusiness (Chapter 4), grain (Chapter 5), dairy (Chapter 6), energy- efficiency and renewable technologies (Chapter 7), and aircraft (Chapter 8) sectors. A roadmap for the Ukrainian government to improve sectoral competitiveness in the selected sectors concludes the study (Conclusion and roadmap for the implementation phase), with a set of strategic recommendations being at the same time the starting point of the next implementation phase of the project. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 23 INTRODUCTION Launched in April 2009, the OECD Eastern Europe and South Caucasus Initiative is the part of the OECD Eurasia Competitiveness Programme, which aims to contribute to economic growth in Armenia, Azerbaijan, Belarus, Georgia, Moldova, and Ukraine. Its objective is to share with the governments of the region the knowledge, experience and best practices of OECD countries to create a sound business climate for investment, enhance productivity and support entrepreneurship, develop the private sector, and build knowledge-based economies to render its sectors more competitive and attractive to foreign investment. Its approach comprises both a regional policy dimension, which entails peer dialogue and capacity building, and a country-specific aspect supporting the implementation of a number of prioritised reforms. A sector analysis is also included, covering the formulation of targeted policies and strategies requested at the industry level. Within the framework of the programme, public authorities, the private sector and civil society in these countries have been engaged in a dialogue and collaboration process to support policy actions and identify the key barriers to sectoral competitiveness. The participation of all the stakeholders in the reform process, including foreign investors, is considered to be crucial for guaranteeing the effectiveness and transparency of the recommended policies. 24 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 PART I Methodology COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 1 Approach and methodology This chapter presents the approach and methodology used to provide a sector competitiveness strategy. This includes the definition of the concept of competitiveness and the description of some tools to prioritise high potential sectors, analyse them, and formulate policy recommendations. Finally, it examines a framework to prioritise among policy recommendations. 27 I.1. APPROACH AND METHODOLOGY T he OECD Sector Competitiveness Review aims to support the reforms needed to enhance Ukraine’s competitiveness and to improve its attractiveness to foreign investors. The project is designed to follow a three-phase approach over five years (2009-14): Phase I includes the Investment Policy Review of Ukraine – offering recommendations on the improvement of the overall policy environment – and the development of a sector competitiveness strategy – for the enhancement of the policy environment of individual sectors; Phase II tests the implementation of the defined competitiveness strategy and introduces quantifiable and measurable objectives; and Phase III aims to put in place the mechanisms to embed sustainable reform. This report summarises the key findings of Phase I and paves the way for targeted implementation. During Phase I of the project, OECD experts worked closely with public authorities and the private sector in Ukraine, as well as with representatives from business associations in OECD member countries, to develop a sectoral competitiveness strategy focusing on specific sectors identified as being promising for the Ukrainian economy. This approach allows the allocation of scarce resources to specific sectors, while increasing the likelihood that policy reforms are successfully implemented. The domestic and international private sector was involved early in the process (e.g. through industry associations and chambers of commerce). This chapter first presents a summary of the concept of competitiveness, its sources and how it evolves over time, and what governments can do to sustain it. Secondly, it describes the framework used to prioritise the sectors in which Ukraine can sustain competitiveness. Finally, it includes a framework to prioritise policy interventions in the selected sectors. The definition of competitiveness Competitiveness is related to productivity and to the maximisation of value-added Academic literature provides different definitions of competitiveness and the concept has been of interest to policymakers in industrialised economies for centuries. Reinert (1995) considers that, over the years, this concept has expressed the concerns of policy makers regarding “national wealth”, “good trade” and “productive power”. Nevertheless, the concept lacks a universally-accepted definition and a broad consensus on the appropriate empirical measures has yet to emerge. Competitiveness is a relevant concept for firms, which can expand their market shares or lose them, be profitable or exit the industry. Krugman (1994) argues that competitiveness cannot be applied to national economies as countries cannot go out of business. However, countries tend to be concerned with shifts in market shares at a sectoral level, as these changes affect the sectoral composition of output, the allocation of resources, and, ultimately, living standards (OECD, 1998). In an earlier report, the OECD defined competitiveness as “the degree to which a country generates, while being and remaining exposed to international competition, relatively high factor income and factor employment levels” (OECD, 1997 – “factor” in the definition refers to 28 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY production factors).1 This definition contains two key elements. First, competitiveness is closely related to productivity, by focusing on factor income or value-added from inputs. Secondly, maximisation of value-added is a key feature of competitive economies. More competitive economies shift idle factors not producing sufficient value-added to more productive uses, achieve relatively high factor employment levels and come closer to attaining their production potential. For the purposes of this publication, the key issues related to competitiveness are the nature of its sources and how they evolve over time. Competitiveness evolves over time The convergence in productivity between countries is likely to be a long process. Therefore, the stage of development of an economy needs to be taken into account when assessing its current and future competitiveness. In this regard, it is possible to differentiate between factor-driven, efficiency-driven and innovation-driven economies (X. Sala-i-Martin and E. Artadi, 2004). The first category includes economies with low incomes and a reliance on natural resources.2 Cost is particularly relevant for factor-driven economies. Competition is mainly through prices. When a country in this first group becomes more competitive, its wages will rise, eroding its comparative advantage. At this point, it will enter a transition phase which will bring it into the efficiency-driven group, which must rely on productivity increases through developments such as increases in supply-chain efficiency and improvements in physical and IT infrastructures to offset the effect of rising wages. Capabilities are particularly important when a country transitions between the first and second levels of development. At this stage competition is through quality. By building capabilities in the labour market, deepening the financial market, investing in technology and ensuring efficiency, a country can reach the “innovation- driven” stage. This is the stage reached by the most advanced economies, which must rely on technological progress. Countries in this final stage cannot compete on price or quality, but need to innovate (M. Porter, 2001, 2005). According to the World Economic Forum’s Global Competitiveness Index (GCI), which uses the stages developed by Sala-i-Martin and Artadi (2004), Ukraine is considered to be in transition between the factor-driven and efficiency-driven phases. This means that to sustain its competitiveness it needs to improve its productivity by addressing current inefficiencies related to its supporting institutional framework, human capital, financial markets and other capabilities. The statistical correlation between the GCI for 2011-12 and GDP per capita in USD at current prices (used as a proxy for wages) highlights that Ukraine could perform better in terms of global competitiveness (Figure 1.1). Poland, which belongs to the efficiency-led group, gets a higher score in competitiveness than some comparable countries with a similar level of GDP per capita. The Czech Republic has already improved its efficiency and has moved into the last group of innovation-driven economies. Governments can adopt different tools to support competitiveness Governments can use three sets of levers to support competitiveness. First, they can implement macro-economic measures, such as monetary, fiscal or exchange rate policies. Second they can improve the legal and judicial framework to promote the rule of law and good governance. The third lever aims at improving the investment and business climate, either at the horizontal or at the vertical level. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 29 I.1. APPROACH AND METHODOLOGY Figure 1.1. Ukraine needs to move from a factor-led economy to an efficiency-led economy Correlation between the WEF Global Competitiveness Index 2011-12 and GDP per capita (2010, USD current prices) WEF global competitiveness score 2011-12 5.5 y = 3E – 05x + 3.9587 R 2 = 0.7507 5.0 POL CZE 4.5 4.0 UKR 3.5 3.0 2.5 2.0 0 10 000 20 000 30 000 40 000 50 000 60 000 70 000 80 000 GDP per capita USD current Source: World Economic Forum (2011), Global Competitiveness Report 2011-12, London; World Bank (2011), World Development Indicators (2011), http://data.worldbank.org, accessed 15 December 2011. This study does not cover the first two levers, although macro-economic fundamentals, good governance and institutions are essential pre-conditions for successful growth and stability. This analysis focuses instead on the third lever. Horizontal policies include market-friendly interventions which create a favourable, sound environment without selecting certain activities over others. For example, the Investment Policy Review of Ukraine calculated the OECD Foreign Direct Investment (FDI) Restrictiveness Index, measuring statutory restrictions on FDI in 22 sectors of the economy. The review proposes some recommendations for improving the overall investment climate, based on the principles of liberalisation, transparency and non-discrimination. It is based on the OECD Policy Framework for Investment, which covers the following areas: investment policy, investment promotion and facilitation, trade policy, competition level, tax policy, corporate governance, responsible business conduct, human resource development, infrastructure and financial sector development, and public governance. Vertical policies are specific interventions related to sectors with important assets and market potential but which still present some barriers to growth. Policy makers could decide to intervene selectively to improve the business environment of specific sectors and eliminate the restrictions. An example of improvement of the sectoral business environment would be a reorganisation of the aerospace sector, in order to separate civilian aircraft manufacturing from military production, and to lift the obstacles to private investment in the former. The likelihood of successful intervention depends partly on the government’s ability to identify market failures, and to select and implement the reforms required. Experience suggests that a transparent framework with objective criteria for selection and institutional processes that consult the private sector in reviewing policies and indentifying priorities is likely to prove effective. Measures oriented towards an active 30 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY involvement of the government in individual sectors, such as subsidies or equity investments, are not the focus of this study. Foreign direct investment can contribute to productivity enhancement and competitiveness The perspective of foreign investors is beneficial to the sectoral competitiveness improvement, in at least two ways. First, FDI can support increases in productivity. FDI can have a positive effect on growth in total factor productivity (TFP) both directly, via the diffusion of foreign technology and expertise, and indirectly, via a spill-over effect on local firms and sectors (OECD, 2007). Empirical studies of the effects of FDI on economic growth in developing countries suggest that the diffusion of new technologies and techniques boosts economic growth. Moreover, under certain circumstances, FDI has an even more significant impact on growth than domestic investment (Borensztein, De Gregorio and Lee, 1998). Second, attempts to promote FDI help to focus the policy interventions on specific areas. Foreign-owned multinational enterprises (MNEs) play a significant role in the economies of many developed and developing countries. Public policies can help a country both to attract more foreign investment and to maximise the effects of FDI on the economy. Depending on the importance of FDI in a given sector, governments have an incentive to improve the specific sectoral policies that best suit the various motives behind FDI (Kudina and Jakubiak, 2008). These motives can be categorised as: ● Resource seeking: depending on the availability of natural resources, cheap unskilled or semi-skilled labour, creative assets and physical infrastructure. The evidence suggests that FDI takes place when resource-abundant areas lack capital for resource extraction, the necessary technical skills, or the infrastructure to deliver the goods. ● Market seeking: traditionally related to markets with high barriers to trade, FDI allows access to these markets by producing locally. Country market size, per capita income and market growth are the main determinants of such investment. ● Efficiency seeking: occurs when the investing firm wishes to benefit from common governance, culture, systems, and politics, in geographically dispersed areas. Greater efficiency is achieved through coordination of international production, from a location which supplies several markets. Therefore, the objective of this study is to provide sector-specific, targeted policy recommendations to the Government of Ukraine to enhance both the sectoral competitiveness of the economy and its attractiveness to FDI. The focus of this project is also to initiate a process whereby government and sector-specific firms engage in strategic co-ordination and to develop strong local capabilities of the policy makers. Identifying sectors for intervention The approach adopted in this study is: ● Private sector-driven: leveraging feedback from the domestic private sector and OECD foreign investors to identify their sector priorities in Ukraine and the barriers they face in developing their business. ● Sectoral: focusing on enhancing sectoral competitiveness and addressing policy barriers from a sector perspective. This aspect is particularly relevant for Ukraine, as well as in other post-Soviet countries, where the centrally-planned economic system led to poorly informed choices and to an inefficient allocation of resources. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 31 I.1. APPROACH AND METHODOLOGY ● Value chain-based: encompassing all the activities and services involved in bringing a product from conception to end use or from input supply to distribution, this report analyses the major constraints and opportunities faced by businesses at multiple levels of the value chain. Sector identification: The Sector Prioritisation Framework The first stage of the approach consists of making an informed choice about the sectors that need to be selected to improve the sectoral competitiveness of Ukraine’s economy. The identification of the sectors was carried out based on the Sector Prioritisation Framework (SPF) methodology. This approach relies on a three-step process involving: first, an analysis of FDI trends; second, a consultation with stakeholders about high potential sectors; and then a final selection and validation of results with key stakeholders (Figure 1.2). Figure 1.2. Sector Prioritisation Framework methodology Step 2 Step 3 Step 1 Consultations Final Analysis about selection of past trends high potential and validation sectors with stakeholders in the future Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Step 1: Analysis of past trends The OECD Secretariat performed a quantitative analysis of the current situation and growth trends of 24 sectors in Ukraine. To facilitate data collection, the sector breakdown corresponds to the Classification of Economic Activities in the European Community NACE 1 (KVED classification in Ukraine). Data was collected from the following sources: OECD, Central Bank of Ukraine, Ukrainian State Committee of Statistics, UNIDO, UNCTAD, International Labour Organisation and European Commission. This evaluation allowed a comparison of sectors in two main dimensions: sector attractiveness and country benefits. The first dimension includes those variables capturing the degree of attractiveness of a given sector, such as its share in total value-added, sector- specific labour costs benchmarked against a cluster of emerging countries, and the average annual growth rate of world FDI inflows over a number of years. The second dimension analyses the positive effect of the given sector on a country’s economy, along dimensions such as the share of the sector in total employment, innovation, labour productivity based on value added, and other factors. Both dimensions were scored on a scale of 0 (low benefits or attractiveness) to 100 (high benefits or attractiveness). To determine the score, each variable within the dimension was allocated a weight, based on a correlation with FDI inflows at sector level, and validated through a comprehensive literature review. The framework is based on the principle that the sectors in each of the four quadrants require different intervention strategies to maintain or improve their competitiveness (Figure 1.3). ● “Sustaining competitiveness” is required if both country benefits and market attractiveness are high. 32 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY Figure 1.3. Sector Prioritisation Framework, analysis for Ukraine Country benefits index 50 Defend Sustain Financial 45 Rubber, activities plastics products 40 Machinery and equipment Real Business Trade estate services Chemicals Coke, refined petroleum 35 products and nuclear fuel Construction 30 Electrical, optical equipment Communication 25 Metals Transport Mining 20 Electricity, gas and water Food supply Fishing Other non-metallic mineral 15 products Wood, Textiles leather forestry Hotels and restaurants 10 Paper, Publishing Transport equipment 5 Re-evaluate Leverage 0 0 10 20 30 40 50 60 Sector attractiveness index Source: Analyses and calculations based on data provided by the State Statistics Committee of Ukraine (SSCU) (2011); State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. ● “Defending” is required if country benefits are high but relative market attractiveness is low (e.g. in the case of traditional manufacturing sectors). For sectors in this quadrant, the objective is to improve the sector attractiveness to private investors. ● “Leveraging” of existing market attractiveness is required if country benefits are low. And, ● “Re-evaluating” a sector is required if both dimensions are low. These strategies are not, of course, mutually exclusive. Countries generally combine them. The framework can be used as a tool to tailor different intervention strategies according to the current assessment of a given sector. No value judgment is attached to it. Step 2: Consultations about sectoral competitiveness Government representatives were asked to provide a list of sectors which they believe are the most attractive in Ukraine and have the highest potential for development.3 The list of sectors collected was then cross-checked against investment strategies and information available in government reports and on websites. Using the list of sectors identified as promising, an initial shortlist of sectors was created. Suggestions and comments concerning the selection of sectors were elicited from private sector organisations, including the European Business Association of Ukraine and the Ukrainian Chamber of Commerce and Industry (Figure 1.4). Step 3: Final selection and validation with stakeholders Combining the shortlist of priority sectors identified by government experts with the additional results of quantitative analysis, three promising sectors were identified for focus. The choice of sectors was presented to the Coordination Council for OECD-Ukraine relations under the chairmanship of the Deputy Prime Minister of Ukraine in December 2010 and finally validated: 1. Agribusiness, with two pilots focusing on the dairy and grain value chains. 2. Energy-efficiency and renewable technologies, including the biomass value chain as a pilot. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 33 I.1. APPROACH AND METHODOLOGY Figure 1.4. Results of consultations with private and public sector representatives Fair interest Rather high interest High interest Public sector expressed interest Machine and equipment manufacturing Manufacturing of food products Agriculture, hunting Waste treatment, materials recovery Manufacturing of chemicals and chemical products Remediation activities Construction Hotels Low interest Fair interest Rather high interest High interest Private sector expressed interest Source: Analyses and calculations based on a survey conducted by the OECD in 2009-10 with private and public sector representatives; OECD (2011), “Country Capability Survey”, internal working document, OECD, Paris. 3. Machinery manufacturing and transport equipment, including the civilian aircraft value chain as a pilot. These sectors present strong synergies with government strategies, and opportunities to develop core capabilities in areas applicable across other sectors, namely human capital, knowledge and innovation, and access to finance. The Sector Performance Review: An in-depth analysis of the selected sectors Following the identification of the priority sectors, the review undertook a series of steps, aiming to answer four key questions: ● Which sub-sectors are promising for private domestic and foreign investors? And why, given domestic and global trends? ● How could the selected sub-sectors position themselves in order to attract FDI? ● Which policy barriers are hindering growth and competitiveness in these sub-sectors? The following paragraphs describe each of these questions and the analytical process followed to prioritise the number of sub-sectors selected. Which sub-sectors are promising for private sector and foreign investors? And why, given the domestic and global trends? Within each category, the analysis focused on the identification of those sub-sectors which are particularly promising for private domestic and foreign investors in Ukraine. The sub-sectors of interest were identified on the basis of specific criteria depending on the sector, and following consultations with stakeholders. For instance, agribusiness sub- sectors were selected based on demand and supply trends both at the global and domestic level, and also on government stakeholders’ assessments. As already mentioned, an important driver of competitiveness is cost: when costs are low, then a country can export goods and supply the domestic market with an advantage over foreign competitors. Secondly, quality becomes more relevant when the country loses its cost- related comparative advantage and also when products become more sophisticated (OECD, 1998). Figure 1.5 illustrates for the grain sub-sector the production cost advantage that Ukraine enjoys compared to its competitors. Production costs, including transport costs, are a key feature of competitiveness in the grain business. However, quality of grain is also an important 34 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY Figure 1.5. Agribusiness example: Comparison of production costs for wheat (USD per metric tonne), 2009 Direct costs – seeds, fertilizers, plant protection products Operating costs – labour, contractor, machinery diesel 200 180 160 140 120 123 91 85 33 100 78 39 91 80 60 51 91 40 72 69 65 57 55 20 40 38 0 y ia li a an nd ia da e in an ss ar ra na st la ra rm lg Ru Po kh st Ca Uk Bu Au Ge za Ka Source: Von Tunen Institute, 2010. element, since even in such a commoditised industry grains are targeted to specific market demands and price discrimination is implemented according to product quality. How could the selected sub-sectors position themselves in order to attract foreign direct investment? Provided that each sub-sector has a specific value chain, the analysis focused on the identification of those segments that could attract FDI. Sub-sectors were analysed as value chains involving numerous players. Therefore, the areas of potential interest for foreign investors were defined. For instance, as illustrated by Figure 1.6, civilian aeronautics is a complex value-chain dominated by the OEM, which integrates numerous components and sub-systems produced by hundreds of suppliers. Components range from low to high-end components, while aeronautic firms can be positioned at different stages along the supply- chain, from tier-4 to tier-1. An initial outline for sub-sector strategies to attract FDI was developed in collaboration with government stakeholders. Which policy barriers are hindering growth and competitiveness in these sub-sectors? Primary research was conducted in order to identify key constraints on the ability of firms to produce, invest and grow in Ukraine in the selected sub-sectors. The combination of semi-directional qualitative interviews and quantitative data collection and analysis allowed the OECD to build up a solid understanding of the key success factors, challenges and policy barriers faced by firms in the sub-sectors covered by the study. Primary research started with interviews with a full range of stakeholders, including government representatives, domestic business associations, private Ukrainian companies, foreign investors and foreign companies potentially interested in investing in Ukraine. The semi-directional interviews included two types of data collection methodologies: focus groups and in-depth interviews during company visits. The qualitative survey was carried out by the OECD using a sample of four to six companies per sub-sector selected for focus. Country missions were conducted with the aim of carrying out consultations with the public and private sectors on the results. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 35 I.1. APPROACH AND METHODOLOGY Figure 1.6. Civilian aircraft industry example: Areas for potential FDI along the supply-chain Hundreds of suppliers produce components at various technological levels Original equipment manufacturer OEM Power Landing In-flight Engine Avionic POD Aerostructure Brakes Interior systems gear entertainment General Various General General General General General General General contractor suppliers contractor contractor contractor contractor contractor contractor contractor TIER 1 Design, Electronics Design, Design, Design, Design, Design, Design, Design, production and production production production production production production production of key-parts, informatic of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, assembling equipments assembling assembling assembling assembling assembling assembling assembling TIER 2 Various Various Various Various Various Various Various Various Various suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers TIER 3 Various Various Various Various Various Various Various Various Various suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers Various Various Various Various Various Various Various Various Various TIER 4 suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers High-end components Mid-end components Low-end components Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Interview guidelines were framed using the Policies for Investment (PFI) framework. The PFI draws on good practices from OECD and non-member economies to propose guidance in ten policy fields identified as critically important for improving the quality of a country’s environment for investment. It involves asking appropriate questions about the economy, institutions and policy settings in order to identify priorities, to develop an effective set of policies and to evaluate progress. The PFI encompasses different policy areas including investment policy and promotion, trade policy, competition policy, tax policy, corporate governance, human resources development, infrastructure and financial sector development, public governance and policies for promoting responsible business conduct (OECD, 2009). The outcome of the qualitative interviews helped to develop sound hypotheses concerning the most critical issues and policy barriers that private sector and foreign investors face in Ukraine in the selected sub-sectors. The OECD Country Capability Survey (CSS) – a quantitative survey questionnaire – was further refined, using the outcome of interviews to narrow down the scope and focus on the most specific and critical issues (Table 1.1). The CCS focuses on sector-specific business and policy constraints experienced in Ukraine. The CCS specifically aims at capturing data that: 1. examines companies’ general operational activities; 2. establishes firms’ perceptions of key success factors and obstacles to business growth; and 3. gathers feedback on a range of suggested policy recommendations. 36 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY Table 1.1. Sample size of the survey questionnaire Value chain Company type Number of companies surveyed Grain Grain producer – wheat, corn, barley (farm) 85 Grain processor 55 Dairy products Raw milk producer (farm) 83 Milk processor 40 Production of energy from biomass Forestry company 11 Wood processor 33 Pellet makers 16 Public utilities 40 Civilian aircraft manufacturing Aircraft manufacturing or maintenance company 31 Total 395 Source: OECD (2011), Country Capability Survey, internal working document, OECD, Paris. The survey questionnaire was elaborated by the OECD and implemented in Ukraine by GfK Ukraine. The survey consisted of approximately 40-45 questions, depending on the sub-sector and the step on the value chain within this sub-sector. The survey was typically completed by firms’ directors, accountants and human resource managers. To secure maximum participation in the survey and ensure data quality, the data have been kept confidential. The CCS highlighted areas where Ukrainian policy-makers should focus their efforts to improve the competitiveness of sub-sectors. In the dairy industry, for instance, difficult access to finance is possibly due to weak relations between farmers and dairy processors: fewer than half of farmers benefit from the support of processors, while this figure is much higher in comparable countries such as Poland (Figure 1.7). Figure 1.7. Dairy sub-sector example: Difficult access to finance is partly due to the weak links between farmers and processors Does the processor(s) you work with provide you with financial or technical support? Question asked Does the processor(s) Yes About 40% of milk 39% you work with producers surveyed provide you with 61% No benefits from support financial or technical from processors support? Question asked Providing cold chain services 66 Providing milk collection equipment 53 If yes, please specify Lending short-term to finance Both technical and working capital 44 what type of support financial support Transferring know-how and skills 13 Providing milking equipment 13 0 20 40 60 80 % Source: OECD Country Capability Survey (dairy farms without processing capabilities); Excerpt from CCS results – Questionnaire targeting dairy farmers without processing capabilities. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 37 I.1. APPROACH AND METHODOLOGY A prioritisation framework to select policy recommendations for the implementation phase Based on OECD member countries’ best practices, sector-specific policy improvements were drawn up and checked against the views of industry experts, private sector representatives and government representatives. Suggested recommendations were formulated to be relevant and actionable, and will be implemented in the next phase of the project. The prioritisation of the policy recommendations for Phase II has been conducted taking into account a two-dimension assessment (Figure 1.8). Figure 1.8. A framework to prioritise among policy recommendations for Phase II based on the country’s strategic advantage and the areas of intervention An example from the Agribusiness sector Strategic advantage Investment Access to finance Dynamic policy Human capital comparative – Co-operative banks advantage Quality standards – Attract FDI in the – Supply chain financing, – Initial education dairy processing warehouse receipts – Vocational education Based on – Food safety regulation industry – Leasing – Continued education high-value added – Streamline of controls – Geographical – Match the needs – Credit guarantee schemes long term – Certifications export diversification – Microfinance of the private sector Infrastructures Static Land reform comparative – Road system advantage – Grain carriers – Land reform completion – Port infrastructure Based on – Lift the moratorium on land sale – Storage facilities natural resources – Cold chain labour cost short term Rules Capabilities Area of intervention Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris; Framework based on Krugman (1987) and Lall (1990); Krugman, P. (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Tatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 1, pp. 41-55; S. Lall, (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. The first element captures the country’s strategic advantage. As explained earlier, a country’s comparative advantage evolves over time and it is subject to shocks. A static comparative advantage is based on natural resources, low labour costs and similar short- term drivers. These advantages erode as income rises and the level of wages converges with that in competitor countries. In contrast, a dynamic comparative advantage is sustainable over the longer term, since it is based on learning by doing, high-skills and high-value added activities. For example, at the moment Ukraine has a static comparative advantage in the production of grain, given the low production cost and the abundance of resources. However, in order to maintain a dynamic comparative advantage over time it needs to improve the quality of its output and to deepen its activity into higher-value products and services. The second dimension takes into account the areas of intervention that the government can leverage. Rules and regulations build the framework for a sector; however they can easily be reversed. Also, new legislation can be passed but then not implemented, or it may be translated into concrete action only after a long delay. Capacity-enhancing measures, in contrast, develop long-term capabilities, such as human capital, financial deepening or innovation. Both rules and capabilities are important, but capabilities create positive externalities for the economy. For example, the completion of the land reform is a necessary step that the government needs to address. However, this reform alone, if not 38 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 I.1. APPROACH AND METHODOLOGY combined with other capacity-enhancing interventions, would not be sufficient to guarantee the country’s ability to defend its comparative advantage and move up into another stage of development. Vocational training in farm economics, extension services to update farmers on how to improve quality, and similar interventions can empower the private sector and create positive externalities. Areas of intervention selected for Phase II of the project were those with the highest assessments in terms of both dynamic comparative advantage and capabilities. Nevertheless, the strategies are not mutually exclusive. This selection does not mean that interventions targeting, for instance, infrastructure in the agribusiness sector are less important. Upgrading the road system is certainly an element that would enhance the country’s ability to produce and trade more efficiently. However, it would not change the nature of Ukraine’s strategic advantage if, even with better road infrastructure, it still produced low quality grain. There are some caveats associated with the proposed framework. First, within each broad category of recommendations the various different measures may have different assessments. For example, upgrading the road system does not receive the same assessment as upgrading grain carriers. Interventions belonging to the same macro-area (e.g. infrastructure) may fall in different quadrants of the matrix. The framework has been simplified by mapping only macro-categories, in order to provide a practical tool that is easy to visualise and to interpret. Second, it is in line with the OECD’s mandate to “promote policies that will improve the economic and social well-being of people around the world” and with the mandate of the OECD Eurasia Competitiveness Programme, which focuses on empowering the domestic and foreign private sector and building local capabilities in the region. Thirdly, the selection also needs to be complemented with a cost-benefit analysis. However, it does provide the government with an instrument to guide strategic policy-making. Notes 1. According to the OECD definition “factor incomes comprises compensation of employees by, and operating surplus of, producers” (OECD, 2011). 2. This is measured by the share of exports of mineral products in total exports. 3. This includes the Ministry of Economic Development and Trade, the Ministry of Finance, the Ministry of Industrial Policy, the Ministry of Food and Agrarian Policy, and the State Agency of Ukraine for National Projects. Bibliography Bianchi, P. and S. Labory (2006), International Handbook on Industrial Policy, Edward Elgar, Cheltenham and Northampton. Borensztein, E., J. De Gregorio and J.-W. Lee (1998), “How does Foreign Direct Investment Affect Growth?”, Journal of International Economics, Vol. 45, No. 1. Dunning, J. (1973), “The Determinants of International Production”, Oxford Economic Papers, New Series, Vol. 25, No. 3. Ewe-Ghee, L. (2001), “Determinants of, and the Relationship between Foreign Direct Investment and Growth: A Summary of the Recent Literature”, IMF Working Paper, No. 2001/175. Fagerberg, J. (1996), “Technology and Competitiveness”, Oxford Review of Economic Policy, Vol. 12, No. 3. Krugman, P. (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Thatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 1, pp. 41-55. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 39 I.1. APPROACH AND METHODOLOGY Krugman, P. (1994), “Competitiveness: A Dangerous Obsession”, Foreign Affairs, Vol. 73, No. 2. Kudina, A. and M. Jakubiak, (2008), Conditions for Positive Spillovers for FDI: A Case Study of Georgia, Kyrgyzstan, Moldova and Ukraine, OECD Investment Policy Perspectives, OECD, Paris. Lall, S. (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. Lall, S. (2001). “Competitiveness Indices and Developing Countries: An Economic Evaluation of the Global Competitiveness Report”, World Development, Vol. 29, No. 9. OECD (1997), Industrial Competitiveness: Benchmarking Business Environments in the Global Economy, OECD, Paris. OECD (1998), “Trends in OECD Countries’ International Competitiveness: The Influence of Emerging Market Economies”, Economics Department Working Papers, No. 195. OECD (2007), “Ukraine. Economic Assessment”, OECD Economic Surveys, OECD, Paris. OECD (2009), Policy Framework for Investment, OECD, Paris. OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. OECD (2011), Country Capability Survey, internal working document, OECD, Paris. Porter, M. (1985), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press, New York. Porter, M. (1990), “The Competitive Advantage of Nations”, Free Press, New York. Porter, M. (2001), “Enhancing the Microeconomic Foundations of Prosperity: The Current Competitiveness Index”, The Global Competitiveness Report 2001-02, Oxford University Press, New York. Porter, M. (2005), “Building the Microeconomic Foundations of Prosperity: Findings from the Business Competitiveness Index”, The Global Competitiveness Report 2005-06, World Economic Forum, New York. Reinert, E. (1995), “Competitiveness and its Predecessors – A 500 Year Cross-National Perspective”, Structural Change and Economics Dynamics, Vol. 6, No. 1. Ricardo, D. (1817), On the Principles of Political Economy and Taxation, John Murray, London. Rodrik, D. (1995), “Getting Interventions Right: How South Korea and Taiwan Grew Rich”, Economic Policy, Vol. 20, No. 1. Rodrik, D. (2004), “Industrial Policy for the 21st Century”, Working Paper Series, rwp 04-047, Harvard University, Harvard. Rodrik, D. (2007), “Normalizing Industrial Policy”, Commission on Growth and Development Working Paper, No. 3, Commission on Growth and Development, The World Bank, Washington, DC, 2008. Sala-i-Martin, X. (1994), “Cross Sectional Regressions and the Empirics of Economic Growth”, European Economic Review, Vol. 38, No. 3-4. Sala-i-Martin, X. and E. Artadi (2004), “The Global Competitiveness Index”, The Global Competitiveness Report: 2004-05, Oxford University Press, Oxford. Savvides, A. and M. Zachariadis (2005), “International Technology Diffusion and the Growth of TFP in the Manufacturing Sector of Developing Economies”, Review of Development Economics, Vol. 9, No. 4. State Statistics Service of Ukraine (SSSU) (2010), Agriculture of Ukraine 2009, SSSU, Kyiv. State Statistics Committee of Ukraine (SSCU) (2011), State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. Stiglitz, J.E. and S. Yusuf (eds.) (2001), Rethinking the East Asian Miracle, World Bank and Oxford University Press, Oxford and Washington, DC. UNECE (2004), Economic Survey of Europe, No. 2, UNECE, Geneva. UNCTAD (2009), “The Relationship between Competition, Competitiveness and Development”, Issues note prepared by the UNCTAD Secretariat, UNCTAD, Geneva. UNIDO (2005), “Private Sector Development. The Support Programmes of the Small and Medium Enterprises Branch”, SME Technical Working Paper Series, No. 15, UNIDO, Vienna. World Bank (2011), World Development Indicators (2011), http://data.worldbank.org accessed 15 December 2011. World Economic Forum (2006), Global Competitiveness Report 2006-2007, London. World Economic Forum (2011), Global Competitiveness Report 2011-12, London. 40 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 PART II Economic overview and findings of the Investment Policy Review of Ukraine COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 2 Economic overview This chapter presents a broad analysis of the Ukrainian economy. It briefly describes its macroeconomic performance and the contribution of different sectors to growth, which frames the sectoral analyses of the next chapters. Also, it assesses the endowments which have sustained economic growth and the challenges that still remains unaddressed. 43 II.2. ECONOMIC OVERVIEW A country with abundant natural resources and a well qualified labour force With a geographical area of 603 548 square kilometres, Ukraine is the second-largest country in Europe, strategically located at the crossroads between Europe, Russia and Central Asia. It has 324 784 square kilometres of arable land, the largest such area in Europe. It has the largest manganese-ore fields and the second-largest mercury deposits in the world. It also has access to other abundant mineral resources, including coal, iron, nickel, uranium and natural gas. The country has access to the Black Sea through the ports of Odessa and Sevastopol and it is a key energy transit country for Russian oil and gas exports to Western Europe. Having dropped by around 6 million since independence, Ukraine’s population stands at around 46 million, which given its vast land area, results in a low population density. Since 1991, income inequality has worsened, with the Gini coefficient rising from 25.7 in 1992 to 35.1 in 1996. According to the World Bank’s estimates, the Gini index was 27.5 in 2008, lower than other neighbouring countries such as Armenia (30.9), Azerbaijan (33.7), Georgia (41.3) and Russia (42.3). The labour force is highly skilled, thanks to the legacy of the rigorous and scientifically- oriented education system of the Soviet Union, and relatively inexpensive. For instance, Ukraine has universal literacy and high general school enrolment: the combined gross enrolment ratio in education of both sexes was 90% in 2009, higher than those of Czech Republic (83.4%) and Poland (87.7%). According to the World Bank (2011), female labour participation is also higher than the average for Europe and Central Asia (Figures 2.1 and 2.2).1 At the same time, the Ukrainian wage in 2006 was USD 206 per month, while in Figure 2.1. Ukraine’s labour force has a high level of tertiary education Percentage of total labour force with tertiary education, 2005 Labour force with tertiary education (% total) 2005 50 45.2 45 40 38.3 35 30.4 30 25 20 15 10 5 0 Ukraine Europe and Central Asia Europe and Central Asia (all income levels) (developing only) Source: World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. 44 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.2. ECONOMIC OVERVIEW Figure 2.2. Female labour participation in Ukraine is high compared to regional peers Labour participation rate, female population over 15, 2010 Labour participation rate, female (% female over 15 population) 2010 51.8 50.1 48.7 Ukraine Europe and Central Asia Europe and Central Asia (all income levels) (developing only) Source: World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. Poland it was USD 798 (Raiser, 2007). Despite this abundant pool of relatively cheap labour, Ukrainian firms find it difficult to compete on quality in non-CIS markets. This poor performance, in a context of considerable natural and human resources, can be attributed mainly to fundamental institutional bottlenecks and poor framework conditions for entrepreneurship. These ultimately affect productivity, and are weaknesses that the government urgently needs to address. After struggling immediately following independence, the Ukrainian economy enjoyed a period of robust growth After independence in 1991, Ukraine’s output contracted sharply and more severely than in other Central and Eastern European countries, with real GDP falling by almost 60% in 1990-99. The official data overestimate the decline as they do not take into account the impact of the shadow economy or the various factors that led output to be over-reported in the Soviet era.2 Even accounting for this, the economy experienced eight consecutive years of severe recession, making the transition from a centrally-planned to a market-based economy a long and difficult process. It did not help that successive governments often prevented structural change rather than implementing necessary reforms. The economy finally returned to growth in 1999, and real GDP grew strongly in the early 2000s, rising at an annual average rate of 7% during 2000-08, among the fastest in Europe (World Bank, 2010). In the same period, FDI inflows to the country grew by an annual average of 43.8% and peaked at USD 10.9 billion in 2008 (Figure 2.3). For a regional comparison, FDI inflows to Georgia in 2000-08 grew by an annual average of 36.3% (UNCTAD, 2011; UNCTADstat). This strong growth was facilitated by the existence of substantial spare capacity in the industrial sector. Temporary external factors also assisted the rebound, including the competitive exchange rate policy that followed the sharp devaluation of the hryvnia after the 1998 financial crisis and the rise of international commodity prices. In addition, the gas prices paid by Ukrainian firms were very low, giving a cost advantage with respect to European countries and an incentive to specialise in highly energy-intensive industries, such COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 45 II.2. ECONOMIC OVERVIEW Figure 2.3. Annual inward FDI flows in the region USD bn at current prices and current exchange rates Armenia Azerbaijan Georgia Ukraine 11 9 7 5 3 1 0 -1 -3 -5 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: UNCTAD (2011), World Investment Report, UNCTAD, Geneva; UNCTADstat, Statistical Database, http://unctadstat. unctad.org/ReportFolders/reportFolders.aspx?sCS_referer=&sCS_ChosenLang=en, accessed 15 June 2011. as chemicals, metallurgy and machine processing. During the recovery, Ukraine did not take the opportunity to diversify its industrial base into other promising sectors, but kept expanding those activities that already existed under the central planning system. As a result, it lagged behind other transition countries in terms of diversification and innovation. The global financial crisis highlighted existing weaknesses Ukraine was severely affected by the global economic and financial crisis. In 2009, the US dollar appreciated by 47.9% against the hryvnia and real GDP shrank by almost 15% (IMF, 2010). Economic activity was dragged down by a 41.5% drop in fixed investment combined with a 15% decline in private consumption (State Statistics Service of Ukraine, 2011). As a result of the fall in output, the external debt ratio soared to 88.3% of GDP, according to the National Bank of Ukraine. The government budget deficit as a percentage of GDP widened from 3.1% in 2008 to 8.7% in 2009. Due to the adverse impact of the global recession, funding dried up and external sources of financing became unavailable to the country’s banks, leading to significant liquidity problems in the banking system. Prominvest Bank, the sixth largest in the country, failed in the last quarter of 2008. In the first quarter of 2009, credit rating agencies downgraded Ukraine’s long-term foreign currency rating to CCC+, seven levels below investment grade. FDI inflows to the country fell by more than 50%, dropping to USD 4.8 billion in 2009. The cumulative FDI stock stood at almost USD 52 billion and FDI per capita was only USD 1 078, significantly lower than in its peers in the region (Figure 2.4). The IMF extended support to Ukraine during 2008-09 to stabilise the banking system and mitigate the impact of the collapse in output. This helped to ease concerns over Ukraine’s sovereign debt position. The package was subject to specific conditions such as reducing the budget deficit, applying a more flexible exchange rate regime and increasing the price of gas. The total loan package was initially supposed to be around USD 16.4 billion, but after the release of USD 10.5 billion disbursements were suspended in November 2009, when domestic reforms stalled and the government refused to cut 46 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.2. ECONOMIC OVERVIEW Figure 2.4. FDI per capita in Ukraine is lower than in its regional peers FDI inward stock, USD at current prices and current exchange rates per capita, 2009 FDI inward stock per capita 2009 (USD) Kyrgyzstan Azerbaijan Ukraine Armenia Turkmenistan Georgia Kazakhstan Poland Slovenia Slovakia Czech Republic Estonia Hungary 0 5 000 10 000 15 000 20 000 25 000 30 000 Source: UNCTAD (2011), World Investment Report, UNCTAD, Geneva; UNCTADstat, Statistical Database, http://unctadstat. unctad.org/ReportFolders/reportFolders.aspx?sCS_referer=&sCS_ChosenLang=en, accessed 15 June 2011. spending ahead of presidential elections. In 2010, the government obtained another USD 7.5 billion loan from the IMF and VTB, a state-owned Russian bank. The global financial crisis and the subsequent recession had a severe impact on incomes and living standards. Disposable income contracted and GDP per capita at constant prices declined by 14.7% year on year, from UAH 16 019 in 2008 to UAH 13 668 in 2009 (IMF, 2010), making Ukraine one of the poorest countries in the region. Unemployment went up from 6.4% in 2008 to 8.8% in 2009. Average real wages declined by 9.2% in 2009 and unit labour costs dropped by almost 20%. Emigration of younger Ukrainians to countries with better job prospects has intensified, causing an ageing of the demographic structure. This human capital flight entails high social costs for the country, and could undermine its long term development. Economic activity relied mainly on agriculture and highly energy intensive industries Once called the “breadbasket of Europe”, Ukraine has traditionally specialised in agriculture. In the 1990s, agriculture accounted for around 20% of GDP, but its share gradually declined to 8.2% of GDP in 2010 following a reallocation of labour from agriculture into the industry and services sectors (Figure 2.5).3 Agriculture still accounted for 25% of total exports in 2009 (WTO, 2010), and the country is the world’s largest exporter of barley and the seventh-largest exporter of wheat. However, agricultural exports consist mainly of goods with a low degree of processing. In 2001, the Land Code introduced a moratorium on the purchase and sale of farm land. This was supposed to be in effect only until the end of 2004, but is still in place and will remain so until at least 2012. There is still no operational land cadastre detailing property holdings and usage, despite the fact that a project to develop one started in 2004. Moreover, since 2006 the government has adopted an unpredictable and non-transparent system of export quotas on grain, originally intended as a temporary response to lower- than-expected grain harvests. However, the restrictions have been lifted and re-imposed several times and were finally removed only in May 2011, with important consequences for COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 47 II.2. ECONOMIC OVERVIEW Figure 2.5. The share of services in GDP has expanded since independence Agriculture % GDP Industry % GDP Services % GDP Real GDP 800 700 600 500 400 300 200 100 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. the domestic agribusiness sector and the widening current account deficit (Figure 2.6). Such measures have created uncertainty over the volumes of crops that could be delivered by Ukraine, increasing the risks shared by producers, suppliers, traders, financial institutions and households. Also, the quotas have not always been administered in a transparent way, contributing to greater inefficiency of both resource allocation and investment in the sector. The unclear quota allocation procedures have resulted in the exclusion of many international traders from the export market. Figure 2.6. The current account deficit has widened Current account balance (% GDP) Current account balance (% GDP) 12 10 8 6 4 2 0 -2 -4 -6 -8 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. Another challenge concerns transport infrastructure. The limited capacity of Ukraine’s ports restrains exports of commodities and agricultural products. For example, in 2008 the utilisation ratio of the five major Ukrainian sea ports was 96%, i.e. approaching full capacity. As a consequence of the current constraints, the share of agriculture in the total FDI stock remains modest at 2%. 48 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.2. ECONOMIC OVERVIEW Ukraine is the world’s eighth-largest producer and fourth-largest exporter of steel, and the fifth-largest exporter of nitrogen-based fertilisers. Industry value added accounted for 30% of GDP in 2010 (World Bank, 2011), while the share of total exports represented by fuels and mining products was 12.3% and that accounted for by manufactured products was 62%, according to the WTO. During 2001-06, there was spare capacity in several sectors of industry, allowing the manufacturing sector to grow faster than GDP, with growth averaging around 10% on an annual basis. In the six years after the 1998 financial crisis, productivity growth in industry was strong, especially in the machine building and wood- products sectors, where Ukraine had a comparative advantage. However, productivity growth slowed in 2005-06 (OECD, 2007). Labour productivity grew at an annual average of 12.5% in 2001-06, driven by spare capacity, the restructuring of firms and the resultant shedding of labour. The sector also enjoyed a substantial comparative advantage in terms of cost of inputs, as the natural gas price was lower than that paid by Ukraine’s European peers. Since the price shocks of 2006, a sharp annual increase in the gas import price has put pressure on firms’ cost structures; despite the incentive to modernise the capital stock, industry remains an inefficient and highly-intensive user of energy. The rise of commodity prices that peaked at record levels in 2007 supported the growth of the ferrous metallurgy sector and its satellite industries. Real GDP growth has been closely linked to the evolution of the price of steel, which accounts for more than one third of total goods exports. In July 2008, the IMF estimated, using a VAR framework, that a 10% decline in steel prices would slow Ukraine’s annualised GDP growth by between ½ and ¾ of a percentage point over a full year (IMF, 2008). Steel prices crashed by 38% in the first quarter of 2009 and bottomed out at 58.5% below their pre-crisis level in the second quarter (Figure 2.7). Figure 2.7. The evolution of real GDP has been closely linked with steel prices Quarterly Real GDP (% yearly change) and Steel price (USD/tonne) % yearly change Real GDP % yearly change Steel price (USD/tonne) % yearly change 15 120 100 10 80 5 60 0 40 -5 20 0 -10 -20 -15 -40 -20 -60 -25 -80 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 1 2 3 4 Q Q Q Q 07 07 08 07 09 10 07 08 10 09 08 10 09 08 09 10 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Source: State Statistics Committee of Ukraine (SSCU), (2011), State Statistics of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011; Economist Intelligence Unit (2011), Country Report: Ukraine, EIU, London. As a result of the reallocation of labour from agriculture and industry into services, the speed of service sector growth since 2000 has been important. Services accounted for 60.9% of GDP in 2010 and around 22% of the inward FDI stock. The financial sector, in particular, has experienced dynamic growth, with rapid increases in consumer and mortgage lending until COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 49 II.2. ECONOMIC OVERVIEW the onset of the financial crisis, when credit growth stalled. The retail sector also expanded strongly from 2000 onwards, driven by the rise in real incomes and consumer demand. However, the global financial crisis has severely constrained households’ purchasing power. This, combined with consumer price increases and the alignment of utility prices towards European levels, has recently hampered the growth of private consumption. Structural reform priorities need to improve the business climate, consolidate the financial sector and deepen the labour force’s skill set Ukraine’s business climate has always been very difficult, but the instability and uncertainty triggered by the financial crisis have contributed to a further deterioration. The World Bank’s “Doing Business” project ranked Ukraine 128th out of 175 countries in 2006; in 2011, it was downgraded to 145th out of 183 economies, despite the new legislation adopted in 2009-10 to simplify the procedures required to start a business. According to the World Bank’s assessment, its scores have worsened in the categories “registering a property”, “getting credit”, “protecting investors”, and “closing a business”. The long-term policy goal of the country is to improve competitiveness. Greater macroeconomic stability is a prerequisite to attracting foreign investment and switching to a long-term sustainable growth path. Ukraine urgently needs to stabilise its budget deficit and reform its fiscal system to support private and public investments, especially investments in infrastructure. These structural fiscal reforms have to be combined with reforms aimed at improving the investment climate, targeting the investment framework and taking into account the importance of foreign investments. For instance, the bureaucratic procedures needed to operate in the country should be streamlined and the entry and exit barriers for companies should be removed. Corruption needs to be tackled to improve governance, accountability and transparency. SMEs need to have access to finance to meet the cost of inputs and to improve the quality of their outputs. Therefore capital market reforms targeting a deepening of financial markets are a priority. Finally, there is a need for education reforms to upgrade the skill-set of the labour force, modernise the education system and minimise the existing skills gap. A sector-specific approach to investment promotion A national long-term investment promotion strategy based on available resources and capabilities must be developed to improve sector competitiveness and increase awareness of strategic opportunities among foreign investors. It is advisable to develop a dialogue on this theme between the government, investment institutions and the private sector. More competitive economies can provide higher levels of income and higher standards of living for their citizens through higher wages. Higher productivity also entails higher returns on capital, which in turn attract higher volumes of investment into the economy. The experience of OECD countries shows that economies with a sector-specific focus on investment promotion activities achieve better results and attract higher volumes of foreign direct investment. Therefore, an investment promotion strategy needs to focus on specific sectors and FDI-originating countries. The OECD will continue to work closely with the government of Ukraine to formulate and implement a number of specific policy recommendations to maximise the potential and competitiveness of these sectors. 50 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.2. ECONOMIC OVERVIEW Notes 1. According to the State Statistics Service of Ukraine the female labour participation rate was 58.4% in 2010, based on the Labour Force Survey conducted at the national level. The World Bank uses the data published by the International Labour Organisation (ILO), which applies harmonised methodologies ensuring cross-country and over-time comparability. The discrepancy between the two sources are attributable to differences in the census scope, coverage and definitions. For example, the definition of unemployed people differs between the ILO and the Labour Force Survey, affecting all the other indicators. 2. During the Soviet era, managers tended to over-report production to obtain bonuses for exceeding production targets. In addition, goods for which there was no market demand were produced anyway. 3. The share of Agriculture, Industry and Services Value added to GDP published by the State Statistics Service of Ukraine differs slightly from the data published by the World Bank. This discrepancy can be attributed to different definitions. For example, the World Bank uses the United Nations International Standard Industrial Classification of All Economic Activities, while the State Statistics Service of Ukraine is based on the NACE classification. Bibliography Economist Intelligence Unit (2010), Country Forecast: Ukraine, EIU, London. Economist Intelligence Unit (2011), Country Report: Ukraine, EIU, London. European Bank of Reconstruction and Development (2011), Transition Report: Recovery and Reform, EBRD, London. International Monetary Fund (2010), International Financial Statistics, IMF, Washington, DC. Kuddo, A. (2009), Labor Market Monitoring in Europe and Central Asia Countries: Recent Trends, World Bank, Washington, DC. Kupets, O. and N. Leshchenko (2008), “Black Sea Labour Market Reviews: Ukraine Country Report”, prepared for ETF by BEST LCC, Kiyv. OECD (2007), Economic Assessment of Ukraine 2007, OECD, Paris. Raiser, M. (2007), “Are Wages in Ukraine too Low? And What Could Be Done to Increase Them?”, draft available from: http://siteresources.worldbank.org/UKRAINEEXTN/Resources/wages_in_ukraine_eng.pdf, accessed 20 September 2011. State Statistics Committee of Ukraine (SSCU) (2011), State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. UNCTAD, (2010), World Investment Report, UNCTAD, Geneva. UNCTAD, (2011), World Investment Report, UNCTAD, Geneva. Voigt, S. (2009), “The Effects of Competition Policy on Development. Cross-Country Evidence Using Four New Indicators”, Journal of Development Studies, Vol. 45, No. 8. World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. World Bank (2010), World Development Report, Washington, DC. World Bank (2011), World Development Report, Washington, DC. World Trade Organization (2010), International Trade Statistics, WTO Publications, Geneva. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 51 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 3 2011 OECD Investment Policy Review of Ukraine – Key findings This chapter summarises the key findings of the Investment Policy Review of Ukraine. Based on the OECD Policy Framework for Investment, it assess the country’s ability to comply with the principles of liberalisation, transparency and non-discrimination and to bring the investment agenda closer to recognised international standards. The chapter provides first general investment policy recommendations and secondly suggests some measures to improve the business climate. 53 II.3. 2011 OECD INVESTMENT POLICY REVIEW OF UKRAINE – KEY FINDINGS T he general objective of the OECD Investment Policy Reviews is to facilitate dialogue between OECD and partner countries, share experience and support investment policy reforms. The work on Ukraine’s Review has been carried out in close cooperation with the Ukrainian authorities, in particular the Ministry of Economic Development and Trade. The draft Review prepared by the OECD Secretariat in cooperation with the Ukrainian authorities, notably the Ministry of Economic Development and Trade, was examined by the Investment Committee’s Advisory Group on Investment on 22 March 2011 at the OECD headquarters in Paris. The final version of the Review published in the OECD Investment Policy Review series in July 20111 reflects discussions during this meeting and OECD delegations’ subsequent written comments. The Review assesses the country’s ability to comply with the principles of liberalisation, transparency and non-discrimination and its policy convergence with recognised international investment standards such as the OECD Declaration on International Investment and Multinational Enterprises. Based on the OECD Policy Framework for Investment, the Review also analyses the interaction and coherence of Ukraine’s investment policy with other areas such as investment promotion and facilitation, trade and competition policy and responsible business conduct. In addition, a separate chapter addresses Ukraine’s specific challenge to attract investment in support of energy efficiency. Ukraine’s foreign direct investment (FDI) inflows, which were strongly affected by the economic crisis in 2009, picked up in 2010 but remain below pre-crisis levels. Financial services and manufacturing together absorb almost two-thirds of the total inward FDI stock. EU27 countries are the main source of Ukraine’s inward FDI, representing over 75% of the total stock. Foreign investors have participated in a number of privatisation deals, in particular in the metallurgical sector in 2005, but the privatisation process has stalled in recent years. The 2010 government reform programme stresses the contribution of foreign investment not only as a source of external financing but also as a market-transformation and competition-enhancing tool and encourages increased participation of foreign investors in the revamped privatisation process (see Chapter 1 of the Review). Ukraine’s legal framework forinternational investment embodies the principle of non-discrimination against foreign investment and general provisions on foreign investment protection. These include protection against nationalisation and changes in relevant legislation as well as guarantees for compensation and the repatriation of profits. All categories of investment are subject to the same establishment procedures, notably state registration, business permits and licensing. Notwithstanding this equal treatment, new foreign investors – usually less familiar with local practices than incumbent firms – 1 More information about OECD Investment Policy Reviews and Ukraine’s Review is available at www.OECD.org/daf/investment/countryreviews. Ukraine’s Review was prepared by Blanka Kalinova and Stephen Thomsen, Senior Economists in the Investment Division of the OECD Directorate for Financial and Enterprise Affairs (DAF) and Wojciech Paczynski from the Center for Social and Economic Research (Chapter 4). 54 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.3. 2011 OECD INVESTMENT POLICY REVIEW OF UKRAINE – KEY FINDINGS have often been discouraged by complex, protracted and costly procedures and resulting regulatory uncertainty. The government’s recent efforts to streamline administrative procedures should be pursued vigorously. Ukraine applies several trans-sectoral and sectoral restrictions on foreign investment, which qualify for the list of exceptions to national treatment and measures reported for transparency in the meaning of the OECD Declaration on International Investment and Multinational Enterprises. FDI is prohibited in unspecified strategic sectors and territories in cases where foreign capital would lead to Ukraine’s “critical dependence on the business cycles of international markets” or “jeopardise its economic independence”. According to the 1992 privatisation law, legal entities in which more than 25% of equity is owned by a state cannot participate in the privatisation of state and municipal property. Defining clearly the scope of “strategic” sectors closed to foreign investors or subject to authorisation procedures would considerably reduce legal uncertainty concerning foreign investment in these sectors. More generally, while safeguarding its essential national security interests, the country’s policy should be designed and implemented to ensure the smallest possible impact on investment flows and be guided by the principles of non- discrimination, proportionality, transparency and accountability as recommended in the OECD Guidelines for Recipient Country Investment Policies relating to National Security. The moratorium on foreign ownership of agricultural land, prolonged until 2012, is perceived by foreign investors as a significant limitation on their activities especially given additional bottlenecks such as the absence of a unified registration system for land and real estate. As part of its WTO accession commitments, Ukraine has opened a number of sectors to foreign investment, including transport, telecommunications and banking. Several remaining restrictions, notably on providing insurance services by direct branches of foreign insurance companies and a 30% limit on foreign ownership in the wholesale trade of books, magazines and newspapers, have to be eliminated within 5 years of the country’s WTO accession, i.e. by May 2013. Several other measures would qualify for the list of measures reported for transparency under the OECD Declaration on International Investment and Multinational Enterprises, notably public monopolies, specifically in energy transport and distribution, railways and local telephone communications. Taking into account the existing statutory FDI restrictions, Ukraine’s score under the OECD FDI Restrictiveness Index is higher than the OECD average but lower than the average of non-OECD countries covered by the FDI Index. Ukraine’s relatively favourable performance with respect to the formal FDI restrictions captured by the OECD FDI Index contrasts with a poor perception of its investment climate in most international comparisons, which assess actual implementation of existing laws and regulations (see Chapter 2 of the Review). Based on the OECD Policy Framework for Investment, which evaluates various policies relevant for the country’s investment climate, Ukraine has made progress in several important areas such as investment facilitation and promotion, trade and competition policies. But more remains to be done to create a favourable investment environment (see Chapter 3 of the Review). General transparency in terms of access to investment-related information has improved, but public consultations and public-private dialogue have not yet been generalised. Investment policy implementation continues to suffer from a lack of regulatory transparency due to frequent changes in legislation, the complexity of existing measures and the absence of, or delays in issuing, implementing regulations. This allows too COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 55 II.3. 2011 OECD INVESTMENT POLICY REVIEW OF UKRAINE – KEY FINDINGS much room for administrative discretion and hence the possibility of corruption. Protection of intellectual property rights is probably one of the most critical areas where the gap between national legislation – generally in line with international standards – and its inadequate enforcement in practice is particularly harmful to foreign investment. Ukraine’s investment promotion activities have been subject to frequent reorganisations resulting in the multiplication of agencies often with overlapping responsibilities. It is essential that the new State Agency for Investments and National Projects, created at the end of 2010, and the restructured Council of Local and Foreign Investors become efficient tools for enhancing policy implementation in close association with the investment community. After its unsuccessful experience with Special Economic Zones (SEZs), Ukraine abolished the differentiated tax and customs regimes applied in SEZs in 2005 but it is now considering reintroducing a preferential investment regime in selected areas. The government’s commitment gradually to reimburse export VAT-refund arrears, which have constituted one of the major disincentives to firms’ operations and investment, is part of an ambitious tax reform package aimed at reducing the weight of taxes in business costs and improving tax management. Ukraine’s accession to the WTO in May 2008 has enhanced trade policy transparency and predictability. The country has concluded a number of free trade agreements, mainly with the countries of the former Soviet Union. Efforts to streamline border procedures and trade facilitation measures should be intensified, especially the introduction of electronic customs documents and procedures as well as the adoption of international technical standards and conformity certification procedures. In the area of competition policy, Ukraine has gradually put in place an appropriate legal and institutional framework. But the development of a competitive environment remains constrained by the size of the public sector, particularly the large number of public monopolies operated by state-owned enterprises, the scope of price controls and the pervasive system of licensing and business permits, which prevent the entry of new firms. Public policies promoting responsible business conduct, such as those embodied in the OECD Guidelines for Multinational Enterprises, contribute to attracting investment. However, both public awareness and responsible business practices, such as compliance with and reporting on environmental performance and management, are still less common in Ukraine than in other emerging economies. Corruption remains the key investment impediment and the main reason for the country’s poor ranking in available international business surveys. Recent delays in adopting new anti-corruption legislation have cast doubts on the authorities’ willingness to deal with this issue. Ukraine faces specific challenges in attracting the investment required to reduce its currently high energy intensity, increase its energy production and upgrade its deteriorating energy infrastructure (see Chapter 4 of the Review). Energy efficiency efforts and investment have been hampered by distortions in energy price setting and the energy market structure, which is dominated by state-owned firms. The June 2010 government economic reform programme addressed these critical issues and set objectives for accelerating the privatisation process in the energy sector and for gradually adjusting energy prices to market levels. Given that public financing will be unable by itself to cover the huge need for energy efficiency investment, implementing these reforms without delay is essential in order to attract private, including foreign, investment. 56 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 II.3. 2011 OECD INVESTMENT POLICY REVIEW OF UKRAINE – KEY FINDINGS Improving efficiency remains the main focus of Ukraine’s energy policy, but the importance of developing renewable energy resources should not be underestimated. In some cases, there are synergies between energy efficiency and environmentally-friendly energy production and technologies, for example in the case of heat production based on biomass and waste. Ukraine has developed a basic policy framework in support of environmentally-friendly energy resources and technologies, but in the absence of energy price reforms, the incentives for such investment have been limited. The government has an important role to play in promoting both public awareness and corporate initiatives aimed at improving the measurement and reporting of environmental performance. The Review shows that Ukraine has made progress in developing a legal framework for attracting FDI, but implementation problems continue to affect domestic and foreign investors alike and prevent the country from mobilising private investment commensurate with its economic potential and investment needs. Although necessary macroeconomic reforms are not expressly addressed in the Review, it is clear that they remain a prerequisite for putting the country firmly on the map of foreign investors. To encourage capital inflows, the country has to shore up its public finances and reform its fiscal system to support public and private investment, particularly in infrastructure. Proposed investment policy recommendations have to be a part of broader reforms that target public and private investment, including foreign capital, and which remove entry and exit barriers for all categories of firms. General investment policy recommendations include: ● Define the strategic sectors in which foreign investment is prohibited or subject to specific authorisation procedures; specify relevant authorisation procedures, including the conditions/documents required for applications and the deadline for reply to applicants by the responsible authority. ● Specify clearly the conditions for foreign participation in the privatisation process in the new law on privatisation currently under preparation and avoid leaving room for administrative discretion in selecting those sectors and firms excluded from privatisation. ● Observe the guiding principles of non-discrimination, proportionality, transparency and accountability in implementing investment measures related to national security, as expressed in the 2009 OECD Guidelines, and consider the formal acceptance of these recommendations. ● Make sure that the new law on investment currently in preparation confirms the non- discrimination principle for foreign investment. ● Implement the state e-registration system and continue to simplify business permit procedures, including applying the “declarative principle” as foreseen by the law. ● Abolish the moratorium on agricultural land ownership in 2012 as currently foreseen and accelerate the implementation of the unified registry of land and real estate property. ● Develop implementing regulations to make possible the rapid and effective application of the law on public-private partnerships. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 57 II.3. 2011 OECD INVESTMENT POLICY REVIEW OF UKRAINE – KEY FINDINGS Suggested measures to improve the investment climate: ● Develop public-private consultations on business-related legislation and regulations with the business community, including foreign investors, notably within the new Council of Local and Foreign Investors. ● Take into account the interests and concerns of foreign investors in small and medium- sized enterprises, which are particularly affected by frequent legislative and regulatory changes and related regulatory uncertainty. ● Consider setting up an ombudsman’s office to tackle concrete problems faced by new and established foreign investors in Ukraine. ● Ensure that the State Agency for Investments and National Projects established in December 2010 fulfils its main tasks in line with the planned schedule, notably the creation of the single window facility for foreign investors before 2012. ● Finalise refunding of VAT arrears and improve VAT administration as foreseen by the IMF agreement and the government’s plan. ● Carry out a thorough costs-benefit analysis before reintroducing preferential investment regimes in special economic zones and priority development territories. ● Promote public awareness and corporate initiatives aimed at improving the measurement and reporting of energy efficiency and environmental performance. 58 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 PART III Sector-specific analysis COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 4 Agribusiness This chapter provides an in-depth analysis of the agribusiness sector in Ukraine. Examining the demand and supply sides, it explains why agribusiness is promising for private domestic and foreign investors given domestic and global trends. It identifies the role that foreign investors could play along the value chain, including farming, processing and retail. It also presents key issues and policy barriers hindering competitiveness in the sector and proposes a prioritised list of policy recommendations. 61 III.4. AGRIBUSINESS Summary Agribusiness represents a comprehensive value chain that covers all aspects of agricultural production (e.g. farming, seed and other agricultural inputs, crop production, post-harvest handling, and animal husbandry), processing, and distribution (e.g. wholesaling, retail sales to final consumers) (FAO, 2010; OECD, 2008). World production, consumption and trade of agricultural products are expected to increase sharply over the coming decade. This trend will be driven by non-OECD countries. On the demand side, strong income growth in emerging economies will boost demand for a wide variety of agricultural products and processed foods. Slow but steady convergence with the food demand patterns of developed countries will require higher attention to quality standards, health, and variety. On the supply side, the main trends are likely to be the concentration of operators at all levels of the value chain (production, processing, distribution), and increased concerns over food security. Emerging economies are forecast to develop their domestic production capacities (OECD/FAO, 2010), both through improved productivity and through better utilisation of available arable land. Increased production capacity will satisfy domestic demand and increase exports of commodities and processed agricultural products. Ukraine has a significant opportunity to further strengthen its already important role in agribusiness. The country has more arable land (around 32 million hectares) than any other European country. Moreover, Ukraine enjoys an abundance of black soil, which is very fertile and offers potential for high agricultural yield. Climatic conditions are favourable to the production of most agricultural products in different areas of the country. Other sources of competitiveness include the country’s long tradition in agriculture and low labour costs. Since the country’s independence, agriculture’s contribution to total output has been volatile. Its share of GDP increased in the 1990s, while non-agricultural industries contracted, but fell back sharply when non-agricultural sectors recovered. In 2009, the share was still higher than 8% (World Bank, 2011) and agribusiness accounted for 25% of total exports. The global context and the country’s endowments could open a wide range of opportunities for domestic and foreign investors. The expected rise in prices for agricultural products in real terms could also make this sector more attractive to private investors. Foreign agro-food companies investing in emerging economies could play a significant role by improving productivity while implementing the highest food safety and regulatory standards, allowing access to developed country markets such as the European Union. However, the Ukrainian agribusiness sector still faces a number of challenges. Some of them derive from the general approach of Ukraine to investment policy. For example, the issues of restrictions on land ownership are rooted in an unfinished land reform, and in the moratorium on sales of agricultural land, expected to end in 2012. Similarly, the quotas on grain exports introduced in 2010-11 relate to the more general issue of export-restricting measures during periods of global commodity price increases. Other challenges are more 62 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS sector-specific. The productivity level is still low for many agricultural commodities, and the quality of products is still not up to the standards of neighbouring markets, therefore impeding high-quality exports. Quality is certainly affected by the limited availability of funds, which ultimately hampers both operational activities, such as the purchase of seeds and fertilisers, and capital expenditures, for example on storage facilities and modern harvesting equipment. Another aspect which has an impact on quality is the set of knowledge, skills, and abilities in the fields of agronomy and agro-management. At the moment this human capital is only partly aligned with demand from the agribusiness companies. The government could intervene in a number of policy areas in order to leverage the country’s endowments, make the agribusiness sector more competitive, and ultimately attract more investment. Improving access to finance could be a tool to empower the private sector and facilitate the improvement of the quality of output. The private sector will also benefit from a set of reforms in the human capital field aimed at improving the technical skills of the labour force and aligning them with market demand. The proposed recommendations also include improvements in safety and quality standards, the lifting of the present land sale moratorium and the amelioration and upgrading of infrastructure. In order to focus the government’s efforts on specific actions, a prioritisation of agricultural sub-sectors was carried out, based on an analysis of demand and supply. This prioritisation led to the identification of two pilot sub-sectors for reform efforts: the grain and dairy value chains. The next two chapters of this publication offer an in-depth analysis of these sub-sectors, along with specific policy recommendations. Sector definition and segmentation Agribusiness can be defined as a value chain that includes all aspects of agricultural production, processing and distribution and spans a number of industries. The FAO (2010) defines agribusiness as “collective business activities that are performed from farm to fork.” Agribusiness refers to the supply of agricultural inputs and agricultural production upstream, and downstream business activities such as storage and distribution of agricultural products to final consumers (FAO, 2010; OECD, 2008). Agribusiness refers to the sum total of all operations involved in the production and distribution of food and fibre. All operations in the agribusiness supply-chain can be grouped into five major segments: agricultural inputs, primary agricultural production, primary processing, food processing and production, and distribution and retail (Figure 4.1). ● The agricultural inputs segment covers producers and suppliers of seeds, fertilisers, agricultural chemicals, tools and agricultural machinery and technologies for crop cultivation and animal breeding. ● The primary agricultural production segment includes activities such as cultivation of food and non-food crops, animal husbandry and includes such sectors as grains, oilseeds, meat, dairy, fish and horticulture. ● Primary processing comprises basic processing of agricultural commodities, such as milling and crushing, as well as handling and delivery of produce that does not require further processing (such as fresh fruits and vegetables) through various distribution channels. ● The food processing and production segment covers companies engaged in deeper processing of agricultural crops and production of food. Products include meat, poultry, bread, snacks, beverages, and frozen food. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 63 III.4. AGRIBUSINESS Figure 4.1. The agribusiness supply-chain A simplified example of the supply-chain Up-stream Middle-stream Down-stream Distribution Agricultural Agricultural Primary Food and inputs production processing production retail Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. ● The distribution and retailing segment covers the operations of wholesale, retail and food service companies. The organisation of the value chain and the links between these segments vary widely between segments of the industry. For example, food processing firms are integrating backward to primary production as well as forward to retail distribution, while a number of large multinational suppliers of seeds, feeds and fertilisers are well diversified in product processing and distribution. However, the scope of co-operation and integration and the nature of relationships differ between the various levels of the agro-industry value chain. Agribusiness connects agricultural producers and consumers by processing, transporting, marketing and distributing agricultural and food products. Thus, a robust agribusiness sector can stimulate the development of agriculture, and create positive spill- over effects on other sectors such as logistics or the chemicals industry, and ultimately economic development overall (World Bank, 2007). Global trends World production, consumption and trade of agro food products are all expected to increase sharply over the coming decade and this trend will be driven by non-OECD countries. In emerging economies, strong income growth will boost food demand and imports of a wide variety of agricultural products and processed food. Slow but steady convergence with the food demand patterns of developed countries will increase pressure to develop domestic production capacity further. This will open a wide range of opportunities for domestic and foreign investors. The expected rise in prices for agricultural products in real terms might also make this sector more attractive to private investors. Foreign companies operating in emerging economies could play a key role by implementing the highest food safety and quality standards, thus allowing emerging country products to access developed country markets such as the European Union. World demand growth will be driven by emerging economies World consumption and trade of agricultural products will expand rapidly over the coming decade (OECD/FAO, 2011). Emerging economies will lead and stimulate the growth of agricultural consumption and international trade. This faster pace of consumption growth is mainly driven by rising per capita incomes, expanding populations and urbanization (Figure 4.2). 64 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.2. Consumption of crop and livestock products to increase more rapidly in non-OECD countries OECD Non-OECD World % Projected compounded annual growth rate of world consumption of key crop products from 2009 to 2020, % 0.030 0.025 0.020 0.015 0.010 0.005 0 Wheat Coarse grains Rice Oilseeds Protein meals Vegetable oils % Projected compound annual growth rate of consumption of livestock products from 2009 to 2020, % 0.035 0.030 0.025 0.020 0.015 0.010 0.005 0 Beef and veal Pigmeat Poultry meat Fresh dairy Butter Cheese products Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. World agricultural production growth should be driven by emerging economies as well World agricultural production has been growing steadily during the last four decades; for example, over the 2001-10 period, global agricultural production grew at an annual average of 2.6% (OECD/FAO, 2011). This was made possible by advances in technology and policy improvements. In crop growing, for example, increased usage of irrigation and fertilisers as well as improved crop varieties have been the main factors behind rising cereals yields. The average global yield of cereals grew from 1.49 tonnes per hectare in 1964 to 3.51 tonnes per hectare in 2008, an increase of 135%. Agricultural production in emerging economies has been growing faster on average than in OECD countries. Between 1960 and 2001, the production growth rate averaged 3.4 to 3.8% per annum, which was more than double the average growth rate in developed economies (FAO, 2006). Over the coming decade, emerging economies are expected to increase their production at a faster pace (Figures 4.3 and 4.4). COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 65 III.4. AGRIBUSINESS Figure 4.3. Agricultural production growth over the last decade was driven by non-OECD countries Production growth comparison for key agricultural commodities, 2003-10, in % OECD countries Non-OECD countries 1.0 0.8 0.6 0.4 0.2 0 -0.2 ilk at er ce ds ls ils al t t r se er ns ea ea t te ea ve he wd wd Ri ee M eo ai ee m gm Bu m gr W d Ch ls po po bl tr y an Pi Oi ein se ta ilk ilk ul ef ge ar ot Po m lem Be Co Ve Pr im ho Sk W Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Figure 4.4. Agricultural production in non-OECD countries to grow at a faster pace than OECD countries Compound agricultural production growth rate, 2010-19 World OECD Non-OECD 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 at l ef ce t t ilk se er ns ds r er ls r ea ea ea t te ga oi Be he wd wd Ri ee M ai ee m m m Su Bu le gr W Ch ls po po n g tr y ab Oi ei Pi se ilk ilk et ot ul ar g Po m m Pr Co Ve im le ho Sk W Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Emerging economies are beginning to resemble OECD countries in their food purchasing patterns Emerging economies, especially middle-income ones, seem to be following the food purchasing trends associated with OECD countries. A USDA analysis of food expenditures across 47 countries indicates that over the last 20 years, food expenditures for high value- added products and packaged food in developing economies have been converging with those in the developed countries (Figure 4.5). This movement reflects food consumption growth in 66 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.5. Demand for high value added products in modern retail outlets grows as incomes rise Share of packaged food in total food expenditure Share of food sales in standardized retail outlets Lower middle-income Upper middle-income Sample of OECD countries 0 25 50 75 100 % Note: Sample of OECD countries includes Canada, USA, Australia, Japan, France, UK, Germany, Netherlands, Austria, Belgium, Finland, Greece, Italy, Spain, Sweden, Denmark, Ireland, Portugal; upper middle-income countries include Czech Republic, Hungary, Poland, Chile, Mexico, Malaysia, South Africa; lower middle-income countries include Brazil, Colombia, Peru, China, Indonesia, Philippines, Thailand, Algeria, Egypt, Jordan, Morocco, Tunisia. Algeria is excluded from the survey of packaged foods. Source: USDA (2008), Convergence in Global Food Demand and Delivery, USDA Economic Research Service, Washington, DC. middle-income countries, primarily driven by income growth (USDA, 2008). Growing incomes allow consumers to shift away from carbohydrate-rich products toward healthier but more expensive foods such as meat and dairy as well as fresh fruits and vegetables. This convergence trend has important implications for private domestic and foreign agribusiness investors (Box 4.1). The majority of the food basket in middle-income countries still consists of intermediate food products with lower added value, such as cereals, dry Box 4.1. Defining “convergence” in food demand patterns The term “convergence” implies dynamics, or movement toward some common outcome. Convergence has been defined and examined most often as convergence in income levels. Barro and Sala-i-Martin (1992) defined beta convergence, in which the income growth of lower income regions or countries is faster than the world average and that of high-income regions is slower. The faster growth rates imply that lower income regions will even-tually “catch up” with higher income regions and all regions will reach a “steady state.” The concept of convergence has been applied to food expen-ditures to assess, for example, if income dynamics and market integration in the European Union are over-coming historical differences in preferences (Hermann and Röder, 1995; Gil et al., 1995). In food demand, the dynamics leading to convergence are driven primarily by income growth. It has long been recognised that diets change in predictable ways as incomes rise. For example Bennett’s Law states that the share of animal products in calories consumed increases as incomes rise (Bennett, 1941; Delgado et al., 1999). Recent research has highlighted how dietary upgrades in middle- and high-income countries include high-value products, in addition to meat (Regmi and Gehlhar, 2005). Generally, these changes in food consumption patterns include an increased demand for services and quality attributes, and are accompanied by the modernization of the retail sector (Reardon and Berdegué, 2002). Seale et al. (2003) demonstrate that lower income consumers make bigger changes in food expenditures as income levels change. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 67 III.4. AGRIBUSINESS Box 4.1. Defining “convergence” in food demand patterns (cont.) For example, an average consumer in the United States is expected to increase meat expenditures by 1% for every 10% increase in income. But, in a middle-income country such as Brazil, a 10% increase in income is likely to translate to a 7% increase in meat expenditures. As income-induced changes occur more rapidly in lower income countries, consumption patterns across countries trend toward convergence. The projected outcome is some universal “saturation” level of demand for food, including demand for higher quality food, which is achieved at high income levels. Source: USDA (2008), Convergence in Global Food Demand and Delivery, USDA Economic Research Service, Washington, DC. pasta, vegetable oils and other dried products. Rising demand for higher value-added food products will thus generate considerable opportunities for growth along the whole value- chain, including agricultural producers, processors, distributors, and modern retailers. Higher prices in real terms are expected, strongly influenced by dynamic global food demand The recent global recession together with high volatility of oil prices had a strong impact on non-oil commodity prices. Commodity prices fell sharply from the pre-recession highs of 2007-08, but they started recovering in 2010 (Figure 4.6). In 2011-20, real prices of all agricultural products are expected to be above their average 2001-10 levels, but below the recent levels of 2008-10 (OECD/FAO, 2011) (Figure 4.7). This is partly due to the fact that energy prices will remain high by historical standards and should increase further with global economic recovery. Figure 4.6. Price changes for selected commodities in 2005-10 Price index, 2005 = 100 Wheat Coarse grains Oilseeds Poultry meat Cheese 250 200 150 100 50 2006 2007 2008 2009 2010e Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Increasing requirements for food safety and standards to access developed country markets The role of standards and food safety has been growing over the last 20 years in developed countries. Stricter standards have been introduced by many governments over 68 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.7. Most commodity prices in real terms to remain above the last decade’s level Changes in % between projected real prices over 2011-20, and: i) 2008-10; ii) the last decade (2001-10) Base 2008-10 Base 2001-10 % 80 70 60 50 40 30 20 10 0 -10 -20 -30 Wheat Maize Rice Oilseeds Oilsee Veg. oils Beef Pigmeat Poultry Butter Cheese SMP WMP meals Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. the last decade and have placed primary legal responsibility for ensuring food safety on food operators. Private companies responded by implementing stricter public standards as well as developing their own standards. The introduction of various certification schemes for farmers, processors and producers in the entire agro-food value chain is a good example of the growing role of standards. The increasing role of food safety regulation in developed countries has several implications for developing countries (Box 4.2). First, it influences access to growing markets for agro food exports, particularly high-value fresh and perishable products such as dairy products: when standards are different, this can be an additional barrier for developing country exporters. Second, it has a “push” effect on food safety regulation in developing countries, by creating expectations among developing-country consumers regarding acceptable levels of safety. It can even determine best practice for regulations in developing-country food systems (IFPRI, 2003). Box 4.2. Food safety regulation in developed countries has implications for developing countries A demand for higher levels of food safety in developed countries Food safety is affected by the decisions of producers, processors, distributors, food service operators, and consumers, as well as by government regulations. In developed countries, the demand for higher levels of food safety has led to the implementation of regulatory programs that are intended to improve public health by controlling the quality of the domestic food supply and the increasing flow of imported food products from countries around the world. Countries regulate food safety through the combined use of process, product (performance), or information standards. For example, specifications for acceptable in-plant operations may be backed up with final product testing to monitor and verify the success of safety assurance programs. Labelling that instructs final consumers on proper food handling techniques may further back up these systems. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 69 III.4. AGRIBUSINESS Box 4.2. Food safety regulation in developed countries has implications for developing countries (cont.) A price of entry into developed country markets Stronger public health and consumer welfare emphasis in decisions by regulatory agencies. This leads to a focus on the food supply chain, on identifying where hazards are introduced into it, and on determining where those hazards can be controlled most cost effectively in the chain. This approach is referred to as “farm to table” or “farm to fork” analysis. When the supply chain extends across international borders, risk analysis may encompass farm or processing practices in developing countries. Adoption of more stringent safety standards, with a broader scope of standards. These evolving standards create continuing challenges for producers and regulatory agencies in exporting countries. Adoption of the Hazard Analysis Critical Control Point (HACCP) approach to assuring safety. Under HACCP, companies are responsible for analysing how hazards such as food-borne pathogens may enter the product, establishing effective control points for those hazards, and monitoring and updating the system to assure high levels of food safety. Since HACCP is primarily a process standard for company-level activity, inspection to assure compliance is challenging for imported products coming from plants in other countries. Increased reliance on certification, including traceability. In developed countries, regulatory systems increasingly require that safety assurance actions be documented internally by the company and externally to government agencies. The system may require documentation tracing a food product back through the supply chain to its source or forward through the chain to the consumer. For example, the European Union is moving forward with mandatory traceability for all food products. The quality control systems required by buyers (such as supermarket chains) have frequently moved faster in the direction of certification and traceability requirements than have government programs. Export of some regulatory responsibility and burden. HACCP and other certification approaches to food safety assurance are process oriented. Assuring compliance for imported products may require oversight and inspection of farms or plants in other countries. This has resulted in some exporting of regulatory responsibility and burden to other countries as the price of entry into developed country markets. Source: International Food Policy Research Institute (2003), Food Safety in Food Security and Food Trade, Washington, DC. The role of foreign investors along the agribusiness value-chain Growing demand for food and increasing globalisation of trade opens a wide range of opportunities for multinational companies in developing countries along the whole value chain, including farming, processing and retail. Inward FDI flows in agriculture were higher in developing countries than in developed countries over 2001-07. This seems to indicate the increasing attractiveness of developing regions and new market opportunities, namely in Asia and Oceania, Latin America and the transition economies of South-East Europe and the CIS (Figure 4.8). In developing countries, MNCs have increasingly focused on other segments of the value-chain, including trading, processing and retailing. Higher average profitability is a key reason. This is reflected in global FDI stocks, with agriculture accounting for a considerably smaller share than food and beverages (UNCTAD, 2009). 70 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.8. FDI stock in agriculture is rising in CIS countries and South-East Europe but it is much smaller than in Latin America and Africa Inward FDI stock in agriculture by region, 2001-07, billions of US dollars Average 2002-2004 Average 2005-2007 2 000 1 500 1 000 500 0 -500 Europe North America Other Africa Latin America Asia and CIS and developed Oceania South-East economies Europe Source: UNCTAD (2009), World Investment Report: Transnational Corporations, Agricultural Production and Development, United Nations Publications, New York and Geneva. Along the same lines, food manufacturers are adapting their investment plans. New strategies include geographic expansion in developing countries and a greater emphasis on product category management. This two-fold approach enables food manufacturing companies to become leaders in certain core product lines in different markets, including developed and developing countries. “Therefore, while manufacturer concentration is not evident at the global level for total packaged food sales, firm concentration may exist in specific product lines and regional markets. Firm concentration is particularly evident for those products where the manufacturer’s brands are popular, such as in soup, breakfast cereal, and baby food” (USDA, 2009b). US and European modern retail firms have expanded their presence in developing countries and small retail firms’ share has become increasingly smaller. The leading 15 global retail companies account for approximately one-third of world retailers’ turnover, which was around USD 4 trillion in 2008 on USDA estimates. Those firms benefit from cost advantages, due to economies of scale and the use of improved technology. Ukraine agribusiness sector at a glance Agriculture plays a significant role in the economy Ukraine’s excellent soil and favourable climate allow for large-scale production and export of agricultural products. Ukraine has over 40 million hectares of agricultural land, of which about 80% (around 32 million hectares) is arable (Figure 4.9). The country is home to over 16 million hectares of chernozem (“black earth”), a very fertile black-coloured soil with high content of humus and minerals, which produces high agricultural yields. Ukraine’s climatic conditions are favourable for growing grains and oilseed crops. Wheat is the most cultivated grain in Ukraine (Figure 4.10). It accounts for nearly half total grain production in volumes in 2008. Barley was the second largest grain produced, with more than 12.6 million tonnes (24% of the total grain crop) harvested over 4.2 million hectares (27% of total land under grains) in 2008. Corn is the third most important grain COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 71 III.4. AGRIBUSINESS Figure 4.9. Arable land in selected European countries, thousand square kilometres 350 300 250 200 150 100 50 0 Ukraine France Spain Poland Germany Romania United Kingdom Source: State Statistics Service of Ukraine, 2011; Central Intelligence Agency (CIA) (2009), The World Factbook 2009, Central Intelligence Agency, Washington, DC. Figure 4.10. Production of agricultural commodities in Ukraine, millions of USD, 2008 3 000 2 500 2 000 1 500 1 000 500 0 Wheat Cow milk, Sunflower Potatoes Indigenous Indigenous Hen eggs, Indigenous Barley Sugar Maize whole, fresh seed cattle chicken in shell pigmeat beet meat meat Source: FAOSTAT (2011), FAO Statistical Databases, http://faostat.fao.org, accessed 15 September 2011. crop. Ukraine is also a large producer of sunflower oil and rape seed: in 2008, it exported over 1.6 million tonnes of sunflower oil and was the largest exporter globally, ahead of Argentina, the Netherlands and Russia. The red meat and dairy sectors are also an important part of agriculture and agribusiness in Ukraine. Both sectors suffered severe declines during the transition period from the planned economy. The share of agriculture in the country’s GDP has been decreasing for most of the last decade and dropped from 17.1% in 2000 to 8.2% in 2009 according to the World Bank (2011) (Figure 4.11). Although this is a significant drop, it does not necessarily mean that agriculture is declining. Rather, it shows that other sectors are developing faster and that their contribution to GDP is becoming bigger. While Ukraine has an overall trade deficit, agriculture is a net exporting sector (Figure 4.12). In 2008-10, agro-food trade accounted for nearly 14% of the country’s external trade turnover (OECD, 2011). Agro-food trade expanded 72 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.11. Ukraine: Share of agriculture sector in GDP, 1999-2009 Agriculture % of GDP % 15 14 13 12 11 10 9 8 7 6 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 December 2011. Figure 4.12. Export structure of Ukraine, 2008 Agricultural and food products Fuels and mining products Manufactures 25% 25% 12% 62% Source: WTO, 2011, International Trade Statistics, Trade Profiles, http://stat.wto.org/CountryProfile/WSDBCountryPFView. aspx?Language=E&Country=UA, accessed 15 March 2011. particularly rapidly in 2010, driven by the depreciation of the hryvnia and the liberalisation of the border regime after accession to the WTO. Agriculture is still recovering from the transition years After declining in the 1990s, agricultural production rebounded and has grown for most of the last decade. Herd size and volumes of milk production declined in the first decade of independence. The cattle headcount has fallen sharply during the last two decades from 24.6 million in 1990 to 4.8 million in 2009. However, during the last five years gross output in the agricultural sector has showed robust growth. In volume terms, total agricultural production in 2009 was 80.7% of the volume in 1991. The horticultural sector has seen strong growth in the last decade, with production levels in 2009 reaching 11.1% above the level of 1991. However, livestock production has not fully recovered and by 2009 had only reached 56.8% of the 1991 level. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 73 III.4. AGRIBUSINESS The food-processing industry is developing rapidly The food-processing sector in Ukraine has grown rapidly over the past 5 years with an average growth rate of over 15%, largely driven by population and income growth (USDA, 2010). The food processing industry’s share in manufacturing is around 20%. In 2010, the industry’s total output was estimated at approximately USD 12 billion. Over 20 000 enterprises operate in the food processing sector. Production growth rates are particularly high in dairy processing, fruit and vegetable processing, edible oils production, pastry and biscuits, and in the production of alcoholic beverages. The Ukrainian food processing industry is forecast to be driven first of all by domestic demand, through production of dairy products, especially hard cheese and whole milk products. The potential for exports to former CIS countries (Russia, South-Caucasus, Central Asia) is also promising, especially for dairy products and beef. The growth of the food processing industry is currently impeded by inadequate domestic supply of raw agricultural products and limited export opportunities. A key obstacle is the lack of quality: only a few food manufacturers stick to EU quality and packaging standards (mainly dairy, meat, confectionery, and beverages). As a result, large food processors purchase raw materials and food ingredients directly from foreign exporters. Key issues and policy barriers to achieving Ukraine’s competitive potential requires an improvement in output quality and a rise in productivity. While the country’s natural endowments are impressive, the sector is held back by insufficient investment in capital equipment and inputs, low quality of output, gaps in technical and entrepreneurial skills, and frequent ad hoc interventions in trade by the government. Enhancing the competitiveness of the agribusiness sector will require aligning its standards to international benchmarks and improving the quality of its output. The experience of OECD countries shows that the government can play a pivotal role in this area, encouraging and monitoring quality. Improving processing and food safety control systems would allow Ukraine to produce and sell competitive high quality products. Foreign direct investment in the processing and retail segments could help to improve the overall level of quality of processed products (World Bank, 2008). Agricultural productivity needs to be improved and stabilised Agricultural productivity in Ukraine as measured by the value added per worker started to recover after a decade of declines in the 1990s and reached USD 1 375 in 2000 and USD 2 461 in 2009. Nevertheless, it is still lower than neighbouring Russia (USD 3 031), Belarus (USD 5 184) or Romania (USD 8 993) (World Bank, 2010). The performance of Ukrainian agriculture is still unstable, with large annual variations in the production of crops. For example, according to OECD/FAO, annual wheat production can vary by 30% or more (Figure 4.13). Low use of plant protecting products due to limited access to short term finance largely explain these variations. Dominance of household plots results in a lack of large-scale investment Lack of investment and slow technological improvements in the sector are partially due to the farm structure of Ukrainian agriculture (OECD, 2009). Commercial large-scale production provides approximately one-third of total agricultural output, while the remaining two-thirds comes from small family-type peasant farms and household plots. 74 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.13. Variation in production of selected commodities in Ukraine, 2006-09, index 100 = 2005 Wheat Coarse grains Rice Oilseeds 200 180 160 140 120 100 80 60 40 20 0 2006 2007 2008 2009 Source: OECD/FAO (2011), Agricultural Outlook 2011-2020, OECD, Paris. There are three broad types of agricultural production structures in the country: corporate farms, peasant farms, and household plots (Lerman et al., 2007). Corporate farms, which number around 17 500, are the successors to the former collective and state farms. They account for approximately 60% of agricultural land, and 40% of the country’s gross agricultural output. Some corporate farms are modern, reaching the productivity levels of developed countries. There are approximately 43 000 peasant farms accounting for 8% of agricultural land and 5-10% of gross agricultural output. Finally, there are roughly 5.3 million household plots, which account for 30% of agricultural land and almost half of agricultural output. Household plots are largely subsistence-oriented. In a survey conducted in 2005, Lerman et al. (2007) determined that the average household plot sold 21% of its output and consumed 48%, with the rest being stored and used as intermediate inputs. The corresponding shares for the corporate farms and peasant farms are 57/64% and 10/9%, respectively (World Bank, 2008). WTO membership provides an incentive to improve quality WTO membership has provided an additional incentive to improve quality, strengthen entrepreneurship and improve the regulatory framework. Ukraine became the 152nd member of the WTO in 2008. New import tariffs agreed within the WTO framework implied a significant reduction in protection for specific agricultural goods, including pork, poultry and sugar. Those sectors are now exposed to stronger import competition while domestic agricultural support is expected to be downscaled to respect the country’s international commitments. The regulatory system is currently burdensome (Box 4.3), with an overlapping of rules and complex administrative procedures. There is a need for harmonisation of domestic food safety controls with international standards. The current negotiations concerning a free trade agreement (FTA) with the EU could provide new opportunities for the agricultural sector to address the existing issues, creating additional pressure to be competitive in domestic and international markets. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 75 III.4. AGRIBUSINESS Box 4.3. Regulatory system of Ukraine Ukraine’s food safety system is implemented by various state agencies that often have overlapping functions. The following agencies are involved in assuring the safety of domestically-produced and imported food products, and animal and plant health issues: ● State Epidemiological Service (SES) of the Ministry of Health Care of Ukraine (MHCU) establishes food safety standards and is responsible for all aspects of food safety. ● State Department of Veterinary Medicine (SDVM) of the Ministry of Agricultural Policy of Ukraine (MAPU) is responsible for animal health, safety of meat, seafood and other products of animal origin. ● Main State Phytosanitary Inspection Service (MSPIS) of the MAPU is responsible for plant health issues. ● State Committee of Ukraine on Technical Regulations and Consumer Policy (SCUTRCP) is responsible for compliance of food products with existing quality and safety standards. ● State Ecological Inspection Service (SEIS) of the Ministry of Environment and Natural Resources of Ukraine (MENRU) is responsible for radiological and environmental control. Source: USDA (2009a), Global Food Markets: International Consumer and Retail Trends, USDA Economic Research Service, Washington, DC. Improvements are needed in the field of land ownership, quality standards, access to finance and human capital A first area of improvement is the completion of the land reform, which will lift the moratorium on land transactions, implement the unification and digitalization of the cadastre and title system, and design the appropriate institutions to supervise the land market. Asset ownership has played an important role in economic growth at the household level (Blanchflower and Oswald, 1998; Hoff, 1996). Poorly defined land tenure and the lack of ownership rights have restricted foreign investors’ involvement in the Ukrainian agribusiness sector. Furthermore, without asset ownership, small and medium- sized farmers lack the collateral needed to secure access to credit. Secondly, state support has created distortions. An evaluation of support to agriculture suggests that the Producer Support Estimate (PSE was 7% in the period 2008-10).* This is lower than the PSE estimated over the same period in Russia (22%) and the OECD average (20%), however it disguises the taxation of exported commodities and subsidies of imported products (OECD, 2011). There are significant disparities in protection among commodities. The share of the potentially most distorting types of support represented 84% of Ukraine’s * According to the OECD definition (OECD, 2000), “the PSE is an indicator of the annual monetary value of gross transfers from consumers and taxpayers to agricultural producers, measured at the farm gate level, arising from policy measures, regardless of their nature, objectives or impacts on farm production or income. The PSE measures support arising from policies targeted to agriculture relative to a situation without such policies – i.e., when producers are subject only to general policies (including economic, social, environmental and tax policies) of the country. The PSE is a gross notion implying that any costs associated with those policies and incurred by individual producers are not deducted. It is also a nominal assistance notion meaning that increased costs associated with import duties on inputs are not deducted. But it is measured net of producer contributions to help finance the policy measure (e.g. producer levies) providing a given transfer to producers. The PSE includes implicit and explicit transfers. The percentage PSE is the ratio of the PSE to the value of total gross farm receipts, measured by the value of total farm production (at farm gate prices), plus budgetary support.” 76 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS PSE in 2008-10 compared to 73% in 2005-07. In Russia it accounted for 81% of the PSE, while in the European Union it represented less than 30% of the PSE (OECD, 2011; OECD, 2009). A third important area of improvement is the alignment to international quality standards and the implementation of transparent and efficient quality controls. Tools which could ultimately improve quality are human capital development and access to finance. Although the region has a positive legacy of high attainment rates in tertiary education, there is a skills gap that affects both the public and private sectors. Farmers rarely have critical skills needed in a market economy, in areas such as financial literacy, farm management and organisation, and marketing. Technical professionals such as veterinarians lack training in updated animal health management practices. Government bodies, such as the ministries responsible for designing and implementing policies, often suffer from a lack of analytical capacity. With regard to the educational system, tertiary education does not deliver the technical skills demanded by the private sector. Specific actions would synchronise educational outcomes with the industry’s requirements. Also, in rural areas credit may be particularly rationed and access to finance for small and medium-sized enterprises (SMEs) is limited, due to lack of collateral, high interest rates and information asymmetries. Policy measures must support investment and entrepreneurship, mobilising financial resources through instruments such as credit guarantee schemes, supply chain financing and microfinance programmes. SMEs may also benefit from the introduction of leasing schemes, the establishment of futures markets for commodities and the development of insurance products tailored to agribusiness. Public private consultations and dialogue could accelerate the reform process During the assessment of policy barriers and the design of reforms, dialogue between the public and private sectors could bring productive interactions, ultimately accelerating the reform process. A free flow of information on policy issues needs to be encouraged, ensuring independent cooperation among the domestic and foreign private sector, the government and academia. Public-private consultations will also ensure that the reform design fits actual needs. However, consultations need to be transparent and to include small and medium-sized entrepreneurs, in order to avoid the reinforcement of vested interests and rent-seeking behaviour (Herzberg and Wright, 2006). Why focus on the grain and dairy sub-sectors In order to target the government’s resources and efforts, an analysis of agricultural sub-sectors was carried out in order to prioritise the selection strategy. The process was conducted in cooperation with the various stakeholders. The decision-making process included quantitative criteria to trace demand and supply trends in domestic and global markets, with data input from both the government of Ukraine and the OECD Secretariat. More qualitative criteria were also used, based on the inputs collected from the stakeholders and the priorities indicated by the government. The sub-sectors included in the analysis were grain, dairy products, beef, poultry, oilseeds and sugar beet. The consultation process led to the identification of two pilot sub-sectors for targeted interventions: grain and dairy. Both have strong existing production capabilities and benefit from favourable natural endowments, with favourable demand prospects in domestic and world markets. Also, interventions could upgrade the technological advancement of both sectors and strengthen specialised skills. The beef sub-sector was not identified as a focus for this phase of interventions, as the effort required to meet food and safety quality standards COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 77 III.4. AGRIBUSINESS and to bridge the technical skills gap would be significant. The oil seed sub-sector was not identified as a target, due to concerns raised during the consultation process over the environmental sustainability of this type of cultivation. Demand and supply overview According to the OECD/FAO, domestic consumption of oilseed-based commodities, dairy products, and beef products is expected to grow strongly (Figure 4.14). World trade in these products is also expected to grow rapidly, while grain trading volumes are also expected to increase significantly (Figure 4.15). On the supply side, raw milk and grain are Ukraine’s most significant agricultural products in value terms,). In 2008, production of both commodities exceeded USD 2.5 bn, as previously indicated (Figure 4.10). Figure 4.14. Domestic consumption status and outlook for key agricultural products CAGR of domestic consumption 2009-2018, % 12 Whole milk powder 10 Beef 8 Cheese Oilseeds Oilseeds Vegetable products oils Oilseeds 6 meals Butter Pork 4 Skim milk powder 2 Poultry Refined sugar Wheat 0 0 500 1 000 1 500 2 000 2 500 3 000 3 500 Domestic consumption in 2009, millions of USD Note: Domestic consumption value in 2009 is based on consumption volumes in 2009 multiplied by international average prices of the commodities in USD in 2009; expected CAGR 2009-18 of the domestic consumption is based on Ukraine consumption volume forecasts multiplied by the international trade prices in USD in years 2009 and 2018. Source: OECD/FAO (2009), Agricultural Outlook 2009-2018, OECD, Paris. Stakeholder consultations Climatic conditions are exceptional for grain growing Concerns were raised by stakeholders regarding the sustainability of the oilseeds sector in the short and medium term (Table 4.1). Oilseed crops in Ukraine exceed 30% of arable area, and they are planted every three years on average. Such frequency is close to the accepted agronomic limit for sunflower seed, making further increases in production hard to realise. Future increases in output could possibly be achieved through improved land productivity, but due to the current growing practices of Ukrainian farmers (who use limited amounts of pesticides and fungicides) yield improvement efforts would be undermined by soil exhaustion and soil-borne fungal diseases (EBRD/FAO, 2010). The grain and dairy sub-sectors both have potential to add value Stakeholders paid special attention to the potential of the different sub-sectors to expand deep processing. Both grain and dairy sub-sectors present opportunities to add value to primary commodities. 78 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.4. AGRIBUSINESS Figure 4.15. Annual world imports of agricultural products, status in 2009 vs. outlook in 2020 Projected growth of annual world imports in 2020, % 100 Butter Cheese 80 Pigmeat SMP Vegetable oils 60 Beef and veal WMP Poultry 40 Coarse grains Wheat Oilseeds High fructose 20 corn syrup Rice Protein meals Sugar 0 0 10 20 30 50 40 60 World imports in 2009, billions of USD Note: Annual world import values (in 2009 and in 2020) are calculated according to the following methodology: volumes * world prices in USD in nominal terms. Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Table 4.1. How are domestic agro-climatic conditions favourable to more intensive crop growing? Key natural endowment feature Grain-wheat, corn, barley Sugar beet Oilseeds Quality of climate + ++ + Quality and availability of soils ++ ++ –1 Water availability + + + 1. Agronomic and environmental limit is close to be reached under current farmers’ practices. Source: Ministry of Food and Agrarian Policy of Ukraine (2010), internal working document. In the grain sub-sector a first priority for Ukraine is to become a major producer and supplier of high quality grain for the domestic and global markets. It could then consider the possibility of moving up the value-chain into processed products, such as gluten and starch, for which there is a demand on the domestic market. In the dairy sub-sector, raw milk is rarely exported while processed dairy products are traded. The country has the opportunity to develop higher value-added products, such as pasteurised and branded milk, cheese and butter or milk powder, which are expected to grow significantly both in the domestic market and on a global scale. Bibliography Blanchflower, D. and A. Oswald (1998), “What Makes an Entrepreneur?”, Journal of Labour Economics, Vol. 16, No. 1. Central Intelligence Agency (2009), The World Factbook 2009, Central Intelligence Agency, Washington, DC. European Bank of Reconstruction and Development (EBRD) (2008), Transition Report 2008: Growth in Transition, EBRD, London. Food and Agriculture Organization of the United Nations (FAO) (2006), World Agriculture: Towards 2030/2050: Interim Report, Global Perspective Studies Unit, FAO, Rome. FAO (2010), Agribusiness Development, Rural Infrastructure and Agro-Industries Division, Agriculture and Consumer Protection Department, FAO, Rome, www.fao.org/ag/ags/subjects/en/agribusiness/ index.html, accessed 12 April 2011. 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World Bank (2008), Competitive Agriculture or State Control: Ukraine’s Response to the Global Food Crisis, World Bank, Washington, DC. World Bank (2011), World Bank Development Indicators, http://data.worldbank.org, accessed 15 September 2011. 80 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 5 Focus on the grain value chain This chapter provides an in-depth analysis of the grain value chain in Ukraine. Examining the demand and supply sides, it explains why the grain value chain is promising for private domestic and foreign investors given domestic and global trends. It identifies the role that foreign investors could play along the value chain, for instance in improving technology and supply-chain efficiency. It also presents key issues and policy barriers hindering competitiveness in the sector and proposes a prioritised list of policy recommendations. 81 III.5. FOCUS ON THE GRAIN VALUE CHAIN Summary The grain sector includes wheat, rice and coarse grains (corn, barley, sorghum, oats, rye, millet and other grains). Wheat, barley and corn represent 60% of the total area used for crops in Ukraine. The focus of this project is wheat, barley and corn, since these three products are complementary: they can be used in crop rotation schemes, thus helping to maintain soil fertility. Grain is processed in various products, both for human and non- human consumption. Typically, the grain value chain is composed of four stages: growing, milling for first grinding, secondary processing for production of basic food products like pasta or biscuits, and tertiary processing for more refined products such as sugar and bio- fuel. Grain waste can also be used as a primary input for biomass-based energy production. Market trends for the grain sector are driven by an expected increase in global consumption. World wheat consumption is projected to rise by around 1.1% annually during the next decade to reach 746 million tons in 2020 (OECD/FAO, 2011). The growth of grain demand will come mainly from non-OECD countries, largely due to increasing GDP per capita, rising feed requirements for fast-growing livestock sectors, and dynamic population growth. The main importers will be middle-eastern, African, and South-Asian countries. Food-security concerns will also increase, due to a combination of steadily rising demand and doubts about the availability of supply. As a consequence, prices are expected to increase, making the grain sector potentially more attractive for investment, both domestic and foreign. On the supply side, Ukraine, Russia and Kazakhstan have emerged as strong competitors to the USA and the EU27 as exporters of grain. Ukraine is already amongst the top five exporters of grain, while Ukraine, Russia and Kazakhstan have the potential to become the global leaders in the export of grains by the end of the decade. Ukraine has significant strengths and untapped potential that could allow it to further consolidate its leadership role as a grain producer and exporter. Its production costs are estimated to be about 50% lower than those of European producers like Germany. Moreover, Ukraine’s geographic position guarantees low freight costs for exports to neighbouring Western Europe, and to growing importers such as middle-eastern and African countries. Finally, the potential for productivity increases and the availability of unused arable land could lead to an increase in Ukrainian grain output by as much as 80%. Nevertheless, medium to low quality of grain and limited yields affect competitiveness. Low productivity is the result of limited use, especially by small and medium-sized farms, of high-quality inputs, and lack of investment in fixed assets, such as machinery and storage facilities. Difficulties in accessing finance are a main concern for small and medium-sized farmers, limiting their ability to invest in operational activities and in fixed assets. Several other policy barriers also hinder the competitiveness of the sector. The land sales moratorium has had an adverse impact on access to finance, since land is rarely owned and as a result cannot easily be used as collateral, and on foreign investments, since land cannot be purchased by foreign individuals or foreign companies. Trade policy is not consistent over 82 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN time, for example restrictions on exports were implemented during the global grain price rise in 2010, lifted in May 2011 and replaced by custom duties on grain exports in June 2011. The logistics infrastructure, including roads, rail, ports, and elevators is either obsolete or close to being fully utilised, and is thus a bottleneck for commodities trade. To improve productivity and raise the quality of output, access to finance has been selected as the prioritised area of intervention, as it can empower the private sector. It must be enhanced by fostering the development of instruments like supply-chain financing, leasing, and insurance to cover against risk. Easier access to finance will probably require the completion of land reform, as a prerequisite for the full usage of land assets as collateral. The alignment of the supply of human capital skills with the needs of the sector is a second area for improvement. Technical skills, financial literacy and entrepreneurship must be better tailored to the requirements of Ukrainian farmers. Another area for improvement is the introduction of institutional services, such as credit information services, collateral registration, and market information services. Finally, the improvement of trade policies is increasingly perceived as an essential condition for improving the attractiveness of the grain sector to domestic and foreign investors. The short- to medium-term strategy for the grain sector should be based on: ● Raising the quality of grain output. ● Improving productivity. ● Facilitating high-quality exports both from a regulatory and from an infrastructural point of view. ● Building and consolidating trade relationships with high-potential grain importing countries. ● Attracting foreign investments into deep processing. Sub-sector definition and segmentation Wheat and rice dominate the staple foods, while a significant share of maize production is for non-human consumption (Table 5.1). Corn and barley are complementary to wheat growing as they can be used in crop rotation schemes, thus helping to maintain fertility by growing in sequential seasons plants that draw different nutrients from the soil. Table 5.1. World grain production and harvest area, 2009 Area harvested (ha) Production (tonnes) Maize 159 531 007 817 110 509 Rice 161 420 743 678 688 289 Wheat 225 437 694 681 915 838 Other 162 105 324 311 587 032 Total 708 494 768 2 489 301 668 Source: FAOStat, FAO Statistical Database, http://faostat.fao.org, accessed 15 June 2010. Wheat can be used as an illustrative example to map the grain value chain. The wheat value chain is divided into four levels at which value is added. The four main stages are growing, first processing, second processing and third processing (Figure 5.1). Stage one is milling, the process of grinding the wheat into flour. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 83 III.5. FOCUS ON THE GRAIN VALUE CHAIN Figure 5.1. Example of the wheat value chain Stage 0 Stage I Stage II Stage III Growing First processing Second processing Third processing Grain Flour Gluten Bioethanol Straw Starch Pastas Bread Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. The growing stage covers the growing of wheat. Wheat can be grown on small-scale or large-scale corporate farms. Stage two refers to second processing, whereby raw materials are then processed into final products for the consumer (pasta, bread), as well as starch and gluten. The starch and gluten industry extracts starch and gluten from wheat and processes these into a number of products that can be used as ingredients and functional supplements in food or non- food applications. Stage three covers third processing and results in the production of sugar and bio-fuel. Ethanol production processes include grinding, cooking, liquefaction, fermentation and distillation. The starch-based mash goes into a liquefaction tank, where enzymes complete the conversion of starch into sugar. Using yeast, the sugars can then be converted to ethanol. Ukraine’s grain value chain is highly fragmented upstream Following independence in 1991, the animal husbandry sector suffered a decline, partly caused by the disappearance of farm subsidies. Diminishing herds freed up feed grains for export. But this surplus grain was exported only in limited amounts until the mid-1990s when state price controls and export restrictions, including export licenses and quotas, were reduced. Grain production has rebounded in recent years (Figure 5.2). Ukraine is a major producer of wheat and coarse grains (Figure 5.3) and it is among the world’s top exporters of both products (Figure 5.4). Wheat is the most cultivated type of grain in Ukraine, which produces 18-19 million tonnes of wheat per year (the average for 2006-07/2010-11 market years), and consumes around 11-12 million tonnes per year in the domestic market. The excess is exported to North Africa, the Middle East, the EU and Asia. In recent years, wheat exports varied from as little as 1.2 million tonnes in 2007-08 to the high of 13.0 million tonnes in 2008-09. Barley remains one of the main feed grains in the country and constitutes a sizeable portion of exports, most of which go to the Middle East, North Africa and Europe. Barley was the second-largest grain produced in Ukraine with more than 12.6 million tonnes (24% of total grains volume) harvested on an area of 4.2 million hectares (27% of the total under grains). Corn is the third most important grain, and it is widely used for domestic consumption in the production of mixed fodder for poultry and pigs. It is exported as feed to the Middle East, Europe and North Africa. Households and individual private farms contributed around 22% of grain production in 2009, according to the State Statistics Committee of Ukraine (SSCU). In 1990, their 84 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN Figure 5.2. Ukraine’s grain production has rebounded in recent years Example of wheat production, thousands of metric tonnes (mt), 1992-2010 30 000 25 000 20 000 15 000 10 000 5 000 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010e Source: For the series 1992-2009, data published by OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. The 2010 data point has been provided by the Ministry of Agrarian Policy of Ukraine. Figure 5.3. Ukraine’s production of wheat and coarse grains Production of wheat (left) and coarse grains (right), average over 2005-09, thousands of tonnes 160 000 350 000 140 000 300 000 120 000 250 000 100 000 200 000 80 000 150 000 60 000 100 000 40 000 20 000 50 000 0 0 27 ia an a li a li a a es da y e n 27 y es a il a ia o da a e in in in ke in in ke di di az Ir a ic ss ss at at ra ra na na st EU EU Ch Ch ra ra In In nt ex Br r r Ru Ru St St Tu Tu ki st st Ca Ca ge Uk Uk M Pa Au Au d d Ar i te i te Un Un Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. production accounted for nearly 3% of the total. However, their role has declined when compared with the period 2005-06 when they accounted for around 25% of grain output. In 2009, agricultural enterprises accounted for almost 78% of grain production. Currently the maximum land plot size that can be owned by one person is limited to 100 ha. A breakdown shows that more than half of the total number of agricultural enterprises operating in the grain segment sow an area smaller than 50 ha; firms operating on an area bigger than 1 000 ha are less than 10% of the total number of enterprises. At the same time, a process of consolidation and vertical integration is underway in which larger farms lease arable land from private households for a given number of years. In 2008, the largest 40 farms controlled 4.5 million ha or 13.6% of cultivated area (Lissitsa, 2010). The role and bargaining power of these large players along the value chain is significant. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 85 III.5. FOCUS ON THE GRAIN VALUE CHAIN Figure 5.4. Ukraine is amongst the top exporters of wheat and coarse grains Exports of wheat (left) and coarse grains (right), average over 2005-09, thousands of tonnes 30 000 60 000 25 000 50 000 20 000 40 000 15 000 30 000 10 000 20 000 5 000 10 000 0 0 Uk i a A r ine a ey an o a n a li a ia a es 27 da ia es 27 a e il da a a in in in in di in ric ric az Ir a ic l ss ss rk at at ra ra na na st EU EU Ch Ch ra In nt ra nt ex Br Af Af Ru Ru St St Tu ki st st Ca Ca ge ge Uk M Pa Au Au n h d d Ar ra ut i te i te So ha Un Un Sa of b- ic Su bl pu Re Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Global trends Grain consumption will grow steadily, driven by emerging economies Since 1980, wheat demand in non-OECD economies has grown from 50 million tonnes to 125 million tonnes. In the longer term, world wheat imports are expected to sustain an upward trajectory as increasing amounts of wheat are required to meet demand for staple food products in countries with low but rising incomes and expanding populations (Figure 5.5). Figure 5.5. Growth of world grain consumption is projected to be higher in non-OECD countries Wheat (left) and coarse grains (right) world consumption, past trends and projections, millions of tonnes OECD Non-OECD 600 800 500 700 400 600 300 500 200 400 100 300 0 200 2000 2005 2010e 2015f 2020f 2000 2005 2010e 2015f 2020f Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-20, OECD, Paris. Wheat imports by non-OECD countries are projected to increase by 2.1% per year to 120 million tonnes in 2020, representing 83% of global wheat trade, while aggregate coarse 86 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN grain imports by developing countries are projected to increase by 2.3% per year to 102 million tonnes, representing 71% of the global total (OECD/FAO, 2011). African, Middle Eastern and East Asian countries will be the fastest-growing wheat importers in the next decade. With the growing consumption of meat, and the resulting growth of the livestock sector, and increasing use of grains for production of bio-fuels, imports of barley and corn are also expected to increase over the next decade. Middle-eastern, European and Asian countries are expected to significantly increase their imports of corn and barley (Figure 5.6). Figure 5.6. Africa, Middle-East and East Asia will drive the additional grain imports over the coming decade Wheat imports in 2010 and projected additional wheat imports in 2020 (thousand tonnes) Projected additional wheat imports in 2020 (th tonnes) 7 000 Sub-Saharian Africa 6 000 5 000 4 000 3 000 Pakistan Egypt 2 000 South Brazil Africa Saudi Arabia 1 000 India Bangladesh United States Algeria 0 Mexico China Iran Turkey Korea Japan –1 000 Malaysia EU27 Russia –2 000 0 2 000 4 000 6 000 8 000 10 000 12 000 Imports of wheat, 2010 (th tonnes) Coarse grains imports in 2010 and projected additional coarse grains imports in 2020 (thousand tonnes) Projected additional coarse grain imports in 2020 (th tonnes) 4 000 Saudi Arabia 3 000 Egypt 2 000 Iran China Turkey EU27 1 000 Chile Sub-Saharan Africa United States Malaysia Mexico 0 Algeria Canada Korea Brazil –1 000 Japan –2 000 0 5 000 10 000 15 000 20 000 Imports of coarse grains, 2010 (th tonnes) Source: OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-20, OECD, Paris. Ukraine has become an important wheat exporter, although quality remains an issue The traditional five largest wheat-exporting nations (USA, EU, Australia, Argentina, and Canada) accounted for 77% of world trade in 2001-10, but Russia, Kazakhstan and Ukraine are expected to increase their wheat export share. These CIS countries have become significant wheat exporters in recent years with a combined world market share of COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 87 III.5. FOCUS ON THE GRAIN VALUE CHAIN about 18%. Over the last decade, wheat yields rose by 32% in Russia and 25 per cent in Kazakhstan, compared with average yields in the nineties, while Ukrainian yields also rose slightly (USDA, 2010). In these three countries export growth has been driven by improved production, generated by the rise of large, vertically-integrated farming operations actively pursuing better agronomic and management practices (OECD/FAO, 2011). By 2020, CIS countries could account for around 30% of world wheat exports. Although low-quality food wheat is a feature of CIS production, importers have compensated by using food additives that enable bread to be baked from low-quality grain (OECD/FAO, 2011). However, wheat quality is an important differentiating factor when determining price on the global market. Protein content and other quality factors determine the type of wheat and its respective end-use by millers and bakers. In an increasingly competitive world market, the OECD experience shows that diversifying production into high-quality grain exports has proved to be important in maintaining a competitive advantage (Box 5.1). Box 5.1. Diversifying into high-quality grain: Australia’s best practice Australia is an important producer and exporter of grain: over 2005-10, it accounted for an average of 10.4% of global wheat exports. Rather than processing domestically, the country has diversified its strategy and specialised in exports of high quality grain; grains are sorted by quality and tailored towards the requirements of specific markets and final products which require different protein levels. Unprocessed exports account for 20.3 million tonnes out of a total of 31.3 million tonnes of domestic production, with only 3.8 million tonnes being processed domestically into food or higher value products. The remaining domestic consumption is used for seed or animal feed purposes. The Australian government has implemented a number of policy initiatives aimed at ensuring competition within the domestic supply chain and ultimately a high quality end product. Prior to the 1990’s, the major roles of grain marketing, storage and handling facilitation and rail transport were controlled by state-owned enterprises. Now, however, the majority of facilities are owned and operated by three private companies; CBH Group, ABB and Graincorp, which operate as natural monopolies in their respective ports. This deregulation culminated in the opening up of the wheat marketing function, previously controlled by the Australian Wheat Board which operated as a monopsony buyer from the three key bulk handling and storage companies and was the only legal seller of Australian wheat on the international market. The country has built an international reputation for clean, low moisture grain that produces high quality flour. The government supports this reputation through state- sponsored research and training facilities, providing best practices in grain production and farm management. Breeding programmes aim to increase resistance to environmental stresses such as salinity and aluminium toxicity. Australian grains are segregated based on protein content and quality, grain hardness and starch quality; this differentiation allows grain to be targeted to specific market demands and price discrimination to be implemented. Prices in real terms are expected to be relatively high, turning food security into a major concern The relative high price of grains in the coming decade should make this sector even more attractive for investment and possibly lead to an increase in foreign investment. By 2020, nominal wheat prices are expected to approach USD 240 per tonne, a price above 88 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN the historical average. In real terms, prices are expected to decline slightly, although they will remain at higher levels than in the past decade. While increasing in nominal terms, corn prices might reach USD 203/t in 2020, which would be much higher than the historical average; however in real terms, they are still heading for a decline (OECD/FAO, 2011). The growing concern about world food security and whether supply can keep pace with demand is an important development. In particular, the food crisis of 2007-08, with its dramatic spikes in global food prices, focussed attention on the need to address the issue of whether the current global food production system will be able to meet this challenge. At the national level, some countries have taken measures to address food security concerns, including through efforts to increase investment and productivity in agriculture, restrictions on exports or, in the case of food-importing countries, investments in overseas farming. Sources of competitiveness Favourable natural endowment has driven a long tradition in grain production In 2009, Ukraine harvested 27 million hectares of crops. According to the Ministry of Agrarian Policy and Food of Ukraine, wheat, corn and barley accounted for nearly 52% of crop area. Favourable endowments such as the black soil and the abundant water supply are partially offset by climate variability, which has caused volatility in output (Box 5.2). As over 95% of wheat grown in the country is winter wheat, which is planted in the autumn Box 5.2. Ukraine has favourable climatic conditions for grain growing Land Land quality is particularly well-suited to crop growth: ● 54% of Ukraine’s land area is covered with a 40-50 cm thick humus layer, which creates the extra-fertile “black soil” or Chornozem land. ● 80% of Ukraine is covered with a thick (5 m) layer of mineral-rich loess sediments that greatly improve the soil’s ability to grow crops. ● Topographically, the country is mainly flat with 95% of land consisting of plains (60% sloped less than 1 degree, 95% sloped less than 3 degrees). Climate Climate allows for diverse crops. Ukraine comprises three distinct climatic zones, which allows producers to vary crop growth across the country. ● The western regions are best-suited to crops that demand high humidity, specifically vegetables and spring grains. It is marked by mild temperatures (–3 to –6 degrees Celsius in January and below 18 degrees Celsius in July) and a high precipitation rate (over 600 mm of rainfall per year). The precipitation does, however, introduce the risk of sowing and harvesting delays. ● The conditions in the central and north-eastern regions are favourable for all kinds of grains. The region has a more continental climate (warmer summers, colder winters), with lower precipitation than the west. Colder winter temperatures and a lack of snow increase the risk of winterkill, while lower rainfall simplifies harvesting and sowing procedures. ● The southern regions are best-suited to winter crops, as the area is Ukraine’s warmest overall (average January temperature above –3 degrees Celsius). Summers, however, can get hot enough to introduce the risk of droughts. Source: BG Capital (2010), “Ukrainian Agriculture: Farming Fortune”, February 2010, BG Capital, Kyiv http://sintalagriculture.com/uploads/files/BG.pdf, accessed 15 March 2010. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 89 III.5. FOCUS ON THE GRAIN VALUE CHAIN and harvested in the summer of the following year, winterkill is a serious threat and during the last decade ranged from 2 to 65% of the total planted territory. Cost-competitiveness Ukraine’s average cost of production per tonne of grain is lower than its competitors. Low production costs on average result from low usage of inputs, low labour costs and a lack of proper accounting for depreciation of equipment. At the same time, yields are still relatively high thanks to the high quality soil (Figure 5.7). Figure 5.7. Grain production costs are competitive, while yield still offers opportunity to improve efficiency of production Wheat example, production costs and yields, 2008 Average cost of wheat production per hectare, US dollars, 2008 200 000 Average cost of wheat production per ton, US dollars, 2008 800 200 180 600 160 140 400 120 200 100 80 0 60 = United Brazil Romania Australia Russia Canada Ukraine Kingdom 40 X 20 Wheat yield, tons/ha, 2008 0 9 Canada Australia Brazil United Romania Russia Ukraine Kingdom 8 Conclusion 7 • Ukraine is competitive because Ukrainian farmers are producing grain 6 at a relatively low cost 5 • Relatively low yield in Ukraine still offers opportunity to improve efficiency of production, through better farm organization, mechanization, use of inputs 4 (chemicals) 3 2 1 0 United Romania Russia Ukraine Australia Canada Kingdom Source: Bidwells Agribusiness Bidwells website, www.bidwells.co.uk/agribusiness, accessed 15 May 2010; OECD/FAO (2009), OECD-FAO Agricultural Outlook 2009-18, OECD, Paris. On the distribution side, Ukraine has a dense railway network that covers all the regions, providing transportation of crops across the country and to sea ports. Railway freight costs are rather low in Ukraine, since railway transport tariffs are still state- controlled. Ukraine’s shorter distances and more developed transportation infrastructure provide significant cost advantages compared with its closest competitors and neighbours, especially Russia and Kazakhstan. Proximity to high potential grain importing countries further provides a transportation cost advantage to the Middle East, North Africa and the European Union (Table 5.2). 90 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN Table 5.2. Black Sea ports have a cost advantage for grain exports to middle-eastern countries Freight cost comparison for grain, 31 December 2008, USD per tonne Origin Argentina Australia Canada US PNW US Gulf EU Black Sea Destination Egypt – Alexandria 28 28 20 29 22 18 10 Morocco 20 17 17 13 13 Tunisia 23 22 23 16 12 Spain – Mediterranean 21 17 29 19 13 13 Pakistan 15 26 28 14 Source: International Grain Council (2009), Internal working document, unpublished. Grain production could increase significantly over the coming years Yields can be improved significantly Current production relies mainly on natural land fertility, leaving significant scope for improved agricultural productivity. Low yields are closely correlated with the low use of fertilisers and plant protection products. For instance, Ukraine currently applies only one- third of the fertiliser volume today that it used during the peak of agricultural productivity 20 years ago (Figure 5.8). Figure 5.8. Ukraine could apply more fertiliser to increase yields 2007 wheat yields vs. fertiliser use in selected countries Wheat yield kg/ha 9 Ireland 8 Germany 7 United Kingdom Sweden 6 5 Austria 4 Poland Slovenia 3 Ukraine 2 1 0 0 100 200 300 400 500 600 Mineral fertilizer use, kg/ha Source: BG Capital (2010), “Ukrainian Agriculture: Farming Fortune”, BG Capital, Kyiv, February 2010, http://sintalagriculture.com/uploads/files/BG.pdf, accessed 15 March 2010. In the last years of the Soviet Union, Ukraine exported around 16 million tonnes of wheat to the Union’s other republics. In contrast, the average export volume for the first half of the last decade was around 3 million tonnes, although exports increased in the second half to an average of 6.5 million tonnes. Assuming that wheat croplands remain at 7 million ha and reach historical high yields of 4 tonnes per ha, production would total 27-30 million tonnes with export potential of 15-18 million tonnes per year. For barley, Ukraine is already among the world’s largest exporters, ranking first in three of the last four seasons. If crop yields increase to 4 tonnes per ha, Ukraine would strengthen its leadership with export potential of 10-12 million tonnes per year. Corn also COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 91 III.5. FOCUS ON THE GRAIN VALUE CHAIN has the potential to double at least, which could make Ukraine one of the most significant exporters after the US, competing with Argentina and Brazil. Some arable land suitable for grain growing is still unused Between 5 and 7% of arable land could be returned to agricultural production, according to private sector estimates. Total sown area fell from 32.0 to 25.9 million hectares between 1991 and 2006, which represents a drop of 6.1 million hectares or nearly 20%. The decline can be attributed almost exclusively to a reduction in forage-crop area coincident with a sharp slide in livestock inventories. Total sown area has slowly but steadily increased again since then. However a number of factors could prevent some of this land from being returned to agricultural production in the near future, including: arable land intentionally left unplanted to replenish subsurface reserves; formerly drained land that has become unsuitable for cultivation; and the existence of unreported sown areas, used for household vegetable production and consumption. The role of foreign investors in the grain value chain Lease or acquisition of farmland Investing in Ukrainian farmland over the long-term could be profitable. Moreover farmland investors might also be encouraged by the inflation hedge that farmland provides, as land prices are still low, and the stable profile of investment returns. According to the FAO, FDI could contribute to greater food security over the coming decades, thanks to increased productivity, technological improvement, infrastructure development and increases in supply-chain efficiency. The FAO estimates that additional investments of USD 83 billion per year are needed if developing countries’ agricultural sectors are to meet the food needs of 2050 (Hallam, 2009). Grain marketing infrastructure To be aligned with the likely grain production increase, industry experts forecast that Ukraine might need to add additional storage capacity. Although domestic consumption of grain is expected to stabilise or even decrease in the short-term due to the population decline, export infrastructure will become of critical importance. This scenario may be affected by a rise in the consumption of grain to feed livestock and cattle, if the dairy and meat industries also grow during the forecast period. However, the development of these industries will take some time to offset the effect of the population’s decline on the domestic demand for grain. Grain exports could become a key driver of infrastructure development and foreign investors have a role to play. Grain export activity is dominated by approximately ten companies, half of which are large, international agricultural commodity traders (Table 5.3). Deep processing of grain As the grain industry grows and develops, Ukraine could consider moving into the deep processing of grain. For example, the adoption of advanced cracking technologies to extract gluten and starch (separation process) could be developed in the food and non-food industries. Products might include food ingredients providing texture, flavour, and preservatives to the final food product (e.g. glucose, dextrose, isoglucose), along with non- food products such as starch for the textile and pharmaceutical industries. 92 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN Table 5.3. Foreign companies are sizeable grain exports Top 10 exporting companies of wheat and barley, 2010-11 (9 months) Export volumes Share of exports Name of the company Residence (thousands of tonnes) (%) Nibulon Domestic 772.0 25.3 Suntrade/Bunge International 306.4 10.1 Kernel Domestic 249.5 8.2 UAC Domestic 181.4 6.0 Cargill International 140.3 4.6 Sema/Glencore International 137.0 4.5 Louis Dreyfus International 126.4 4.1 Alfred C. Toepfer/ADM International 87.3 2.9 Vitalmar Agro/Nidera International 60.0 2.0 Agro trade Domestic 32.6 1.1 Total 2 092.9 68.8 Source: Investment Capital Ukraine (2010), “Sector Primer Agriculture”, Investment Capital Ukraine, Kyiv. Large multinational firms can raise the funds and provide the technologies needed to establish such facilities. Deep processing of grain to produce starches and gluten is a capital- and technology-intensive process. Achieving a high extraction rate of proteins and vitamins from the wheat grain and a more complete processing of all parts of the kernel requires increasingly sophisticated production technology. Research and development (R&D) efforts and large initial investments in complex and technologically-advanced equipment would be required to build the necessary deep processing capacity. To attract foreign investments in deep processing of grain, Ukraine has two main advantages. On the one hand, it has access to low-cost grain supplies, since the procurement of raw materials is the main component of the cost of production. In addition, domestic demand for starch and gluten is significant. For instance, Ukraine imports around 80% of its domestic consumption of gluten and is a major importer of starch and gluten worldwide (Figure 5.9). Figure 5.9. Major importers of starch and gluten, millions of USD, 2007 700 600 500 400 300 200 100 0 Mexico Indonesia Malaysia Brazil Viet Nam Philippines India United Arab Ukraine Emirates Source: United Nations Commodity Trade Statistics Database (2007), 2007 International Trade Statistics Yearbook, United Nations Statistics Division, New York. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 93 III.5. FOCUS ON THE GRAIN VALUE CHAIN Key issues and policy barriers Lack of access to finance results in low input use and insufficient capital investment Ukrainian farmers face problems in accessing finance. Among 85 farms surveyed, 58% indicated that they did not have sufficient access to credit (Figure 5.10). The key problems with access to finance are high interest rates (cited by 76% of surveyed farms) and the absence of appropriate collateral (mentioned by 32% of respondents). Commercial interest rates typically range from 25 to 30% and banks usually expect 200 to 300% collateral, depending on the farm’s credit history and the perceived risk level. Figure 5.10. Percentage of farmers having difficulty in obtaining credit Short and long-term credit Only short-term credit Only long-term credit % 100 90 80 41 70 60 50 40 37 30 20 10 22 0 Source: OECD (2011), Country Capability Survey, internal working document, OECD, Paris. Limited access to financial resources hampers both the use of inputs and the increase in land productivity. For example, the amount of fertilisers used per ha of agricultural land in 2008 was 26 kg, compared with the European Union’s average of 83 kg. The price of fertilisers and pesticides is a major concern for farmers, particularly since they cannot use the land as collateral for borrowing. The land is not willingly accepted by banks as collateral since it is difficult to foreclose on land in case of default. The burdensome and ineffective legislative framework, which does not necessarily protect creditors’ interests, makes financial institutions even more cautious about lending, with detrimental effects on small and medium-sized farmers. The lack of adequate collateral or credit history is a significant constraint on small farmers’ access to credit from commercial financial institutions. Moreover, the global financial crisis has affected the balance sheets of local banks, which are still burdened with non-performing assets and are unable to focus on new lending. The Ukrainian government has therefore intervened to provide assistance to the agricultural sector during the crisis, supporting for example, interest rate reimbursement on loans and leasing schemes. The difficulty of obtaining long-term loans prevents farmers from investing in fixed assets such as harvesting or transportation equipment, new storage facilities and processing units. The lack of highly efficient modern agricultural machinery, especially harvesting equipment, remains one of the key impediments to improving grain yields (Figure 5.11). Lack of financing also means that farmers don’t have sufficient on-farm storage capacity. As a result, they are forced to sell shortly after harvesting when prices are the lowest. Large farms avoid many of these problems, as they have better access to finance. 94 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN Figure 5.11. Limited access to long-term loans results in very low use of agricultural machinery 2008 tractor use in selected countries, tractors/thousands of ha 300 250 200 150 100 50 0 ly nd m y d ce k ia ic e in an ar an bl It a tv do an la ra nm rm pu nl La Po ng Fr Uk Fi Re Ge De Ki h d ec i te Cz Un Source: FAOStat (2011), FAO Statistical Databases, http://faostat.fao.org, accessed 15 September 2011. Non-completion of land reform and moratorium on land transactions The process of land reform started in 1990 when private farms were allowed. The pace of reform was rather slow and there are still significant changes to be made in order to make Ukraine’s agricultural sector more competitive on a global scale. Around 72% of Ukraine’s arable land was privatised during the land reform, while the remainder is owned by the state. Private owners received their land following the restructuring of state and collective farms after the collapse of the Soviet Union. Trading of agricultural land is currently restricted by a moratorium included in the Land Code, although non-agricultural land can be sold. Ukrainian agricultural firms adapted themselves to this context by forming their own land banks. They purchased small firms that had consolidated land by signing lease contracts with individual small landowners. The average length of a lease contract is 7 years, while every 10 000 ha of bundled leases consists of approximately 2 000 individual contracts. Agricultural producers are unable to purchase the land that they lease. The moratorium probably benefits companies that are already present in Ukraine, since it restrains potential domestic and foreign investors. Quality standards are still an important issue The quality standards for grain products are currently not aligned with those of other markets, impeding the full exploitation of the grain sector’s growth potential on an international scale. The lack of equipment combined with limited use of fertilisers make the seeds more sensitive to weather conditions and parasitic diseases. Controls are inefficient and compliance procedures are often arbitrary as they are not applied in a transparent way. Responsibility for food control is fragmented across several ministries, with a multiplication of competencies and a lack of co-ordination. Private players bear most of the costs of compliance in performing the necessary tests and laboratory procedures. The legislative framework does not enforce strict controls over product safety and quality and has not been particularly helpful in promoting convergence with trading partners’ COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 95 III.5. FOCUS ON THE GRAIN VALUE CHAIN Box 5.3. Challenges faced by the current system of warehouse receipts for grain The introduction in 2002 of a system of warehouse receipts for grain was in part aimed at improving access to private credit resources by allowing grain producers to use grain as collateral for loans, or to sell, trade or use the receipts for delivery against financial instruments such as futures contracts. However, the system still faces a number of challenges that continue to limit farmers’ access to credit by undermining the trust of the financial institutions in the system, including: Lack of coherence in the legal framework Different laws give contradicting rules with regard to the rights, liabilities and responsibilities of each party to the single and double warehouse receipt (producer, warehouse, bank, etc.). Inadequate monitoring system Although private and independent mechanisms for verifying the quality and quantity of stored commodities exist, these mechanisms are costly for grain owners. In addition, verifying agents often have limited access to the state-owned storage facilities. No reliable performance guarantees Holders of warehouse receipts do not receive adequate compensation if the stored goods do not match in quantity or quality with what is specified on the receipt (due to either negligence or fraud). Ineffective futures exchange market Agricultural market operators cannot hedge effectively against price fluctuations using futures contracts due to the absence of a well-developed futures exchange. Although the government established an Agricultural Exchange, the latter cannot be considered an exchange in the traditional sense of the word. Rather, it constitutes a focal point for registering the Agrarian Fund’s contracts. The Agricultural Exchange’s activities are thus largely determined by the Agrarian Fund. Under these conditions, the exchange fails to attract private investors by limiting the liquidity of exchange contracts. Source: FAO/EBRD (2010), “Ukraine: Grain Sector Review and Public Private Policy Dialogue”, Report Series, No. 15, December 2010. standards, despite the incentives provided by accession to the WTO and the possibility of a free trade agreement with the EU. For instance, in 2008, the government approved the Plan of Priority Measures to meet Ukraine’s commitment within the WTO membership framework, which specifies tasks for ministries and agencies. However, there has not been any significant progress on a new legislative framework for quality standards and controls. Transportation and storage infrastructures are still a bottleneck and increase costs The competitiveness of Ukraine’s grain sector to a certain extent depends on the available storage and transportation infrastructure. In spite of significant improvements, the grain sector is still characterised by high post-harvest losses and high transaction costs. This results in low farm-gate prices and discourages further investment in agribusiness. Large farms that do not own elevators run the risk of losing crop quality or being compelled to sell their harvest at unfavourable prices. Improved infrastructure could reduce transportation and marketing costs, increase competition and attract further investment into agribusiness. 96 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN Exports of grains to global markets are hampered by the logistics and transport infrastructure, including roads, railways, storage and drying and port capacities. Roads in Ukraine do not have spare capacity to handle increased truck traffic. Transportation by rail is limited by the lack of specialised rolling stock. Ukraine’s storage capacity (approximately 30 million tonnes) is more or less sufficient to meet normal demand, but problems might arise in peak years. In the medium term, the capacity of Ukraine’s ports could limit the growth of exports of agricultural products (Figure 5.12). Figure 5.12. Cargo handling volume is near to maximum capacity of Ukrainian ports Capacity Cargo handling volume 35 30 30 28 25 20 16 15.8 15 14.8 15 10 6.5 6.4 5 2.5 2.2 0 Odessa Mariupol Ilychevsk Nikolaev Berdjansk Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Ukrainian ports continue to receive public and private investment and can currently handle around 24-26 million tonnes of grain exports per year, which is sufficient to accommodate Ukrainian, Russian and Kazakh grain exports. However this leaves little scope to meet higher demand, especially at peak times in the summer. State regulation of grain trade flows is detrimental to private investment Public interventions, such as grain export quotas, increase uncertainty in the market. For instance, rising food prices coupled with a poor harvest resulted in the imposition of export quotas by the government in 2006. The quotas for wheat, barley, maize and rye exports remained in force until 2008. As a result, grain exports dropped from 13.2 million tonnes in the 2005-06 marketing year to 3.7 million tonnes in 2007-08. The quotas policy implemented in 2010-11 resulted in lower revenues in the grain sector, but its impact on food price rises is uncertain (OECD, 2009). Activity on the domestic market was limited, and the execution of export contracts that had already been negotiated and signed was impeded. Processors encountered difficulties in purchasing inputs at prices that allowed them to make their products (flour, bread) and sell them at government-controlled prices (Box 5.4). Ukrainian farmers suffered considerable losses as a result of the increase in the spread between export prices and ex-warehouse prices for grain following the introduction of the quotas. In 2010-11, losses to Ukrainian agriculture were estimated by the private sector at over USD 1 billion. The negative impact on investment and liquidity in the agricultural sector still needs to be precisely estimated. Grain producers usually react to decreasing profitability by reducing investment. The restrictions may also be discouraging foreign COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 97 III.5. FOCUS ON THE GRAIN VALUE CHAIN Box 5.4. The 2010-11 grain export restrictions Grain export restrictions were implemented in Ukraine in the second half of 2010. The restrictions started with burdensome State Customs measures applied in ports of loading mainly for wheat exports in August-September 2010. Subsequently, official export quotas came into force on 19 October 2010 and remained in place until 30 June 2011. In late July 2010, additional grain testing was required by the State Customs Service at points of export. The official government objective for such measures was the accuracy and compliance with contract terms of each corresponding shipment, and the prevention of unregistered or grey market deals at a time when there were concerns over possible food grain shortages. This resulted in delays of cargo for up to 8 weeks. The restrictions applied mainly to wheat shipments, but other grains were also tested and delayed from time to time. On 18 October 2010, the Cabinet of Ministers of Ukraine signed Resolution #938 effective immediately setting export quotas for wheat, barley, corn, buckwheat and rye. Export license applications required certification of grain quantities that the applicant had at its disposal; these were issued by the Ministry of Agrarian Policy and Food. Lack of clarity and non-transparency characterised the process of quota distribution. In December 2010, the Cabinet of Ministers of Ukraine signed Resolution #1 182 changing the original export quota legislation. The new regulation extended the duration of the grain export quota regime until the end of March 2011 and increased the quantities of grain allowed. Similar to the previous round of quota distribution, market players reported unfair treatment and lack of transparency in the procedures. A majority of the grain export quota was awarded to Khlib Investbud, a trading division of a larger state-run enterprise, the State Food and Grain Corporation of Ukraine. As in the previous distribution, international and domestic grain trade representatives received either small shares or no share at all. On 2 April 2011, the Cabinet of Ministers of Ukraine signed Resolution #337 again extending the duration of grain export quotas until the end June 2011. This legislation increased the quantity of corn exports and left quantities of other grains unchanged. The grain export restrictions were lifted in May 2011 and replaced by custom duties on exports in June 2011. There appears to be an intention to maintain the role of Khlib Investbud, with government quotas or without them. On 16 March 2011, it was announced that Khlib Investbud had started a forward contracts campaign for the 2011 crop and intended to purchase 786 000 metric tonnes (mt) of wheat, 99 000 mt of rye, and 10 000 mt of buckwheat. Khlib Investbud was contracted by the Agrarian Fund to conduct state purchases of grains for the State Intervention Fund. According to the top management of Khlib Investbud, the company was signing forward contracts with Ukrainian farmers with the disbursement of payment as follows: 50% of contract value paid on signing; 20% paid just before the harvest; and the remaining 30% paid after the harvest. This scheme was aimed at providing farmers with the financing they need for the spring planting campaign. The Government of Ukraine put the Agrarian Fund (AF) in charge of providing agricultural producers with inputs (mostly fertilisers and fuel) at discounted prices. AF would provide a 10-15% discount on ammonium nitrate fertiliser and about 6.7% on fuel. These inputs were to be supplied by Ukraine’s largest fertiliser and fuel producers. Source: USDA (2011), “Ukraine: Grain and Feed Annual”, USDA Foreign Agricultural Service, Washington, DC, April 2011. investors, with some threatening to reconsider Ukrainian projects. The EBRD has also warned that the risks related to investing in Ukraine are increasing. In addition, the IMF required an improvement in grain market conditions and greater market transparency as 98 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN a condition for the release of the next tranche of IMF funds. Moreover, the recent grain trade restrictions could lead to WTO challenges. Support measures distort production and trade Producer support, measured using the Producer Support Estimate (PSE), was 7% in the period 2008-10, compared with 10% in 2005-07 (OECD, 2009; OECD, 2011).1 The share of this categorised as “most distorting” was 84% of the total in 2008-10. Payments based on commodity output (market price support, payments based on output) and payments based on input use (based on variable input use) accounted for around 70% of Ukraine’s PSE in 2010. Other market price support measures are also used, such as tariff protection, non- tariff regulation, direct state purchases and sales of agricultural and food products. Frequent changes in policies have an adverse effect on agricultural performance. For example, the list of commodities covered by state price regulations is updated frequently (EBRD/FAO, 2010), with a resulting lack of clarity and coherence ultimately affecting producers. Secondly, rules are not always transparent and unified, giving room for misunderstandings and contributing to an ineffective application of the interventions. The high involvement of the administration puts an additional burden on the activity of private companies. Another measure which has caused important distortions is the cancellation of VAT refunds for exporters, hurting the profitability of exporting companies and in particular that of small and medium-sized enterprises, which are unable to hedge themselves against these sudden changes in regulations. Even for companies that are still entitled to receive a VAT refund, the reimbursement procedures are burdensome and lengthy. There is a high level of arbitration and ineffective application of the measures, which is ultimately beneficial to a few oligopolistic players while interfering with the development of a competitive private sector. Policy recommendations Improving access to finance Broadening access to finance could be achieved by various means. One option would be the more widespread use of credit guarantee schemes, with a guarantee agency standing ready to reimburse lenders if the borrower fails to repay a loan, therefore assuming part of the risk of lending to famers.2 The sponsors could be international financial institutions, private investors or public agencies. In the case of bankruptcy, the sponsor would repay the amount of the loan covered by the guarantee, usually between 50 and 80%. Credit guarantee funds have become a fairly common practice in OECD countries, with Japan establishing its fund in 1931, followed by the Netherlands and Germany in 1951 and 1954, respectively. Since the 1990s, transition economies have started developing these instruments, with some success stories such as in the case of the Czech Republic. However, credit guarantee funds are not significantly developed in Ukraine yet. The OECD experience proves that this mechanism could support access to finance, especially for creditworthy SMEs. Another option could be the development of co-operative banks, which could channel community deposits to farmers in a more efficient way. Co-operatives could share equipment costs and pool assets to support organised services for their members. The Law “On Banks and Banking” of 2000 introduced the co-operative legal form in Ukraine. In 2002, the Law “On Credit Unions” established credit unions. Nevertheless, co-operative banks have not developed to a significant extent and those that do exist suffered during the COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 99 III.5. FOCUS ON THE GRAIN VALUE CHAIN financial crisis. In addition, the costs of establishment remain significant and there is a lack of structure at a national level. As a result, these institutions are much less common than in many other countries with strong agricultural sectors. Access to agricultural equipment and working capital could be improved through the support of leasing services. During the financial crisis the government allocated UAH 120 million to a leasing programme meant to support the purchasing of “domestically produced machinery and equipment for the agro industrial complex”.3 However, without detailed data, it is too early to assess the success and impact of this scheme. Agricultural machinery accounted for 13.2% of the total value of leasing contracts signed in the first quarter of 2011, for a value of UAH 168 billion, according to the Ukrainian Union of Lessors. Given the demand to replenish ageing agricultural and processing equipment, leasing clearly has considerable potential to provide farmers with reasonably priced and modern equipment. The Draft Law on State Budget for 2012 plans to further increase the leasing programme for farmers. Supply chain financing and receivables financing could be used to let other value- chain players fund working capital requirements or use account receivables as collateral for lending. Warehouse receipt programmes have been adopted since the late 1990s in Bulgaria and Kazakhstan and since 2002 in Ukraine, with the support of the EBRD and USAID. This mechanism allows farmers to store some of their harvest in a licensed warehouse and use it as collateral. The agricultural insurance market is still underdeveloped in Ukraine, as the sector is considered highly risky due to high exposure to weather variations and price volatility. Only 3.4% of cultivated area was covered by insurance contracts in 2007, according to the SSCU. Agricultural insurance could be pivotal to the modernisation of the grain sector, providing access to credit and encouraging best farming practices (IFC, 2010). The creation of a commodity futures market would enable commercial producers and consumers to offset the risk of adverse future price movements in the commodities they are trading. From a farmer’s perspective, the risk of price variation for both inputs (e.g. fertiliser) and outputs (e.g. grain) could be neutralised. An example of the multiple benefits associated with a futures market can be seen through the establishment in 2003 of the Indian Multi Commodity Exchange. This has grown to be the world’s sixth-largest commodities exchange: it enables participants along the agricultural supply chain to optimise their risk exposure. It reduces transaction costs to farmers who would otherwise have to trade through middle- men, improving price information through collation of national spot prices on an electronic database. A commodity futures market could also help to raise quality standards at the farm level by specifying standards as part of contracts. Completing the land reform Completion of the land reform could help to improve competitiveness and increase awareness of local opportunities among foreign investors. This would require further reforms, such as the unification and digitalisation of the cadastre system, and the end of the moratorium on land sales. According to the World Bank (2011), 95.8% of land owners have received state deeds proving their rights. However, there is no operational land cadastre yet, although it has been in development since 2004. A reliable cadastre system would constitute a guarantee underpinning real estate transactions and provide a reliable basis for negotiating long-term credit (Kozlowski, 1997). Its establishment could help to attract FDI, develop the real estate and land markets, improve access to finance for 100 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN businesses and improve the protection of ownership rights. It will also allow efficient farmers to expand and poor farmers to exit the market. The land administration system needs to be reorganised with appropriate institutions, avoiding the current overlapping of responsibilities. From a private business perspective, rules are a prerequisite but their predictability in the medium term is even more important to ensure visibility. Removing restrictions to grain trade Restrictions on the export of grain, including quotas, tariffs and other barriers, urgently need to be removed. Export duties can have a particularly negative effect on FDI and on trade liberalisation. In the first quarter of 2011, the Ukrainian government announced plans to scrap the grain export quotas set in 2010. However, in March 2011, it extended quotas for another three months. The quotas were finally removed in May 2011, but, in June 2011, were replaced by customs duties on grain exports. The unpredictability of these changes clearly affects the activities of farmers and traders. The design of an efficient and sustainable VAT refund system is another urgent priority. The problem has been extensively analysed by international organisations and academia, but there is a lack of commitment to address the issue and restore the transparency in the system (Legeida, 2002). Improving transport and storage infrastructure The current subsidy structure is inefficient and does not encourage farmers to innovate or follow best practices. Subsidies should be gradually phased out, with the cost savings being diverted into an infrastructure development programme. A 2010 FAO/EBRD programme report suggests several priorities for public infrastructure. The road system is in need of improvement in order to provide efficient access to ports. Railways also have scope for increased efficiency; for example there is a need for substantial investment in additional grain carriers to increase capacity. The current capacity of the country’s port infrastructure is sufficient to meet short-term demand requirements, thus increasing investment here should not be prioritised. Public infrastructure improvements provide dependable and low-cost connectivity in the national market, connecting producers with multiple purchasers. This increases competition, reducing regional monopsonies, and boosts farm profits, which in turn can act as a catalyst for private investment. At the farm level a rural development programme should be set up that actively includes the private sector, local authorities and communities in a bid to co-ordinate improvements in infrastructure. One such improvement could be a machinery pool that allows farmers to group together to share the cost and use of heavy machinery, which may not be justified on a smaller-scale farm. A marketing co-operative could co-ordinate farmers’ efforts to sell grain to processors. It could also help to ease transportation problems through methods such as shared trucking systems. Further, this could link farmers to the market who may currently be excluded as a result of the prohibitive costs to processors of collecting grain from individual producers. Competitive grant programmes could also be introduced to co-finance farm investments. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 101 III.5. FOCUS ON THE GRAIN VALUE CHAIN Notes 1. See Note 1, Chapter 4. 2. Legeida, N. (2002), OECD Glossary of Statistical Terms. “VAT Refund Crisis in Ukraine: Causes, Risks and Solutions”, Institute of Economic Research and Policy Consulting, www.ier.com.ua/files/ publications/Policy_papers/German_advisory_group/2002/Q18_eng.pdf, Kyiv. 3. The Cabinet’s Resolution dated 28 July 2010, No. 648, “On Adopting the Procedure for Use in 2010 of the Means of the Stabilisation Fund, Aimed at Purchase of Pedigree Heifers and Cows, Home-Made Machinery and Equipment for the Agro-Industrial Complex and Their Further Sale to Agricultural Enterprises on the Terms of Financial Leasing”. Bibliography BG Capital (2010), “Ukrainian Agriculture: Farming Fortune”, BG Capital, Kyiv, February 2010, http://sintalagriculture.com/uploads/files/BG.pdf, accessed 15 March 2010. FAOSTAT (2010), FAO Statistical Databases, FAO, Rome, http://faostat.fao.org, accessed 15 June 2010. FAOSTAT (2011), FAO Statistical Databases, FAO, Rome, http://faostat.fao.org, accessed 15 September 2011. FAO/EBRD (2010), “Ukraine: Grain Sector Review and Public Private Policy Dialogue”, Report Series, No. 15, December 2010. International Grain Council (2009), “Grain Shipments”, www.igc.int/en/default.aspx, accessed 15 March 2009. Investment Capital Ukraine (2010), “Sector Primer Agriculture”, Investment Capital Ukraine, Kyiv, December. Hallam, D. (2009), “International Investments in Agricultural Production”, Paper presented at the Expert Meeting on “How to Feed the World in 2050”, FAO, Rome, 24-26 June. International Finance Corporation (2000), “Strategy for the Development of Agri-Insurance in Ukraine: Conceptual Framework for Agri Insurance Development in Ukraine”, White Paper, Washington, DC. Kozlowski, J. (1997), “Polish Experience in Creation of Real Property Registration System”, High-level Technical Seminar: “Private and Public Sector Co-operation in National Land Tenure Development in Eastern and Central Europe”, Bertinoro. Krugman, P. (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Tatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 41-55. Lall, S. (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. Legeida, N. (2002), VAT Refund Crisis in Ukraine: Causes, Risks and Solutions, Institute of Economic Research and Policy Consulting, Kyiv. Lissitsa, A. (2010), “The Emergence of Large Scale Agricultural Production in Ukraine: Lessons and Perspectives”, Paper presented at the Annual Bank Conference on Land Policy and Administration, Washington, DC, 26-27 April. OECD (2009), Agricultural Policies in Emerging Economies, OECD, Paris. OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. OECD (2011), Agricultural Policies in OECD Countries and Emerging Economies, OECD, Paris. OECD (2011), Country Capability Survey, internal working document, OECD, Paris. OECD/FAO (2009), OECD-FAO Agricultural Outlook 2009-2018, OECD, Paris. OECD/FAO (2010), OECD-FAO Agricultural Outlook 2010-2019, OECD, Paris. OECD/FAO (2011), OECD-FAO Agricultural Outlook 2011-2020, OECD, Paris. State Statistics Committee of Ukraine (SSCU) (2011), State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. United Nations Commodity Trade Statistics Database (2007), 2007 International Trade Statistics Yearbook, United Nations Statistics Division, New York. 102 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.5. FOCUS ON THE GRAIN VALUE CHAIN USDA (2004), Ukraine: Agricultural Overview, USDA Production Estimate and Crop Assessment Division, Washington, DC. USDA (2011), Global Food Markets: International Consumer and Retail Trends, USDA Economic Research Service, Washington, DC. USDA (2010), Former Soviet Union Region To Play Larger Role in Meeting World Wheat Needs, USDA Economic Research Service, Washington, DC. USDA (2011), Ukraine: Grain and Feed Annual, USDA Foreign Agricultural Service, Washington, DC, April 2011. World Bank (2008a), World Development Report 2008: Agriculture for Development, World Bank, Washington, DC. World Bank (2008b), Competitive Agriculture or State Control: Ukraine’s Response to Global Food Crisis, World Bank, Washington, DC, May. World Bank (2011), “Ukraine Partnership Programme Snapshot”, World Bank, Washington, DC. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 103 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 6 Focus on the dairy value chain This chapter provides an in-depth analysis of the dairy value chain in Ukraine. Examining the demand and supply sides, it explains why the dairy value chain is promising for private domestic and foreign investors given domestic and global trends. It identifies the role that foreign investors could play, for instance in increasing productivity along the whole value chain. It also presents key issues and policy barriers hindering competitiveness in the sector and proposes a prioritised list of policy recommendations. 105 III.6. FOCUS ON THE DAIRY VALUE CHAIN Summary The value-chain of the dairy sector comprises four main steps: input supplies, raw milk production, milk processing (using chilling, pasteurisation, homogenisation and other technologies), and distribution and retail. On the demand side, the global dairy market is expected to follow a similar path to other food products. Emerging economies are forecast to lead the increase in consumption of dairy products. This trend is driven by population growth and rising per capita incomes. It can also be expected that consumers’ preferences in these countries will increasingly move in the direction of more varied, healthier and safer products. The increase in demand and the reorientation of the mix of products will drive prices up, improve profitability and increase investments in the sector. On the supply side, the dairy sector has been undergoing globalisation and consolidation at all levels of the value chain. Concentration has been observed in processing and in production. Integration has been observed at production level, where independent milk producers tend to integrate forward. Ukraine is traditionally a dairy producer, although its herd sizes and output have been decreasing since independence. Production costs in the sector are comparable to those of New Zealand, and significantly lower than other Eurasian countries. The domestic market is expected to grow strongly in the coming years. Finally, Ukraine enjoys proximity to a number of large or developing markets, such as the EU, Russia and the CIS countries. Meanwhile the sector faces a number of challenges, mainly related to the structure of supply and output. The quality standards of milk for food production do not match those of the EU, and even the highest-quality Ukrainian milk is not exportable to Western Europe. The production of raw milk is still scattered, with 80% of production coming from households that own fewer than five cows. As a result, the level of investment in the sector is low, and does not allow for technological upgrades or for access to skilled human resources, like veterinary services and management capabilities. Finally, the milk yield, although improving, is still less than 50% of that in other producing countries. The medium-to-long-term strategy for the dairy sector in Ukraine could be built around several priorities: improving both the quality and productivity of raw milk production; targeting geographic markets, starting with the domestic market moving on to the CIS countries, and finally to the EU; and attracting major foreign investors to the dairy processing sector. Implementation of this strategy would require overcoming several identified policy barriers. Milk quality standards would need to be raised to meet WTO commitments and EU standards. Improving access to finance and better matching of available human capital with companies’ needs are also urgent requirements. Better access to finance would allow an increase in the number of cows per household, in order to reduce the number of contact points for processors and facilitate the implementation of better quality standards. A number of approaches are possible, including supporting micro-finance institutions, introducing supply-chain financing or designing efficient credit guarantee schemes. Other options include strengthening co-operative banks, which can provide funding to milk producers and processors at lower interest rates than commercial banks. 106 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN The recommended priority policy improvement is the supply of human capital (e.g. university education, vocational and educational training (VET), and extension centres for farmers) to be tailored to the practices of effective animal husbandry. Veterinarians currently perform basic operations, but are not sufficiently trained to ensure proper monitoring of a herd’s health and to optimise the birth cycle. A public-private dialogue should be fostered between the relevant government bodies and the players in the industry to understand the sector’s actual needs. The curricula of the veterinary training institutions should be updated to include technical topics such as scientific feeding and herd monitoring. VET programmes should provide a substantial amount of practical training in the workplace. Agricultural extension centres in rural areas could provide households and small farmers with training courses focusing on feeding efficiency, financial literacy programs, marketing activities and management skills. Sub-sector definition and segmentation The dairy sector is a major part of the global food chain. It covers operations from raw milk production at dairy farms to processing it into a wide variety of products such as milk, yogurt, cheese, butter, condensed milk, milk powder and ice cream using chilling, pasteurisation, homogenisation and other technologies. Derivatives such as buttermilk and whey are by-products of milk processing. Global production of milk in 2009 reached over 696 million tonnes, of which 580 million tonnes were cow’s milk (Figure 6.1). The remaining 116 million tonnes (16.7% of the total) were accounted for by buffalo, goat and sheep milk, which enjoy a considerable level of consumption in some nations (e.g. India and Pakistan), but account for a small share of consumption in most other countries. Even though the share of cow’s milk in total production declined from 84.9% in 1998 to 83.4% in 2008, it remains the main product of the dairy sector (FAOSTAT, 2011). Figure 6.1. Cow’s milk dominates the global raw milk output Global raw milk production volume and structure, million tonnes Cow milk Other milk 800 700 110 116 116 600 104 107 97 100 92 94 87 89 500 400 300 570 579 580 527 543 559 483 490 498 510 518 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: FAOSTAT (2011), FAO Statistical Databases, http://faostat.fao.org, accessed 15 September 2011. Global milk production has been growing steadily during the past decade, driven by higher demand due to growing population and increasing disposable incomes. Over the decade 1999-2009, global milk output rose by over 22%. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 107 III.6. FOCUS ON THE DAIRY VALUE CHAIN Activities along the dairy value-chain can be grouped into the following segments: input supplies, raw milk production, milk processing, and distribution and retail (Figure 6.2). Figure 6.2. The dairy value chain Farm inputs Raw milk production Milk processing Distribution and retail Feed suppliers Commercial farms Primary processing Supermarkets Shops Veterinary services Dairy co-operatives Secondary processing Food services Genetics (breeding) Individual farms Deep processing Exports Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. The farm inputs segment of the value chain covers operations that provide dairy farms with essential supplies such as feed, breeding stock, veterinary services and medicine, fertilisers, farm machinery, equipment and technologies. The raw milk production segment includes all types of raw milk producers irrespective of their size, from large-scale commercial farms with a dairy specialisation to dairy co- operatives and smallholder (individual) farms. Dairy farm operations span from calving and cattle-raising through to milking. Milk production is the basis of the dairy sector as raw milk is the main ingredient for all other products of the dairy value chain. The milk processing segment covers operations involved in the transformation of raw milk into a wide variety of dairy products, either for consumers or to be used as inputs in other industries. According to the degree and type of processing the segment can be further subdivided into primary, secondary and deep processing stages. The first stage involves cleaning, standardisation and homogenisation of milk, resulting in liquid milk and cream. Processed milk ready for consumption is the output of the secondary stage, which involves pasteurising, sterilising, skimming and homogenisation. The deep processing stage covers production of the entire range of dairy products including cheese, whey, yogurt, butter, condensed milk, ice-cream, milk powder, casein, and lactose. At the distribution and retailing level dairy products are delivered to consumers via a range of channels including modern retailers, other shops and restaurants. Dairy products and ingredients are also supplied to food-processing, pharmaceutical and other industries. Global trends Increasing world consumption of dairy products with fastest pace in developing countries The global demand for dairy products is expected to grow further with an annual growth rate averaging 1.9% until 2019 (OECD/FAO, 2010). The large and mature dairy markets in developed countries in Europe and the United States will see little growth as their per capita consumption is already very high. On the other hand, many developing economies in Asia, the Middle East and Africa, where per capita consumption is much lower and domestic production capacities are unable to meet domestic demand, will become the main sources of consumption growth for the global dairy sector (Figure 6.3). Dairy demand in developing countries will be driven by increasing incomes and population growth, as well as by changing preferences and new diet patterns, all of which are further encouraged by further urbanisation, economic growth and development. 108 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.3. World consumption growth of dairy products driven by non-OECD countries OECD Non-OECD Million tonnes 25 20 15 10 5 0 2007-09 2019 2007-09 2019 2007-09 2019 2007-09 2019 Butter Cheese SMP WMP Source: OECD/FAO (2010), Agricultural Outlook 2010-2019, OECD Publishing and FAO, Paris. Consumption of processed products in non-OECD countries will drive dairy sector growth As rising income leads to more diversified demand in developing countries, consumers in those markets should become increasingly willing to replace fresh fluid milk with pasteurised, UHT or reconstituted milk. This trend will be further supported by the growth in dairy marketing and expanding retailing channels in developing countries (USDA, 2010). This will gear the sector towards higher value-added dairy production. Rising supply potential will enable future production growth and improved domestic marketing linkages, placing producing countries in a more competitive position. According to recent projections produced by OECD/FAO (2010) the value of the global dairy market will increase to reach USD 392 billion by 2019. Compared with 2005, the value of processed dairy products (milk powder, butter and cheese) will increase by 74.4% by 2019 and will reach USD 150 billion, while milk will grow by 14.1% during this period (Figure 6.4). Figure 6.4. World dairy production value and structure, recent trends and forecasts, 2005-19 Milk Cheese Butter Milk powder 450 400 350 300 243 250 199 200 213 150 100 85 74 50 52 31 37 18 0 16 21 28 2005 2010 2019 Source: FAOStat (2011), FAO Statistical Databases, http://faostat.fao.org, accessed 15 September 2011. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 109 III.6. FOCUS ON THE DAIRY VALUE CHAIN After decreasing during the global crisis, trade in dairy products should increase, mainly for cheese and whole milk powder, driven by the fast-growing demand in developing countries. While New Zealand is expected to remain the leading exporter (one third of global exports), its long-term capacity to satisfy the demand from importing countries will not be sufficient as its global milk output share is less than 2.5%. This opens room for other exporters, such as Brazil, which is expected to further increase its presence on foreign markets. On the import side, the Russian Federation and middle-eastern countries are expected to remain the most significant importers of butter. The Russian Federation will still be the largest importer of cheese and imports are expected to grow by 2% per year over the next decade (Figure 6.5). Figure 6.5. Key importers of selected dairy products globally CAGR Imports of cheese, 2020 over the avreage 2008-10 (%) CAGR Imports of WMP, 2020 over the average 2008-10 (%) 8 2.5 China China 7 2.0 6 1.5 Russia 1.0 United States 5 Mexico 0.5 Mexico Algeria 4 0.0 3 United States –0.5 2 Russia Japan –1.0 Saudi Arabia 1 Saudi Arabia –1.5 Algeria 0 –2.0 0 50 100 150 200 250 300 350 0 50 100 150 200 250 Imports of cheese, 2008-10 (th tonnes) Imports of WMP, 2008-10 (th tonnes) Source: OECD/FAO (2011), Agricultural Outlook 2011-2020, OECD Publishing and FAO, Paris. World dairy price trends should prompt a supply response from investors On average, world market dairy prices in real terms are expected to stay 15-40% higher when compared to the decade preceding the 2007-08 peak (OECD/FAO, 2010). This will prompt supplying countries to invest, expand and restructure their production units to meet market needs. Rising supply potential will enable future production growth and improved domestic marketing linkages, placing these countries in a stronger competitive position. However, uncertainty remains regarding the volatility around this future trend (Figure 6.6). Sources of competitiveness A highly fragmented production segment which involves households and small farmers The dairy sector is an important component of the rural economy in Ukraine, providing employment and income in an environment of weak social security and scarce job opportunities. Dairy farming in Ukraine includes a broad range of farms: from households with one or two cows selling raw fresh milk via village collecting stations – which provide a significant income for vulnerable groups – up to large corporate farms, some of which have already made significant investments and control thousands of hectares (Figure 6.7). 110 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.6. Annual dairy, food and meat price indices, 2002-04 = 100 Cheese imports in 2008-10 (thousand tonnes); projected average annual growth of cheese imports 2020 over 2008-10 (%) Food price index Meat price index Dairy price index 210 190 170 150 130 110 90 70 50 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: OECD/FAO (2011), Agricultural Outlook 2011-2020, OECD Publishing and FAO, Paris. Figure 6.7. Millions of cows producing milk in Ukraine, 1990-2006 Households Dairy farms 9 8 2.2 7 6 2.9 5 4 6.2 3.2 3 3.3 3.2 4.6 3.0 2.8 2 2.7 1 1.7 1.4 1.1 0.9 0.9 0.8 0 1990 1995 2001 2002 2003 2004 2005 2006 Source: SSCU (2011), State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. Ukraine witnessed a significant decline in milk production during the 1990s: between 1990 and 2001 the number of cows fell by 40 per cent (SSSU, 2011). Yields also fell in the early 1990s although they subsequently recovered and, since 2000 (Figure 6.8), the whole dairy sector has been one of the most dynamic branches of the Ukrainian agribusiness sector, producing around 4% of total national output (Nivievskin, 2008). The Ukrainian dairy supply chain involves a significant number of individual households, resulting in a high fragmentation at the production level. This affects the profitability of dairy farming, as small herds are considered to be economically inefficient. Households’ bargaining power is low and there is a high level of idling of production facilities. Technological upgrading has been hampered by lack of investment at the farm level. After the production phase, milk collection is rather heterogeneous: for households with one or two cows it is organised by milk collecting entrepreneurs without a proper contract; for bigger enterprises it is organised by either dairy processors or by local authorities or COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 111 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.8. Milk yield, tonnes of fluid milk per cow per year, 1990-2006 Households Dairy farms 8 7 6 5 3.9 3.6 2.7 4 3.4 3.1 3.2 3.2 3 2.7 2 3.0 3.2 2.9 1 2.1 2.2 2.1 2.5 1.9 0 1990 1995 2001 2002 2003 2004 2005 2006 Source: SSCU (2011), State Statistics Service of Ukraine website, www.ukrstat.gov.ua, accessed 30 September 2011. co-operatives. In 2010, around 60% of the raw milk collected for processing came from household farmers. For processors, the presence of small farmers represents higher transaction costs, depending on whether co-operatives aggregate the output (Reardon et al., 2009). Milk collecting points in rural areas are too numerous and widespread as a result of the dispersion of households. Contractual links between producers and dairy processors are weak. At the same time, processors have strong bargaining power. For example, a change in the subsidy system introduced in January 2011 was passed on to producers through a reduction of the price processors pay for raw milk of around 12% on a quarterly basis, from UAH 3.02 per kilo in the last three months of 2010 to UAH 2.64 in the first quarter of 2011. There are some big international players in the processing segment, such as Lactalis and Danone, two French dairy groups, and Wimm-Bill-Dann (WBD), a Russian food and dairy group. However, the shortage of high quality raw milk is a problem for international players: for example, in 2010 Danone collected less than 1% of the milk in Ukraine, due to its low quality. Cost-competitiveness of raw milk production Raw milk production in Ukraine is relatively inexpensive due to low input and labour costs. Feed is a key driver of milk production costs, accounting for around 60%, and Ukrainian farms mostly produce their own feed. Ukraine’s production costs in the period 2007-08 were only slightly higher than those estimated in New Zealand and significantly lower than those estimated for Kazakhstan, Germany, or France (Figure 6.9) by the International Farm Comparison Network. However, competitiveness is undermined by the need to improve the quality of products and adhere to international standards. Access to fast-growing markets, high domestic demand and advantageous geographic position According to the most recent FAO-OECD forecasts, the expected growth of dairy product consumption in Ukraine is promising (OECD/FAO, 2010). This growth process will be driven by the increase of GDP per capita and the purchase by customers of higher-value- added products. This will involve the development of all price segments from low priced traditional products to the medium and premium segments, along with the introduction of new products and product categories. Whole milk powder and cheese are expected to grow at an average annual growth rate of 6.9 and 5.3% respectively over 2010-19. In addition to 112 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.9. Cost of milk production in selected countries, US dollars per 100 kg, 2007 Depreciation Labour costs Material costs (feeding) and miscellaneous 50 45 5 40 4 7 35 14 1 30 4 4 25 7 1 20 1 35 6 15 6 25 26 10 19 15 12 5 0 France Germany Thailand Kazakhstan Ukraine New Zealand Source: International Farm Comparsion Network (2009), Dairy Report 2009, www.ifcnnetwork.org/en/news/2009/09/ pressrelease_dairy-report_2009.php, accessed 15 April 2009; Author’s calculations based on estimates provided by Milkiland Ukraine (2009), corporate website www.milkiland.com/en, accessed 15 April 2009. the growing domestic market, there will also be increasing opportunities for exports of processed-goods (Figures 6.10 and 6.11). Ukrainian dairy producers and foreign investors in the dairy industry could take advantage of the favourable geographic position of the country. In 2005, 66% of Ukrainian dairy products were exported to Russia. But the Russian market also poses risks. For example, the 2006 Russian import ban on dairy products from Ukraine caused a decrease in this share to 32% and had an extremely adverse impact on cheese and butter producers in Ukraine (Figure 6.12). Figure 6.10. Domestic demand for processed dairy products is expected to increase by 30% over the coming decade Consumption index of selected dairy products in Ukraine, past trends and forecasts, 100 = consumption in 2005 Cheese Whole milk powder 350 300 250 200 150 100 50 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Therefore, to minimise such risks Ukraine should diversify its export structure to include other markets, such as Central Asia, the Caucasus, Asia, and the Middle East. CIS countries, as well as the Middle-East, remain the most promising regions for Ukrainian dairy products, especially for whole milk powder and cheese. This process is already underway. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 113 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.11. The Ukrainian dairy industry exports significant volumes of its production Dairy consumption/export ratio of Ukraine, thousands of tonnes, 2009 Exports Consumption Imports 350 300 250 200 150 100 50 0 Cheese Butter Whole milk powder Skim milk powder Source: OECD/FAO (2011), Agricultural Outlook 2011-2020, OECD Publishing and FAO, Paris. Figure 6.12. CIS countries and Middle-East already key importers of Ukrainian dairy products Export structure of Ukraine dairy products, 2007 Russia Algeria Kazakhstan Japan China Moldova Georgia Azerbaidjan Turkey United Arab Emirates Syria Rest of the world 0 5 10 15 20 25 30 35 % Source: State Statistics Service of Ukraine (SSCU), (2008), website, www.ukrstat.gov.ua, accessed 15 June 2008. The export possibilities for dairy products are currently limited to developing countries, for quality reasons. In the EU, a close and sizeable market, Ukraine exports dairy products for non-human consumption. Exporting to the EU is a medium to long-term opportunity that Ukrainian producers could take advantage of, but quality issues need to be tackled first. The role of foreign investors in the dairy sector The trend towards concentration is already visible in the processing sector. The growing power of suppliers and buyers has triggered pressures to improve efficiency and has resulted in increasing concentration at the global level. The 20 largest dairy processors account for the majority of dairy market sales in the world. Their sales amounted to USD 172 billion in 2009, with the top six accounting for nearly 67% of this (Table 6.1). 114 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Table 6.1. Turnover of the largest global dairy processing companies, 2009 Company Country Turnover, USD billion Nestlé Switzerland 27.2 Danone France 15.7 Lactalis France 13.7 Friesland Campina Netherlands 13.7 Fonterra New Zealand 12.0 Dean Foods United States 11.8 Dairy Farmers of Am. United States 10.8 Arla Foods Denmark/Sweden 10.1 Kraft Foods Unites States 7.5 Unilever Netherlands 6.6 Parmalat Italy 5.4 Saputo Canada 5.3 Bongrain France 5.2 Meji Dairies Japan 4.7 Morinaga Milk Ind. Japan 4.3 Land O’ Lakes United States 3.7 Nordmilch Germany 3.7 Schreiber Foods United States 3.7 Mengniu China 3.7 Muller Germany 3.4 Source: Rabobank (2010), Rabobank Dairy Top 20, Press Room Rabobank Group, corporate website www.pressroomrabobank.com/publications/food__agri/rabobank_ dairy_top-20.html, accessed 15 June 2010. Some of the largest global players in the dairy industry have already invested in Ukraine, purchasing and modernising old dairy processing units. In general, starting from a low level in 2000, FDI has increased significantly in recent years, reaching USD 65.5 million in 2006. For example, Lactalis has been present in the market since 1996, when it acquired its first asset. In 2004, it purchased the Ukraine-based operations of American Food Master International, namely the Bilosvit dairy plant in the Cherkasy region. In 2007, Groupe Danone bought the Rodych Dairy Plant in the southern Ukrainian regional hub of Kherson and in 2006 Fromagerie Bel Group bought the Shostka City Milk Plant in the Sumy Region. There has been an important debate in the literature on the impact of FDI on the local producer base. Some argue that FDI has had a negative effect on small local farmers by excluding those that can’t comply with high quality standards (Farina and Reardon, 2000; Reardon et al., 1999). Others ascribe the negative impact on farmers to the fact that foreign investors prefer to deal with larger suppliers in order to minimise transaction costs (Runsten and Key, 1996). On the other hand, Dries and Swinnen (2004) found evidence of positive vertical and horizontal spill-over effects of foreign investment on the Polish dairy production sector, leading to significant quality improvements by small local suppliers, better access to finance and increased investment. These spill-over effects occur in three phases: first, foreign investors control output quality and provide incentives through the provision of inputs, credit and technology. At a second stage, domestic processors start copying the most successful vertical integration strategies. The evidence from the Polish dairy market shows that five years after the introduction of FDI in the sector there were no longer any significant differences in the way local and foreign firms sourced their supplies. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 115 III.6. FOCUS ON THE DAIRY VALUE CHAIN Attraction of FDI into the dairy processing sector The experiences of other regional economies suggest that FDI could have a positive impact on the dairy sector in Ukraine. Although FDI can place small or marginal producers under pressure as some struggle to meet the new, higher quality standards demanded by processors, the negative direct effects on the industry as a whole are generally offset by the positive impact of spillovers such as technology transfer, improved skills and better management. Critics of FDI suggest that the establishment of foreign processing capacity leads to consolidation of the supplier base, with some smaller suppliers in particular unable to meet the higher quality demands of newly-established foreign-owned processors. However, evidence from the earlier experiences of the dairy sectors of Poland and Hungary suggests that these negative direct effects are relatively small (Gorton and Guba, 2001; Dries and Swinnen, 2004). Moreover, they are offset by positive indirect effects, including better access to financing (including from the processors themselves), higher investment and improvements in quality. In Poland’s case, foreign investments in processing companies resulted in new contracts with suppliers that demanded higher quality standards and consistent supplies, but in return offered help with management training, better access to credit, technology and skills transfers, and better access to raw material inputs. These included programmes that provided producers either with direct access to feed for livestock or with the necessary inputs (such as seed and fertiliser) for producers to grow their own feed. On the financing side, foreign investors offered leasing contracts for equipment and livestock, along with either direct loans or guarantees as collateral for commercial bank loans. Encouraged by the example of foreign-owned processors, domestic firms subsequently also began to adopt similar strategies, leading to productivity improvements across the industry. The quality of milk produced, even by small local suppliers, also improved significantly. These experiences suggest that a strategy of encouraging foreign investment in the dairy industry could produce similar benefits in Ukraine. Key issues and policy barriers Shortages of human capital There is a shortage of the key technical skills required to both improve productivity in the dairy sector and to raise milk quality to the highest international standards. According to the OECD Country Capability Survey two-thirds of the dairy farmers surveyed highlighted problems in recruiting veterinarians, due to a lack of supply of these professional skills, especially in rural areas (Figure 6.13). Even when specialists are available, their technical skills might not be aligned to international best practices. For example, breeding plays an important role in the improvement of herds and currently there is a lack of knowledge of scientific feeding and herd monitoring techniques. Feeding needs to be balanced, ensuring sufficient protein intakes, and tailored to the birth cycle of the herds. Inadequate feeding usually leads to a diet rich in carbohydrates, which is detrimental to the herd’s health. Veterinarians currently perform basic operations, but are not well enough trained to ensure proper monitoring of the herd’s health and to optimise the birth cycle. Improvement of veterinary skills would strongly benefit private dairy farmers in Ukraine. At the same time, veterinary and health inspectorates in the public health and monitoring bodies need to modernise their regulation, streamlining their frequently lengthy 116 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.13. Workforce skills are seen as an area for improvement where government action is called on “What do you think should be done to improve the annual milk yield?” Access skills and know-how about breeding 67 Access better quality feeding 53 Other 26 0 10 20 30 40 50 60 70 80 % “What are the areas for improvement in milk quality?” Technology and equipment 75 Expertise 47 Quality of inputs 47 Milk collection and transport 24 Better stick to processor needs 24 Other 10 83 dairy farms were surveyed 0 10 20 30 40 50 60 70 80 % More than 2/3 of the farms surveyed pointed out skills improvement as key to higher milk yield Source: Calculations based on OECD (2011), Country Capability Survey, internal working document, OECD, Paris. inspections. Outdated rules need to be replaced with updated animal health management practices. Public sector organissations could disseminate information, providing guidelines and appropriate training in the desired practices. The Ukrainian education system focuses on scientific subjects without providing sound management and business administration curricula. There is a need to improve accounting, finance and management skills, in order to develop a business and entrepreneurial mindset. At the moment, dairy farmers lack technical skills in fields such as operations management, finance and risk management, and expertise in business planning and product promotion. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 117 III.6. FOCUS ON THE DAIRY VALUE CHAIN Outdated and excessive dairy safety regulation is ineffective and burdensome Excessive requirements for permits, certifications and standards, prescribed testing methods that are not aligned with international guidelines, and overlapping inspections from different agencies constitute a significant burden to the dairy sector, estimated at approximately 23% of annual turnover (IFC, 2009). Nevertheless, the current system does not overcome a major problem as it does not align with safety and quality standards accepted in major developed-country markets. Dairy producers have to comply with more than a hundred different testing methods, but only 37% of these are in line with international standards (IFC, 2009). Moreover, the system lacks effective enforcement mechanisms. This limits dairy sector exports mainly to other CIS and developing country markets. Exports to the wealthy western European markets are presently concentrated on low-value-added products such as casein, dry milk powder and other intermediate products. Improvements in safety standards would open up significant new markets for higher-value-added exports such as milk, cream and cheese, boosting profitability for producers and processors. Certifications and standards are mandatory but are not WTO compliant or aligned with international standards. They impose strict guidelines for product specifications, which limit technical innovation without achieving the goal of producing exportable, safe final products. Rigid rules and sanitary norms often refer to outdated Soviet Union standards. Despite their complexity they do not ensure a high level of safety. Compliance is enforced by multiple institutions, which lack communication and co-ordination, creating a duplication of procedures and inefficiency. Entrepreneurs surveyed in the OECD Country Capability Survey conducted in 2011 reported that their dairy products were reviewed and certified for export to the EU, but that state veterinary standards were not, therefore they could not trade with the EU market (Figure 6.14). A review of best practices suggests that the harmonisation of regulations towards the EU voluntary compliance system would significantly reduce costs to both government and producers whilst increasing the access of Ukrainian products to the EU market. Milk quality standards: design and enforcement Under the Ukrainian standard, raw milk is sorted into three quality grades: extra grade, Category I and Category II, while in the EU there is only one grade for raw milk, which is of higher quality than Ukrainian extra grade milk (Table 6.2).* Ukraine households’ milk output is usually Category II, which is not used by the food processing industry in the EU and the USA. The situation is better at large dairy farms, since they deliver mainly extra grade and Category I milk. Because of these low food safety and quality standards, Ukraine’s dairy industry can’t enter large Western European markets. Moreover, enforcement and monitoring of standards is questionable. Milk quality is rarely controlled or monitored at the collecting points or at the processing plants. Some processors are, however, taking steps to improve standards, by paying higher prices to farms producing higher quality milk. Nonetheless the strong seasonal pattern of milk production and the subsequent scarcity of raw milk in autumn and winter encourage processors to pay higher prices for any category of milk at certain times of the year. * The main piece of legislation is the Law of Ukraine No. 1870-IV “On Milk and Dairy Products produce” adopted on 24 June 2004, which sets up the institutions ensuring quality and safety of milk and dairy products along the whole dairy value chain, including production, transportation, processing, storing and marketing, exports and imports. 118 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.14. Quality of state controls and regulation are debated Control systems could be improved – Regulation can lack effectiveness especially veterinary and sanitary controls • Design of control systems debated Ex: sending an animal to the veterinary service “I have some old cows that produce instead of having it checked on the farm very little milk. I would like to slaughter them and replace them with younger, • Implementation even more key more productive ones. But if I want to do so, I need special authorization, because under “We have all the papers in order, it makes us easier local policy, it is not allowed to slaughter to check and thus we are much more controlled milking cows” than less organized producers” Foreign milk processor in Ukraine Foreign milk producer in Ukraine “We were reviewed and certified for export to the EU, but state veterinary services were not. As a result, we could not export.” Large Ukrainian milk processor Source: OECD (2011), Country Capability Survey, internal working document, OECD, Paris. Box 6.1. Duplication of procedures and inefficiency in enforcing standards Overlapping institutions and lack of co-ordination in enforcing safety standards is illustrated by an IFC study conducted in 2009. The study concluded that on average a typical milk processing value chain (“from farm to fork”) needs to: ● comply with up to 120 permits, authorisations, and other regulatory requirements; ● comply on average with up to 50 mandatory standards for each dairy product; ● comply with up to 51 orders and mandatory guidelines from the Ministry of Health Care and other supervision agencies for each dairy product; ● comply with around 110 prescribed testing methods, in spite of the fact that 63 per cent of them are not in line with international standards; ● receive repeated and overlapping inspections from several inspecting agencies. Source: International Finance Corporation (2009), Reforming Food Safety Policy in Ukraine: Proposals for Policy Makers, IFC, Washington, DC. Poor enforcement of standards also hampers the shift towards higher value-added products. Many products that do not meet mandatory standards are still sold in the market, undermining consumer confidence in the sector as a whole. Fragmentation in raw milk production has a negative impact on quality, efficiency and productivity The weight of households’ in total raw milk output and the presence of widespread and numerous collection points are two significant challenges for the development of the COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 119 III.6. FOCUS ON THE DAIRY VALUE CHAIN Table 6.2. Quality standards for raw cow milk for food production in Ukraine and the EU Ukraine EU Extra grade Category I Category II Plate count 30 degrees Celsius (‘000 per ml) 100 300 500 500 Somatic cell count (‘000 per ml) 400 400 600 800 Source: Nivievskin, O. and S. von Cramon-Taubadel (2008), “The Determinants of Dairy Farming Competitiveness in Ukraine”, 12th Congress of the European Association of Agricultural Economists, Ghent. sector and the entire dairy value chain. Productivity of cows is very low in Ukraine by Western standards. The average productivity in the United Kingdom, for example, is about 7 tonnes per cow per year; in Israel it is about 11-12 tonnes. In Ukraine, even for large modern farms, milk yield approximates 2.9 tonnes per cow. Reasons include the very low level of investments (both private and public), the poor condition of facilities, high taxation of inputs and the lack of cattle breeding skills. The large share of households in raw milk production adds costs to the value chain, making Ukrainian dairy products less competitive on the global market. Households cannot capture economies of scale in production. A recent study shows that in Ukraine, productivity grows as herd size increases, making large-scale production more advantageous, on average (Nivievskin and von Cramon-Taubadel, 2008). For example, increasing the average size of households’ herds from one to five cows would allow them to attract financial and technical support from dairy processors (Figure 6.15). Figure 6.15. Milk yields in Ukraine’s large dairy farms are half of the European Union average Annual milk yield comparison, tonnes of milk per cow, 2006 12 10 8 6 11 4 8.2 7 6.1 6 5 4.5 2 2.9 0 Israel Denmark United Kingdom EU25 France Greece Poland Ukraine – large dairy farms Source: Nivievskin, O. and S. von Cramon-Taubadel (2008), “The Determinants of Dairy Farming Competitiveness in Ukraine”, 12th Congress of the European Association of Agricultural Economists, Ghent. The high fragmentation of production significantly increases the cost of milk collection, since most households own only one or two cows. Most household farms sell to dairy logistics or milk collecting firms, which are typically small-scale entrepreneurs. The prevalence of households in raw milk production also has a negative impact on the quality and safety of milk. Raw milk supplied to processors is often of poor and inconsistent quality. Milk collection and cooling facilities are not widespread or up to date. For instance, 120 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN milk is first supplied to special collecting points in rural areas, where milk from different origins is mixed together without any preliminary quality tests. Lack of financing affects the level of investments and therefore productivity Small and medium-sized farms face problems accessing finance due to the high cost of borrowing. Therefore, they have limited resources to finance investment in capital equipment, other inputs and specific training. According to the OECD Country Capability Survey conducted in 2011, more than 75% of the farmers surveyed indicated that access to credit is a barrier to the development of their business (Figure 6.16). The key reasons quoted by the respondents were the high level of interest rates (82% of responses), with annual rates typically in the 20-30% range. The lack of collateral was considered a barrier by 26% of respondents. More than half of the farmers surveyed (51%) assessed the milking equipment in use as technically “outdated”. Increasing herd size was perceived by 53% of respondents as a necessary investment during the next five years, while 40% of the panel planned to either upgrade their existing equipment or fully re-equip. Technology and equipment were indicated by 75% of the surveyed farmers as areas for improvement, followed by “expertise”. Figure 6.16. Lack of financing affects the level of investments and therefore productivity Are you currently receiving sufficient access to finance? Yes No 24% ~75% of farms indicated 80 % of respondents cited lack of access to credit interest rate as a key (short and long-term) reason for limited access as an issue 76% to finance 83 dairy farms were surveyed On short-term or long-term credit? What are the key reasons for such difficulties? % Long-term Short-term Short and long-term % 100 100 26 90 80 80 70 60 33 60 82 50 40 40 30 20 41 20 10 26 0 0 High interest rates No appropriate collateral Source: OECD (2011), Country Capability Survey, internal working document, OECD, Paris. The fragmentation of raw milk production impedes access to the credit market and deters necessary investment. In Ukraine, the distribution of milk yields varies depending on the size of dairy farms (Nivievskyi, 2008). Smaller herds of 10 to 100 cows have an average yield of 1.7 tonnes of milk per cow, while in herds with more than 700 cows the yield averages 6 tonnes per cow. Also, dairy intermediaries or processors are less willing to provide financial, technical or logistical support to households with one or two cows. The COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 121 III.6. FOCUS ON THE DAIRY VALUE CHAIN financial crisis has negatively affected an already fragile situation, as small and medium- sized farmers have witnessed a sharp contraction in the credit market combined with the devaluation of the currency. Imperfect information and price heterogeneity affect farmers’ profitability The dairy industry in Ukraine is dominated by small, disconnected players without access to information or bargaining power. This renders farming profits uncertain and low. Since independence, farmers’ prices have been lower than international prices with considerable disparities between producers (Sauer et al., 2011). Processors are generally local monopolies, created during the soviet era, and continue to dominate pricing for their specific region. The creation of a nation-wide integrated market information system could increase producers’ information, thereby encouraging competition between processors, reducing disparities in regional prices, and increasing profit and investment at farm level. Further, such an information system could be extended to share research, techniques, industry forecasts and other information relevant for optimising farm-level decisions. Taxation of inputs via tariff and non-tariff import barriers Imports of inputs, such as feed, seeds, agrichemicals or technologically-advanced machinery are limited by both tariff and non-tariff barriers. The liberalisation of the current non-tariff measures would be beneficial, in particular in the machine building sector as higher imports would ensure technological modernisation and therefore productivity gains. A study undertaken by Movchan and Shporttyuk (2010), found that non-tariff protectionism in Ukraine increased in the period 1996-2006, peaking in 1999 with the introduction of minimum customs values and a rise in the number of products subject to licensing. Non-tariff measures are still high in four sectors of the Ukrainian economy, including the food industry and machine building. During the first two years of WTO membership, Ukraine has met its obligations with respect to reductions in import duties. On joining in 2008, Ukraine committed to “bind” its import tariffs. In particular, it joined a series of sectoral arrangements for import duty rate reductions, including one covering agricultural equipment (Kobouta et al., 2010). However, in 2008 the Ukrainian parliament approved a law introducing a temporary surcharge of 13% on the import duty on several products. This was in contravention of WTO rules and Ukraine was obliged to abolish the 13% surcharge in September 2009. The manoeuvre did not send a positive image of the country to international partners, as it was clear that the surcharge was an attempt to restrict imports despite WTO commitments. Imports in the machine building sector (including machinery, equipment and vehicles) dropped from USD 17.8 billion in the first ten months of the first WTO membership year, to USD 8.2 billion in the first ten months of the second membership year. Policy recommendations Ukraine has considerable opportunities to improve the competitiveness of its dairy sector. A major issue preventing long-term investments in the industry is the uncertainty regarding land ownership, which has already been discussed in previous sections. Investments in dairy production have a long pay-back period and the uncertainties related to land ownership raise the risks involved. In addition to the policies identified earlier in the field of land tenure and land reform (see Chapters 4 and 5), a number of sector-specific recommendations would be beneficial. 122 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Human capacity building policies would have a positive impact on productivity Human capacity building programmes are recommended to fill the skills gap between the competences provided by the Ukrainian educational system and the practical needs of the dairy industry, notably in the fields of veterinary medicine, feed efficiency, animal husbandry skills and management. A long-term and focused commitment by policy makers to develop human skills and social capital could have an important effect on the improvement of milk quality and on the development of the dairy sector. Specific action could target initial agricultural education, fostering public-private dialogue between the relevant government bodies and industry players to understand the sector’s actual needs (Figure 6.17). For example, the curricula of veterinary courses could be revised and updated with current business practices including technical topics such as scientific feeding, herd monitoring and optimisation of birth cycles. Animal husbandry skills should be harmonised with international and EU standards. Secondly, in order to raise the exposure of professors and students to international standards, linkage and exchange programmes could be introduced. Internships of veterinary students within dairy companies might also improve training. This would also facilitate the recruiting process for veterinarians and reduce the hiring cost to farmers. Thirdly, tertiary and university education curricula need to be integrated with organisation and management foundation courses. Problem solving and leadership skills need to be taught to facilitate entrepreneurship. Figure 6.17. A summary of policy options to enhance initial and VET education Key issues in the Ukrainian educational system A series of potential solutions Organisational reform • Increased autonomy for universities Unadapted organisation • Possibly bringing education and research closer • Convergence towards the Bologna process • New management (tools, people) Private sector involvement Irrelevance of programmes and training • Permanent and ad hoc forums for public-private dialogue • Review of curriculum, course revision Lack of funding • Reform of VET framework and trainings International exposure Isolation from international best practice • For students: partnerships, exchanges, linkage programmes • For faculty: publications in int’l reviews, exchanges Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. The quality of the upper-secondary and post-secondary vocational education and training (VET) system needs to be improved, developing a close link between job-specific requirements and relevant training. Currently, Ukraine offers a certain amount of VET in schools but very little post-secondary, non-tertiary training (OECD, 2011). VET programmes should provide a substantial amount of practical training in the workplace. Ukraine has no plans to implement a national system of continuing education and training (CET), but legislation does give employees the right to paid training provided by employers. CET could provide privately-financed training to dairy farmers. Agricultural extension centres in rural areas could be targeted, as they support and assist households and small farmers (Figure 6.18). COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 123 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.18. Extension programmes are an example of a policy option to develop producers’ skills Extension programmes: Who does what: Non-formal continued education different funding and operational models FUNDING OF TRAINING Role: disseminating information and advice through the transfer Public Private and exchange of practical information: – Promoting knowledge and skills. Public – Promoting attitudes and aspirations. Deconcentrated/decentralized Fee-based State State training programme DELIVERY OF TRAINING – Reinforcing the local community. – Some programmes may include financing schemes. State-support to farmers Financing of extension programmes is varied: who decide to contract with – Public (state and/or local authorities). extension service providers All-private programme, Private – Private (training participants and/or other supply chain members). e.g. commercialization programme Scope: technical as well as business skills: State contracting with private players to provide extension – Intervention of experts. services to farmers – Knowledge sharing between producers. Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Improving safety regulations and streamlining administrative controls Dairy safety regulations, standards and certifications need to be simplified, while administrative controls and processes should be streamlined. This will increase the efficiency of the system and reduce the compliance costs for private firms. The move towards a free trade agreement with the EU will probably accelerate this process. Priority should therefore be given to the harmonisation of standards, certification, and food safety regulations with international and EU best practice. Recent international experience suggests that an overhaul of the current system of excessive regulation and overlapping responsibilities would yield significant benefits. The establishment of a single regulatory authority responsible for food control and safety issues would mark a significant step forward. A redesigned food control system should take account of EU legislation and practice, and should include the scrapping of the existing mandatory certification system, which imposes burdens but provides few benefits. A new system should also not differentiate between domestically-produced and imported products, which would further simplify compliance procedures. The current system is a complex mixture of mandatory quality specifications, technical regulations and safety standards. In order to comply with WTO requirements and EU practice, this approach should be replaced with a system of mandatory technical regulations but voluntary standards. Moreover, a number of different pieces of existing legislation deal with food-related issues, creating confusing and sometimes contradictory requirements. Food should be removed from the provisions of most of these laws in favour of more specific legislation designed to comply with WTO rules. There is also a need to update regulations regarding the use of food additives, flavourings, pesticides and other contaminants, including limits on permitted levels and rules regarding the types of food in which such additives can be used. A recent study drawing lessons from international experience (IFC, 2011) suggests that, although the introduction of food safety management systems would involve short- term costs for producers and processors, it would provide net benefits over the medium 124 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN term. IFC estimates suggest a payback period for food safety investments of around one to two years, and notes that some Ukrainian producers in the dairy sector have experienced shorter payback periods following the introduction of more rigorous food safety systems. Start-up costs are typically more than recouped through higher revenues as a result of access to new markets, lower wastage, better management and a rise in the attractiveness of the business to investors. Strengthening the role of producer co-operatives The prevalence of small-scale producers results in high costs of collection and transportation and difficulties in quality control. Experience in other countries suggests that the development of producer co-operatives can be a successful means of overcoming these problems. Co-operatives can act as collection centres for milk, provide members with common access to shared cooling and initial processing equipment, provide shared storage facilities, allow a greater degree of quality control, organise transport services and provide a range of other services for members. Also, the strongest argument in favour of developing the co-operative structure is the ability of collective organisations to provide greater bargaining power in dealing with milk processors and, as a result, to obtain better prices for members. By improving quality and consistency, reducing costs and improving management, co-operatives can increase the returns to small-scale farmers, and thus encourage producers to increase herd sizes and output. The establishment of centralised facilities for initial treatment and storage allows the costs of quality improvements, which would be beyond the financial reach of individual small producers, to be shared. In Asia, for example, development of the dairy sector in recent decades has in a number of cases involved the development of a tiered structure of co-operatives, with local-level or primary co-operatives providing basic collection, storage and transport services, while secondary- or tertiary-level federations of co-operatives provide marketing, training, bargaining, standardisation and other functions across a wider geographical area, or even at national level. In some cases, governments have provided representatives on the boards of directors of local co-operatives, with the remainder being elected from among local producers. Government representatives, often with expert knowledge such as veterinary skills, can act to guide local management, at least in the early stages of development of the co-operative. There are a number of other areas in which governments can assist in the development of co-operative structures. These might include providing information and simplifying the task of establishing a co-operative, for example by making available standardised legal agreements and recommended management structures. Expert advice could be provided by local or regional government departments responsible for veterinary services or regulatory issues. The provision of grants or low-cost credits to cover start-up expenses and provide initial investments in shared facilities would also help to encourage the development of co-operatives. Specialised training courses in management, animal husbandry and other relevant skills would increase the chances of success. The government could also appoint regional or national-level federations to represent local co-operatives. These would be able to offer marketing and training services, set quality standards and negotiate on behalf of smaller co-operatives. Improving access to credit Several solutions could support the enhancement of access to finance. They include: microfinance, co-operative banks, credit guarantee schemes, and supply chain linkages. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 125 III.6. FOCUS ON THE DAIRY VALUE CHAIN Microfinance programmes support mainly informal activities with a low return and limited market demand. They could provide lending specifically targeted to the needs of households, small farmers and dairy producers, allowing them to purchase higher quality inputs, upgrade working capital and increase the size of herds. Reaching critical mass, with at least 5 cows, is considered essential in order to attract the interest of dairy processors and benefit from their assistance schemes. At the moment few micro finance institutions are active in Ukraine, with a loan portfolio of only USD 268 million in 2009. ProCredit Bank is the biggest player, with 25 500 active borrowers in 2009, according to the Microfinance Information Exchange. New microfinance schemes could be encouraged to promote dairy businesses, following the example of other emerging markets where well designed microfinance services contributed to increased incomes and stronger employment generation. Thanks to their proximity to customers, co-operative banks could play an important role in local and regional financing, pooling resources from their members and channelling personal savings to provide mutual credits. Co-operatives could provide funding to milk producers at a lower interest rate, compared to those of commercial banks. Credit guarantee schemes could alleviate the high collateral requirements requested by financial institutions and reduce information asymmetries between banks and small and medium-sized farmers who do not have a long credit history and are unable to provide information on their creditworthiness (Figure 6.19). Three aspects need to be monitored to ensure the desired results: i) regulation and supervision; ii) the role and involvement of the private sector; and finally iii) the appropriate design of credit guarantee schemes (OECD, 2010). Figure 6.19. Credit guarantee schemes are a way to foster access to finance for mid-size farmers A way to bridge the gap between SMEs and banks A mechanism creating a win-win situation Purpose: help small, credit-worthy companies which might otherwise fail access financing of working capital or investment due to lack of collateral or of credit history. Bank loan Mechanism: a guarantee against default of the SME is SMEs Banks issued by a sponsor to the lending bank: – In the vast majority of cases, the SME reimburses the loan and has only paid a small guarantee commission Guarantee Guarantee to the sponsor. commission Scheme Guarantee – In case the SME defaults, the sponsor pays out all or a (fee) portion of the loan, usually 50-80%, to the lending bank. Counter Guarantee Financial Support Several types of sponsors can be considered State Legal environment and framework State budget, private investors, international financial institutions. Establishing a guarantee system in transitioning economies requires political support and budgetary State involvement Source: England’s Financial Service Authority (2005), “A Framework for Guarantee Schemes in the EU”, a discussion paper, London; European Training Foundation (2010), Labour Market Needs and Employability: Trends and Challenges in Armenia, Azerbajan, Belarus, Georgia, Republic of Moldova and Ukraine, ETF, Turin. The introduction of supply chain linkages could encourage lending to weaker players in the value chain, such as small and medium-sized farmers, by milk processors (Figure 6.20). Risk could be shared between farmers and processors, with one side providing funding, technology and know-how in return for a reliable supply of milk. This would raise the market participation of smaller farmers and strengthen co-operation between different players across the value chain, aligning their interests and requirements in terms of volume, quality and security of supply. Such linkages would reinforce the loyalty of farmers and encourage long-term commercial relationships (Wilner, 2000). 126 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN Figure 6.20. Supply chain financing brings the financial means of large or foreign firms to small-scale producers Two examples of supply-chain financing schemes • Guarantee on loans by the supplier Processor Sales Guarantee Farm Loan Bank • Direct loan from the processor to buy inputs Processor Sales Farm Proceeds Inputs Bank Input Supplier Advance payment Source: Professor Swinnen, OECD Agribusiness Workshop, 14-15 October 2009, Paris. Evidence from the Asian financial crisis of the late 1990s suggests that, during periods of collapse in bank credit, supply chain financing compensated for the lack of funding in the system (Love et al., 2007) especially for short term financing. A recent example of supply chain financing in Ukraine is a project worth EUR 2 million in low rate credits for dairy producers initiated in 2011 by Danone, a French food-products multinational, and Index- Bank, a universal bank owned by the French Credit Agricole group. Index Bank will provide loans at an annual rate of 16-19% to famers and producers supplying milk to Danone. The French food group will reimburse farmers for up to half of the interest charges. The funding will be channelled to projects aiming at increasing herd sizes, renovating equipment, and improving milk quality (US Ukraine Business Council, 2011). Bibliography Danone (2010), “Interview with Dario Marchetti by Expert Magazine”, http://danone.ua/en/press_center/ view/press/view/1, accessed 15 September 2011. Dries, L. and J. 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White (2011), “Marketing, Co-operatives and Price Heterogeneity: Evidence from the CIS Dairy Sector”, Annual Meeting, Agricultural and Applied Economics Association, Pittsburgh, 24-26 July. State Statistics Service of Ukraine (SSCU), (2008), website, www.ukrstat.gov.ua, accessed 15 June 2008. SSCU, (2011), website www.ukrstat.gov.ua, accessed 30 September 2011. 128 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.6. FOCUS ON THE DAIRY VALUE CHAIN The International Bank for Reconstruction and Development/The World Bank, (2007), Food Safety and Agricultural Health Management in CIS Countries: Completing the Transition, World Bank, Washington, DC. US Department of Agriculture (USDA) (2010), Ukraine: Exporter Guide Annual, Global Agricultural Information Network, Washington, DC. US Ukraine Business Council (2011), “Corporate Social Responsibility Bulletin”, No. 141, www.usubc.org/site/ corporate-social-responsibility-csr/corporate-social-responsibility-csr-141, accessed 15 September 2011. Wilner, B. (2000), “The Exploitation of Relationships in Financial Distress: The Case of Trade Credit”, Journal of Finance, Vol. 55, No. 1. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 129 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 7 Energy-efficiency and renewable technologies: Focus on production of energy based on biomass This chapter provides an in-depth analysis of biomass heat and power generation in Ukraine. Examining the demand and supply sides, it explains why the biomass value chain is promising for private domestic and foreign investors given domestic and global trends. It identifies the role that foreign investors could play along the value chain, for instance in producing heat and power or in the designing and engineering of plants. It also presents key issues and policy barriers hindering competitiveness in the sector and proposes a prioritised list of policy recommendations. 131 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Summary Energy efficiency technologies include several applications along the energy value chain, steps including production, transmission and distribution, and industrial and residential consumption. Within energy production, the use of alternative (non-fossil) sources of energy has emerged as one of the most interesting sectoral case studies for Ukraine. In particular, heat and power production based on biomass was identified as a pilot sub-sector. The sub-sector covers a whole range of activities from the collection of residues and wastes, through their processing, transportation and storage, to their combustion in order to produce heating and electricity. Finally, the distribution of the produced energy is considered as well. The use of biomass for production of energy has been pioneered by the US and the Nordic countries, such as Denmark, Finland and Sweden, for small-scale heating and for industrial use. Starting in the 1980s, biomass has also been increasingly used for district heating. In 2006, about 10% of global primary energy demand was met by energy from biomass (OECD, 2010). Power and heat production based on wastes and biomass has become increasingly profitable and private sector driven, due to the increase in prices of other traditional sources of energy. Experiences in several OECD countries, including Sweden and Poland, show that governments can take several steps to stimulate the establishment of a biomass-based energy production sector. On the demand side, a government strategy that stimulates awareness and quick adoption of this alternative energy, including but not limited to tax policy, allows for the necessary investments and organisational measures that in turn stimulate the development of the sector. On the supply side, the development of an easily accessible distribution infrastructure (electricity grid, district heating network) seems to be a key factor for the development of this market. The organisation and regulation of the whole value chain is also a facilitator. For example, the creation of a market for agricultural residues, the establishment of organisations of biomass producers and of equipment manufacturers, and promotional activities to increase awareness are all factors that have allowed for development of this sector. Ukraine has high potential for energy efficiency technologies as its energy efficiency is only one third of the average for industrialised countries. This reflects a combination of: a bias towards energy-intensive industries, such as cast iron, steel, cement and chemicals; the use of out-dated technologies, both in industries and in energy transit infrastructures; and low energy prices. Ukraine’s abundant agricultural waste and increasingly expensive fossil energy could be the basis for the future development of energy production based on biomass. Biomass resources are widely and conveniently available from a sizeable agricultural and forestry sector. The economic potential of crop wastes has been estimated by the National Academy of Sciences of Ukraine at 14 million tonnes of coal equivalent per year (around 60% of Ukraine’s measured heat production). The planned convergence of natural gas import prices to Western European levels, agreed by the government with the 132 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS IMF under the stand-by arrangement, should further increase the attractiveness of renewable energy sources. However, administrative barriers substantially limit investment opportunities in the sector, and a national plan defining the role and objectives of biomass in the energy landscape is still lacking. One of the consequences is limited communication and low awareness among farmers, industrial companies and utilities about the possible use of biomass. Development is also held back by the lack of access to capital for most players, indebtedness of local utilities and arrears in payments by consumers. As a result, today fossil fuel-based boilers and combined heat and power plants still dominate the market and produce more than 80% of heat supply in Ukraine. A strategy for this sector could be based on attracting: ● domestic and foreign utilities in rural and peri-urban areas; ● biomass-related equipment production companies and services; ● investors in agriculture and forestry, who might be interested in the sale of by-products and waste-streams as a means of diversifying or complementing their core activities. The suggested priority area for reform in this sector is investment policy and promotion. Administrative hurdles to investments in the field should be lifted. Specifically, focus should be on streamlining the administrative processes (e.g. permits), implementing a single-window approach for investors, and creating a pre-approval process for green tariffs. A sector-specific plan should be defined by the government, spelling out a long- term strategy for development of biomass-based energy production, and a mid-term action plan including, for example, support mechanisms, R&D and infrastructure investments, and specific measurable targets (e.g. biomass as a percentage of total energy production). Other areas for reform are related to the overall energy sector, including alignment of prices, market regulation, solution of the payment arrears problem and privatisation. Why focus on production of energy based on biomass The need for energy efficiency Ukraine has high potential for energy efficiency technologies as its energy efficiency is one third of the average for industrialised countries (Figure 7.1). This reflects a combination of a bias towards energy-intensive industries, such as cast iron, steel, cement and chemicals, the use of out-dated technologies, both in industries and in energy transit infrastructures, and low energy prices. Within the energy sector, key sectors with the potential to improve energy efficiency and develop alternative sources were identified. Traditional technologies for energy production, alternative technologies, and the transmission and distribution system were all evaluated (Figure 7.2). Traditional energy production, transmission and distribution activities are still dominated by state ownership Natural gas production, transportation and distribution activities are dominated by the state-owned sector. Gas usage and losses in the transportation and distribution systems are higher than in equivalent OECD countries. There is a need to reduce operational costs and to modernise distribution infrastructures: for example, more than 8 billion cubic meters of gas are spent each year in the transport system, representing a cost of more than USD 1.5 billion. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 133 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.1. Energy intensity, a cross country comparison Tonnes of oil equivalent per thousand USD of value-added, 2006 0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0 OECD-Europe World Poland Czech Republic Belarus Russia Ukraine Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris. Figure 7.2. Opportunities to reduce energy-intensity and to develop alternative sources of energy along the value chain Traditional and alternative Industrial and residential Transmission and distribution energy production consumption Improving the energy efficiency Reducing network losses Reducing the energy-intensiveness of traditional productions of the industry Gas production Distribution of gas and gas products Metallurgy Oil production Distribution of oil and oil products Coal production Transmission and distribution of electrical power Heat and power production based on nuclear, gas, oil, coal, large hydro Reducing the commercial, public Heat distribution and individual energy consumption Buildings technologies – insulating Leveraging alternative sources materials, appliances to monitor of energy and regulate heating consumption Energy production based on biomass, Transportation sector – wind, small hydropower, geothermal automotive industry energy, sun energy Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Natural gas extraction, transportation and distribution are still heavily regulated and controlled by the government. Naftogaz Ukraine, a company fully owned by the state, dominates the gas value chain in Ukraine (Figure 7.3). The government has direct access to reserves and infrastructure, pricing and tariff setting, import and export transactions. Moreover, administrative procedures for granting exploration and production licences are cumbersome for foreign investors (IEA-OECD). A new gas law was passed in August 2010 giving access to the distribution network to potential gas producers, but it remains to be seen whether implementation will prove effective. There are also substantial opportunities for improving energy efficiency in oil production, distribution and refining activities. Unlike oil refining and distribution, which are controlled by powerful private domestic and Russian players, oil production is fully owned by the state. State-owned Naftogaz dominates exploration and production, as well as the main oil pipelines (Figure 7.4). Oil exploration and production equipment is old and 134 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.3. Naftogaz (100% owned by the state) dominates the gas-value-chain in Ukraine UPSTREAM MIDDLESTREAM DOWNSTREAM Exploration and production Transmission Processing Distribution and trade Monopoly through One major player Full ownership of the pipes, > 92% of the production 2 subsidiaries in gas processing shares in a majority of the 42 privatised regional distribution companies Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Figure 7.4. State-owned Naftogaz dominates exploration and production, as well as the main oil pipelines UPSTREAM MIDDLESTREAM DOWNSTREAM Exploration and production Transmission Refining Distribution and trade > 95% of the E&P is due State monopoly Private and foreign Private and foreign (Russian) to state controlled through (Russian) companies companies control most companies – Ukrtransnafta own the 6 refineries filling stations Naftogaz of Ukraine with some state shares (Ukrnafta, State-owned companies – Chornomornaftgas), Ukrnafta, Naftogaz – have a Nadra of Ukraine share of the oil retail market Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. inefficient and requires upgrades. Oil refining technologies are also outdated. The depth of processing varies between 47 and 70% in Ukraine, while it reaches 90% in OECD countries. Worn-out and inefficient coal production equipment provides opportunities for improving the efficiency of coal mine operations, especially in state-owned mines. Further efficiencies can be achieved by utilising coal-bed methane, which is currently wasted. The state owns over 150 coal mines producing only half of the volume of coal, which is primarily used for power plants (Table 7.1). The other half is produced by 30 more competitive private mines, primarily producing coking coal for metallurgy. State-owned coal production in Ukraine is currently unprofitable and needs financial support from the government. Table 7.1. The distribution of Ukraine’s coal mines Features of State-owned and Private-owned mines Ukraine’s coal sector State-owned Private > 150 mines < 30 mines Mainly coal for power plants Mainly coking coal mines Half of Ukraine’s coal production Half of Ukraine’s coal production Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 135 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Mining and geological conditions in Ukraine’s mines make profitable coal extraction difficult. Average coal prices are below short-term production costs because of rapidly increasing prices of mining equipment and operating costs. Thus, in order to support production the government is forced to provide subsidies. Privatisation of state-owned coal mines is a possibility in the medium-term, but would raise political risks due to the possibility of redundancies and associated social issues. The efficiency of power plants needs to increase. Ukraines thermal power plants tend to be quite inefficient due to excess capacity and age. The average load factors for thermal power plants are very low, measuring just 28% in 2004 compared to 70% in 1990. The nuclear and large-hydro power generation sectors are not open to private and foreign investment. To a large extent, state ownership still prevails in power generation, with 100% state ownership of nuclear facilities, 85% ownership of thermal stations and 99% ownership of hydropower plants. Privatisations of thermal power assets might happen in the coming years, according to the economic reform plan of the president, but the timeline remains unclear. The electricity market is highly regulated with wholesale prices for nuclear and hydro generation set by NERC, a special agency that regulates energy prices and tariffs. At the moment, regulated tariffs are still not high enough to cover depreciation or re-investment in power system assets. There are also opportunities for improving efficiency in the power transmission and distribution sector. The losses of electricity during transmission and distribution in Ukraine amount to about 15% (8% in 1990), compared to 6% in the OECD countries. According to Ukraine’s State Agency for Energy Efficiency and Energy Savings, at the beginning of 2011 the actual technical loss of electricity in the grid dropped to 10.7% of the overall electricity supply. Currently, power transmission is fully controlled by the state, while distribution activity is shared between private and public ownership (Figure 7.5). One domestic private investor has a significant degree of control over the market, owning up to 75% of shares in ten distribution companies, which may make it difficult to build a level- playing field for potential newcomers. Figure 7.5. State and private ownership of power transmission and distribution assets until mid-2011 Transmission Distribution and supply Ukrenergo is a 100% state-owned company 14 oblenergos are state-controlled 7 oblenergos are partly state-owned 6 oblenergos are fully controlled by the private sector 3 independent suppliers are owned by private industrial companies Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. However, there are a couple of successful case studies. The distribution companies owned by foreign investors have a very good track of record of reducing losses from electric power lines. AES, a US company, has been making large investments in its distribution lines and billing systems, totalling around USD 80 million during 2003-09. 136 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Alternative sources were selected with a focus on production of energy based on biomass The dominant presence of the state in most existing energy sub-sectors, high administrative barriers to entry in most markets, and consultations with stakeholders led to the final selection of alternative sources of energy. The low level of state ownership and relatively lower barriers to entry were the key reasons for such a choice. Production of energy, and in particular of heat and power, based on biomass was selected as a pilot sub-sector on the assumption that gas prices will continue to increase as expected by the government. In the initial stages, government intervention in this sector would be required to define a strategy and launch some pilot projects; however, the economic viability of the biomass sector is sustainable without major government subsidies. This was a key selection factor, as private players would not be interested in a sector highly dependent on uncertain public subsidies. Ukraine’s abundant agricultural by-products and the rise in fossil energy prices are the two elements that are likely to drive the future development of energy production based on biomass. Biomass waste and residues are widely and conveniently available from the sizeable agriculture and forestry sectors. Straw, manure and wood are especially promising as primary biomass sources of heating. The economic potential of crop wastes has been estimated by the National Academy of Sciences of Ukraine at 14 million tonnes of coal equivalent per year. Thus, the use of primary agricultural residue could partly satisfy increasing heat consumption needs and replace traditional heat production systems. At present, fossil fuel-based boilers and combined heat and power plants still produce more than 70% of the heat and power supply. With natural gas prices expected to increase further as a result of the price reform in the internal market, the use of natural gas for production of heat and power will become very expensive. Global prices for other fossil fuels, such as oil and coal, are also expected to rise in future. In contrast, renewable sources of energy, such as hydropower, geothermal, wind and solar energy and biomass energy, are nearly limitless. Generation of energy from renewable sources avoids damaging the climate and environment by eliminating emissions or, in the case of biomass, by recycling the carbon. Sector definition and segmentation The OECD (2010) defines biomass as “any organic material of plant and animal origin, derived from agricultural and forestry production and resulting by-products, and from industrial and urban wastes, used as feedstock for producing bio-energy and other non-food applications”. Biomass involves different technological processes and areas of application. Energy generation from biomass is very flexible in terms of production scale. The size of production facilities can be matched to the needs and requirements of consumers and can range from private small-scale installations to industrial multi-megawatt operations. The biomass and waste energy production value chain includes three stages: fuel supply; production; and the sale of heat, hot water or electrical power. The supply stage includes collection of various types of agricultural and municipal residues, their transportation, processing and preparation, and transportation and storage at the power generation facility (Figure 7.6). Biomass potential of crop origin is not addressed in this study.* * This kind of study would require an assessment of the potential adverse effects on arable land fertility or food prices. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 137 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.6. Biomass residue supply chain for energy production Biomass supply Production Sale Collection Processing Combustion- of residus or production Sale of heat Transport Transport Storage or hot water and wastes preparation of heat or hot water Agricultural Truck Pressing Truck Tank Burning Own use by-products TYPICAL OPTIONS Forestry Gasification District by-products Tractor Drying Tractor Storehouse and burning heating Municipal Conveyor belt Mixing Conveyor belt Silo Rural heating by-products Pile Industrial heating PRODUCTS RESIDUES AND WASTES FUEL HEAT OR HOT WATER Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Heating and combined heat and power plants (CHP) can use different types of biomass, including hay, grass, peat, and wood as well as waste. Industrial heating systems are usually based on waste generated by their own production processes and may include paper, manure, wood waste and other materials. The use of traditional stoves and open fireplaces is on the decline as it has very low energy efficiency of 20-25%. Modern biomass boilers provide much higher efficiency in the 70-80% range. They also offer relatively clean combustion and can use different types of fuel, such as wood logs or pellets. Biomass can also be used along with coal in co-firing systems for either power production or for heat and CHP production (Table 7.2). Requiring moderate initial investments, this option could be considered in the near term as it uses existing facilities that require only minor modifications. It is the most competitive option for using biomass in power generation (IEA, 2007). Several OECD countries, including Australia, Denmark, Finland, the UK and the US, have successfully promoted co-firing, and this has proven to be a key initial step in encouraging the development of a biomass market as well as improving the necessary technical expertise. Global trends Renewable sources of energy play an increasingly important role and biomass is amongst the most dynamic segments Renewable energy sources are playing an increasingly important role in meeting energy needs across the world. Not only do they reduce dependence on fossil fuels but they also help to protect the environment by reducing greenhouse gas emissions, create new jobs and contribute to economic development. Rapid development of the emerging economies, especially China and India, will drive future demand for all types of energy sources. Rising prices of fuel and energy for the end consumer, high carbon emission penalties and environmental protection policies will 138 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Table 7.2. Energy uses of biomass Scale Use Type of heating Features Small scale heating and Traditional stoves and open fireplaces Individual heating Often low level of efficiency 20-25% hot water applications, Modern biomass boilers Individual heating Energy efficiency around 70-80% capacity < 1 MW/th Relatively clean combustion Larger installation used for heating of flats Large scale applications Biomass fired CHP plants for district heating Power and heat Fuels are hay, grass, peat, wood Interesting alternative in the modernisation of DH grids Biomass boilers for district heating District heating An alternative in converting coal fired DH plants Smaller installations used for block heating Industrial heating biomass boilers Industrial heating Fuels are waste products coming from the production process: paper, sawmills, manure from cattle farms Larger installations might be used for small scale DH Co-firing Power and heat Moderate additional investment required Efficiencies up to 45% is the most cost-effective biomass use for power generation Source: Van Holsteijn en Kemna (VHK) (2002), “Heat from Renewable Energy Sources”, The RES-H Initiative and related Directives, VHK., No. 332, the Netherlands. partially restrain energy demand growth. At the same time, these developments will stimulate the growth of renewable energy, and biomass in particular. In OECD countries energy supply from biomass increased 7.8 Exajoule (EJ) in 2006 from 5.5 EJ in 1990. The share of energy produced from renewable sources in the world total energy supply equalled 12.4% in 2007 (Figure 7.7) with energy generated from renewable combustible and waste materials accounting for 9.6% of the total. Figure 7.7. Structure of the global total primary energy supply, 2007 Natural gas, 20.9% Non-renewable waste, 0.2% Nuclear, 5.9% Hydro, 2.2% Oil, 34% Renewable combustibles and waste, 9.6% Coal, 26.4% Other1, 0.6% Source: IEA (2009), World Energy Statistics, IEA, Paris. Looking at the application of biomass for production of energy, different forms of biomass are used for different purposes across sectors. According to available data, about 25% of biomass was used for generation of heat and power, about 30% in the residential sector and about 46% in industrial applications in 2006. At the same time, liquid biomass is largely used for the production of fuel for the transport sector and biogas consumption is concentrated in the heat and power generation sector (OECD, 2010). Although the availability of data on the renewable sector is still rather limited, the majority of biomass in non-OECD countries is still used in the residential sector, while OECD economies have the leading position in the application of biomass for energy COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 139 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS production. Generation of heat and electricity from both liquid and solid biomass has been increasing steadily for the past 2-3 decades. There is a wide variation in the use of renewable sources both among developed and developing countries. Among the OECD countries, more than 75% of energy consumed in Iceland comes from renewable sources, while in Korea it is only 1%. Renewable combustibles and waste account for over 77% of the total renewable energy supply, 72% of which is generated from solid biomass and charcoal (Figure 7.8). The share of energy produced from biomass in the OECD countries has been higher than energy produced from other renewable sources since 2003. Figure 7.8. Structure of world renewable energy sources supply, 2007 Liquid biomass, 2.40% Wind, 1.00% Renewable MW, 0.90% Solid Hydro 17.70% biomass/ charcoal, 72.90% Solar, tide, 0.60% Geothermal, 3.30% Renewable Gas from biomass, combustibles and 1.10% waste, 77.30% Source: IEA, (2007), “Biomass for Power Generation and CHP”, IEA Energy Technology Essentials, Paris. Box 7.1. The case of biomass adoption in district heating in Sweden The use of biomass in Sweden increased by 88% between 1980 and 2002. During this period biomass application increased considerably and reached 14% of the total energy produced in the country. The application of biomass in district heating increased substantially and in 2002 about 43% of district heating was based on biomass. The existence of a large forest industry and well developed district heating systems provided a good organisational basis for the biomass expansion. The growth of the sector was assisted further by the existence of structures that could handle products from the forestry sector and strong and stable demand from the district heating systems. Higher demand for biomass has in turn led to reduced production costs as new methods and technical solutions for biomass were continuously introduced during the last decade. Heat production plants benefitted from the growth of the biomass market and the emergence of new suppliers. Source: Bengt Johansson (2001), “Biomass in Sweden – Historic Development and Future Potential Under New Policy Regimes”, Energy and Environmental Systems Studies, Lund. Proximity of resources and stability of supply are key to ensuring profitability of a biomass project One key success factor at the supply stage is related to the intrinsic physical characteristics of biomass. The low energy density of biomass means that a considerably larger volume is required to generate the same amount of energy compared to fossil fuels. High moisture content increases the weight of fuel and raises the cost of transportation. 140 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Biomass fuels in their raw form are typically consumed on site or transported over short distances, within a 50-80 km radius as a maximum, depending on transportation costs. As a result, collection and transportation represent a major cost for suppliers of biomass material. Key success factors for the expansion of the biomass sector include the creation of a reliable supply and stable market conditions. In order to operate biomass-based power plants efficiently, operators require a stable supply of fuel throughout the year as well as clear and predictable prices. In many cases the lack of raw materials is the key barrier. Lack of feedstock for the production of wood pellets in many EU countries has led to a reduction in production volumes during the last few years. However, lack of raw materials should not be a problem for countries with large agricultural, forestry and wood processing sectors. Rather, governments have to facilitate the development of suppliers, perhaps by means of demonstration projects. Also, in order to overcome the seasonality of biomass supply, appropriate storage facilities for feedstock have to be built, requiring high initial investments. Key success factors for profitability at the next stage are related to the distribution costs of heat and power generated from biomass (Figure 7.9). The required investment in distribution should be minimised as heat distribution or electrical power transmission and distribution networks should be present prior to the installation of a bio-heat plant. However, some investment in better insulation in the network and other energy-saving measures might be necessary in order to reduce losses of heat during transmission and to improve efficiency of distribution. There may also be a need to invest in connections to the national electricity grid. Figure 7.9. Key success factors for a bio-energy project Biomass supply Production of heat/power Sale Biomass fuels must typically be Supplies of biomass must be stable The heat or electrical power network consumed on-site or transported to ensure stability of heat should exist prior to the installation on short distances only or power production of a bio-energy plant Biomass has a low energy High utilization rate will ensure Investments in energy networks density stability of heat production distribution should be minimized and shorter pay-back period A significantly larger volume Existence of market instruments, i.e. Distribution costs should not be of biomass fuel is required to generate long-term contracts with farmers, higher than fossil-fuel based heat the same energy as a smaller volume ensure stable biomass supplies with and power production of fossil fuel clarity and predictability of prices The costs of fuel collection and Storage capabilities near the plant transportation can quickly outweigh allow to overcome the seasonality the value of the fuel of the biomass supply Source: Hurstboiler (2010), Corporate website www.hurstboiler.com, accessed 15 June 2010. Sources of competitiveness Biomass resources are widely available in Ukraine Ukraine’s agricultural sector is a rich source of biomass, including straw from grain crops and rapeseed, residues from the production of corn for grain, residues from the production of sunflowers, secondary agricultural residues (sunflower and rice husks, sugar bagasse), wood residues, and peat (Table 7.3). COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 141 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Table 7.3. Straw, wood, husk and manure as primary biomass sources are promising in Ukraine Biomass residue Origin Final use source Straw To conserve humus for soil fertility, straw is left on the field The straw surplus can be used as fuel in small straw-fired boilers after harvesting if it is not needed for livestock. and in straw-fired district heating plants. But this is not mandatory in a well-planned crop rotation. Wood Sawmills, pulpmills, and other wood processing industries Residues can be made into wood-chips or pellets to fire boilers. generate bark, sawdust, wood chips and other residues. The energy produced can help to meet the heating needs of the wood industry or be sold to wood-fired district heating plants or Combined Heat and Power plants. Manure National cattle and swine herds of approximately 17 million The manure can be used in biogas plants to provide heat in animals. small-sized plants for households, villages or in modern plants supplying thousands of people. Animal manures are typically disposed of through application The resulting sludge at the end of the process could be used as to farmlands as organic fertilisers. fertiliser since the nitrogen and phosphorous content is not lost. Source: Institute for Economic Research and Policy Consulting (2007), “Bioenergy Production in Ukraine: The Competitiveness of Crops and Other Raw Materials from Agriculture and Forestry”, Policy Paper, No. 11, Institute for Economic Research and Policy Consulting, Kyiv. In terms of regional distribution, all regions except the western part of the country and the Crimean peninsula have high economic potential for development of energy generation based on agricultural residues. This primarily correlates with production of wheat and sunflowers, which are the primary sources of agricultural residues, however it is also influenced by other factors, such as the quality of the soil and the region’s climate. According to the National Academy of Science of Ukraine, the economic potential of crop wastes is estimated at 14 million tonnes of coal equivalent per year. For example, this would imply that primary agricultural residues could potentially replace more than half of the measured fossil fuel consumption for heating (Figure 7.10 and Box 7.2). Ukrainian government experts estimate that up to 1.4 million cubic meters of wood, 1.1 million of cubic mters of wooden waste and 3.8 million cubic meters of firewood could be annually used for energy purposes. Biomass residue use is cost competitive for production of heat and power Wide availability of biomass resources further ensures a cost advantage, mainly due to the low cost of raw materials, labour and transportation. For example, under certain assumptions, heat produced with straw-based boilers is 67% cheaper than using a gas-fired unit (Figure 7.11). Figure 7.10. Economic potential of biomass sources in 2008, breakdown by type of agricultural residue, millions of tonnes of coal equivalent Residues from sunflower 4.48 Residues from corn for grain 4.31 Straw of wheat 2.17 Straw of other rapeseed 2.06 Straw of barley 0.83 Straw of other grain crops 0.30 0 1 1 2 2 3 3 4 4 5 5 Source: Institute of Engineering Thermophysics – National Academy of Science in Ukraine (2010), BEE FP7 Project, Kyiv. 142 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Box 7.2. Assessing the biomass potential of a country: From “theoretical” to “economic” potential Theoretical potential The overall maximum amount of biomass which can be considered theoretically available for bio-energy production within fundamental bio-physical limits. Technical potential The fraction of the theoretical potential which is available under the existing techno- structural framework conditions and with the current technological possibilities, taking into account competition with other land uses (food, feed, fibre production), ecological and other-non-technical constraints. Economic potential The share of the technical potential which meets criteria of economic profitability within the given framework conditions. Source: Zhelyezna, T. and V. Leznova, (2008), Presentation of the EC FP7 Project “Biomass Energy Europe”, Presentation at the 4th International Conference on Biomass for Energy, 22-24 September 2008, Kyiv. Figure 7.11. Production costs of heat by straw-based boilers are lower than by gas-fired boilers Operational costs of heat production, using a 600 kW boiler, natural gas vs straw-wheat crop residue, ‘000 hyrvnias, 2007 Purchase of electrical power Other operational costs Labor costs Technical maintenance Fuel purchase 400 10 350 15 25 300 26 250 200 293 5 150 13 25 100 26 90 0 Gas-based Straw-based heater heater Gas-based heater Straw-based heater Number of utilisation days Half a year – 4 272 hours Fuel quantity needed 293 000 m3 of gas 746 tonnes of straw Energy density 35 MJ per m3 16 MJ per tonne Fuel price 1 000 grivnas for 1 000 m3 120 grivnas per tonne Electrical power consumed 25 000 kWh 13 000 kWh Total annual heat production 2 204 Gkcal Note: Amortisation costs are not included. Source: Zhovmir, N. et al. (2007), “Al’ternativnoe teplosnabzhenie za schet ispol’zovanija solomy” (Alternative Heat Supply Through Use of Straw), Kommunal’noe khozjaystvo, No. 8, pp. 24-27, December. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 143 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Similarly, as Ukraine has considerable forest resources and a large wood processing sector, it can also use wood for heat generation. Wood-fired boilers for heat and hot water supply require a low upfront investment and ensure a 3-year simple pay-back period (Figure 7.13). For example the operation of a 6.0 MWh hot water boiler plant on wood biomass can generate operating profits of around 50% of annual heat sales revenues (Figure 7.12). Figure 7.12. Operating costs and profits of a hot water boiler based on wood biomass for supply of a middle-size city, thousands EUR Operating profit Labor cost Maintenance cost Power cost Wood-based fuel cost 600 283 500 400 300 14 18 44 200 100 199 0 Source: Scientific Engineering Centre “Biomass” et al. (2004), Ukraine: Market Potential for District Heating Projects in the Ukraine and their Modernisation with Austrian Technology, The Austrian Energy Agency, Wien. Figure 7.13. Net cash-flow plan in the five first years of the project, thousands EUR 400 Initial investment 283 283 283 283 200 0 -200 -400 -600 -800 -760 -1 000 Year 0 Year 1 Year 2 Year 3 Year 4 Note: The technical, environmental and economic assumptions are the following: 6.0 MWh hot water boiler plant operating on wood biomass; availability of wood wastes and residues due to neighbouring forests; distance of transportation of wood and residues is no more than 10 km to obtain reasonable cost of wood biomass; existing hot water distribution network to households and companies; tariffs on the supplied heat – 4.03 EUR/GJ; heat supplied to the customers – 138 240 GJ; distribution losses – 20%; fuel consumption – 26 667 tonnes/year; cost of fuel (including transportation and processing) – 7.45 Euro/tonne. Source: Scientific Engineering Centre “Biomass” et al. (2004), Ukraine: Market Potential for District Heating Projects in the Ukraine and their Modernisation with Austrian Technology, The Austrian Energy Agency, Wien. 144 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Increasing prices of natural gas in Ukraine should make biomass an even more attractive fuel to utilities With the vast majority of heat and power produced from fossil fuels, natural gas is the primary source of energy in Ukraine. Ukraine depends on imports for the majority of its energy supplies, including natural gas and oil (Figure 7.14); domestic production of gas meets only 25% of total demand. Figure 7.14. Fuel used for power and heat production in Ukraine, 2006 Combined heat and power plants Heat-only boilers Coal, 6% Heavy fuel oil, 16% Coal, 32% Natural gas, 55% Natural gas, 78% Heavy fuel oil (mazut), 13% Source: International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. The growing cost of fossil fuels, especially oil and gas, should pave the way for using alternative fuels in power and heat production. As a result of the current gas reform, monitored by the International Monetary Fund, natural gas will become increasingly expensive in Ukraine and will gradually rise to reflect the current market price of the fuel after decades of subsidised prices. The IMF’s requirements for gas prices include: ● gradually bringing domestic gas prices to import-parity; ● 50% domestic gas price increases for households and utility companies were implemented on 13 July 2010, effective 1 August 2010, with the next billing period; ● a further 50% increase was planned in 1 April 2011, with semi-annual increases thereafter until import parity is reached for all categories of consumers, with automatic adjustment mechanism planned thereafter; however, in 2011 due to the gas price negotiations between the Russian Federation and Ukraine, the gas price increase was delayed; ● most of the industrial prices are already at market levels, and preferential tariffs for various industries have been eliminated. According to World Bank estimates, prices of natural gas might increase by more than 400% from 2009 until 2017 in Ukraine (Figure 7.15). The role of foreign investors in the biomass value chain Ukraine offers a number of opportunities for foreign direct investment along the entire value chain of biomass-based heat and power generation, including supply of waste to utility companies, production of biomass burning equipment, design and construction of biomass- based heat and power utilities, and conversion of fossil fuel units to biomass (Figure 7.16). COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 145 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.15. Price of natural gas for utilities in Ukraine, past trends according to IMF requirements 2 500 2 000 + 125% 1 500 1 000 500 0 End of 2008 Mid 2010 2nd quarter of 2011 2014 2017 Source: International Monetary Fund (2010), Country Report, No. 10/262, Country Report Series, International Monetary Fund, Washington, DC. Figure 7.16. Potential opportunities for FDI along the value-chain Biomass Production of heat and power Sale supply Supplying Supplying Designing and Construction Owning and the agriculture the equipments engineering of the heat operating the heat wastes for a heat or the heat or or CHP plant or CHP plant, CHP plant project CHP plant distributing heat Large grain or Boiler manufacturers Engineering, procurement Utilities companies PRIVATE PLAYERS sunflower and construction companies producing heat or TO BE INVOLVED Other equipments producers electrical power (heat exchangers) Large cattle raising manufacturers farms Wood producers or processors Acquisition of grain Partial or total Partial or total acquisition Privatisation of district or cattle farms or acquisition of EPC companies with transfer of skills heating companies and POSSIBLE FDI forestry companies of a boiler and technologies in biomass based heat further conversion with further effort manufacturer with and power utilities of fossil-fuel units on sales of wastes further focus on to biomass-based units to utilities biomass companies technologies and equipments Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. 146 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Key issues and policy barriers Regulatory framework and administrative complexity limit access to utilities companies Private actors operating in Ukraine face an over-regulated and highly complex administrative and legislative framework, which limits private and foreign access to utilities companies. According to the Enterprise Surveys conducted by the World Bank (World Bank, 2009), in 2008 the major constraints on investment in the country were political instability, high tax rates, endemic corruption, practices in the informal sector, and access to finance. According to the survey’s respondents, 31.8% of firms expected to have to pay officials informally to get things done, compared with an average of 23.5% in Eastern Europe and Central Asia. Nearly 60% of the firms surveyed expected to give gifts in order to obtain construction permits, twice as many as the eastern and central European average. On Box 7.3. Example of foreign direct investment by AlterEnergyGroup Foreign investor overview: Swiss renewable utility company with its first operating asset located in the small city of Smela in Cherkassy. Investment characteristics: Full conversion in 2008-09 of a gas-fired CHP to a wood-fired CHP; Capacity – 10 MW/th and 2.5 MW/el; forest of Cherkassy ensures low-cost and stability of supply. Amount of investment – 1 million euro. Rationale for investment: “Ukraine was chosen due to the poor state of its existing power generating infrastructure, heavy reliance on imported and domestic hydrocarbon energy sources, abundance of vastly underutilised alternative energy sources, and lack of competitive barriers to entry”. Company structure and activities Corporate level JugEnergoPromTrans SmelaEnergoPromTrans Core focus is in power plant Legal entity for the Smela engineering and construction as a contract biomass based cogeneration service provider with experience power plant located in Smela, in electric power and water Cherkassy heating systems The JEP acquisition allows AEG The pilot biomass CHP is the first to control the engineering, commercial wood biomass CHP procurement, and construction (EPC) operating in Ukraine and proved that of power generation projects foreign Direct Investment is without incurring high cost viable in this specific sector third-party EPC contracts Designing and Utility’s ownership operations – Procurement Construction engineering prod. and sale of heat and power Source: AlterEnergyGroup (2010), Corporate internet site, www.alterenergygroup.com/content/home.php?lang=en, accessed 15 June 2010. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 147 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS average, 2.1 days were spent meeting Ukrainian tax officials, compared with an average of 1.6 days in Eastern Europe and Central Asia. Another interesting indicator is the number of days required to obtain a construction-related permit, which was 135.6 days in Ukraine compared with 79.6 days in the region. The IFC, the private sector arm of the World Bank group, estimates that in 2008 private firms and entrepreneurs spent USD 1.55 billion on complying with permits, inspections and technical regulations (IFC, 2009). Although these issues have been highlighted for some time and there has been a commitment by different governments to simplify procedures, barriers have still not been removed. According to the World Economic Forum Global Competitiveness Index 2010-11, the country dropped by seven positions to 89th (or by five positions in a constant sample) as a result of the weak institutional framework and the lack of competition in the market for goods and services. In the renewable energy sector a support scheme based on feed-in tariffs for electricity produced from renewable resources was introduced in 2008 and then modified in 2009. The tariff path is fixed until 2029 at a level that is linked to conventional energy prices with an additional guarantee against exchange rate fluctuations, as the calculation contains a floor for prices expressed in euro. However, the business community observed that there is a lack of clarity of certain provisions in the green tariff law (Box 7.4). The changes in the tax code in introduced several tax benefits in favour of renewable energy companies, such as a reduction of taxes on land used for the construction of renewable energy facilities and an exemption from corporate tax of sales of power generated by renewable sources, available until January 2021 (OECD, 2011). But apart from these measures, there are few incentives for existing companies operating in the energy sector to reduce the consumption of natural gas and switch to biomass. Box 7.4. The application of feed-in tariff regulations The business community has raised some issues related to the application of feed-in tariff regulations, notably the costs of connecting renewable energy facilities to the grid and the lack of clarity of certain provisions in the green tariff law. It considers in particular that the investment risk of renewable projects could be mitigated if access to green tariffs were guaranteed when the relevant building permits are issued, not only after the plants start producing electricity (International Chamber of Commerce-Ukraine, 2010). However, such modifications would probably increase considerably the risks for the state and the grid operators given frequent delays in the finalisation of renewable energy projects. Source: OECD (2011), “Investment Policy Reviews: Ukraine 2011”, OECD Investment Policy Reviews, OECD, Paris. Biomass sector is not promoted enough as an area for foreign investment Despite the synergies and potential that the biomass sector could provide, there is a lack of promotion of alternative sources of energy generally and, more specifically, of biomass. The absence of a clear promotion and communication strategy on the topic affects both the development of the local biomass market and the attraction of foreign investors. The level of public and corporate awareness of the key features of the biomass sector is generally low. According to the OECD Country Capabilities Survey, 43% of the utility companies interviewed reported a medium perception of public interest in biomass energy production, while 45% of them assessed the interest as being either low (around 22%) or very 148 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS low (around 22%). A significant proportion of the surveyed firms suggested that there is a need to raise the level of awareness both among utility companies (63% of respondents) and among end-consumers (43% of respondents) (Figure 7.17). Investing in the sector would mean taking advantage of the vast natural asset base and transforming it though technology and innovation into a new green industry. The process would create new jobs, develop capabilities and help to reduce Ukraine’s dependence on natural gas and other sources of energy. All these elements need to be combined into a clear promotion strategy on energy efficiency and green growth, targeting the business sector and end-consumers. Figure 7.17. Lack of public support and awareness for the biomass industry was pointed out QUESTION ASKED Very low 22 Low 22 45% of the How do you assess Medium 43 respondents assessed public interest about as low or very low the possibility of using High 11 the public interest biomass for energy for biomass sector production? Very high 3 40 utilities companies were surveyed in Ukraine 0 10 20 30 40 50 % Source: OECD (2011), Country Capability Survey, internal working document, OECD, Paris. In 2009, the Ukrainian government drafted, with the assistance of the Dutch government, an Action Plan for the Biomass Sector that highlights the lack of effective communication and information exchange between ministries, agencies and other institutional stakeholders as well as among potential consumers of biomass energy. Overall, the actual understanding of issues related to the sustainability of renewable energies remains poor. Workshops and training courses on regulation, financing, standards, sustainability and certification in the sector have been sporadically organised, mainly thanks to the support of international donors, such as the Dutch government. Interestingly, the potential of the Ukrainian biomass sector is seen as an important goal for the development of the country more by foreign counterparts than at the national level. Power and heat payment arrears The distribution of power and heat is perceived as a social service in Ukraine, with subsequent free-riding behaviour by final consumers who are not forced to pay their bills in full and can accumulate large arrears (Figure 7.18). Disconnection from the power and heat supply is not common and often delayed, mainly for cultural and social reasons. According to the Ministry of Fuel and Energy the average level of payment for heating services amounted to only 60% of the total due in 2008, with big regional disparities (e.g. it was only 36% in the Luhanska oblast compared with 93% in the Odesska oblast). The toleration of energy sector payment arrears is common in other former-Soviet Union countries. Evidence suggests that it has declined in some of the energy-importing countries, such as Armenia, Kyrgyz Republic and Ukraine, while it has risen in energy-rich countries such as Azerbaijan and Russia (Petri and Taube, 2003). This quasi-fiscal activity has hidden costs that have created inefficiencies and distorted the power and heat market. Firstly, there is an incentive to over consumption and waste, such that resources are not allocated in an efficient way. Secondly, these cumulative debts have a negative, even if not direct, impact on the budget deficit. Thirdly, they create cross-subsidisation between oblasts, COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 149 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.18. Payment arrears also need to be solved to allow for investment The case of heat payment arrears in Ukraine, end of August 2008 • • • • Source: Centre for Social and Economic Economic Research Ukraine (CASE) (2008), Ukrainian Heating Sector Review, www.case- ukraine.com.ua/u/publications/5a6fa8e6557b434db34f03aee0e6e9e9.pdf, accessed 20 October 2008. where the complying regions are actually taking the burden and subsidising those that do not comply. Finally, they are detrimental to the restructuring and upgrading of the whole sector, as private or foreign investors would not have an incentive to intervene in an uncompetitive market where the current players are accumulating debts and the profitability of their activities is at risk. For instance, according to the Country Capabilities Survey in Ukraine conducted by the OECD in 2011, 58% of the firms interviewed identified the lack of visibility regarding future profits as a major hurdle to foreign investment in the sector. Natural gas, heat and electrical power prices are still subsidised The subsidies that are keeping energy prices at artificially low levels are preventing investments in renewable energy. Despite the recent increase in the price of natural gas, Ukrainian households still enjoy subsidised energy prices, which have typically been artificially below international levels. Prices tend to cover only operating costs, instead of long run marginal costs. For example, at the beginning of 2011 the import price for natural gas (including VAT) stood at around UAH 2000 per thousand while consumers paid an average of UAH 911 per thousand. The IEA estimates that in 2009 the level of energy subsidies in Ukraine was equivalent to some 4.7% of the country’s GDP, i.e. around twice the levels observed in Russia and Kazakhstan (IEA, 2010). This has hampered both efficiency and investment, minimising competition (IEA, 2006). One of the consequences of the current pricing scheme has been chronic under-investment in building, maintenance, and upgrades of all energy infrastructures, including pipelines and the electricity grid. The Economic Reform Programme for 2010-14 envisages a gradual increase of gas prices and aims at achieving a liberalisation of the energy industry. Energy sector reforms are facing political resistance, but until the era of subsidies and cheap energy comes to an end, other alternative, more efficient energy sources that are not subsidised will struggle to 150 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS be competitive. For instance, the bailout granted in July 2010 by the IMF is conditional on structural reforms including a realignment of energy prices with market fundamentals. State ownership of power and heat production assets The participation of private actors could bring in much-needed investment in the biomass sector, reduce the costs of processes and upgrade service quality. There is a lack of funding to replace fossil fuel-based boilers with biomass-fired equipment. Private investors could play a key role in the provision of funds as they have the ability to raise financing on capital markets. However, most of the old facilities are currently owned by the state, the regions or the municipalities. Public authorities perceive the production of power and heat as a social service and do not generally link it to market dynamics. The size of the state-owned enterprises in the energy sector prevents the entry and exit of new players, limiting its modernisation and growth. As a result the private sector has not had the chance to be particularly involved so far. Due to the protracted lack of government investment, the rate of depreciation of existing capital assets has already reached 70% on average and the presence of obsolete equipment raises the inefficiency of current processes. There is therefore an urgent need to modernise or replace existing assets. Policy recommendations Streamline administrative processes, including a single-window approach and pre-approval for green tariffs The licensing, permit and administrative processes need to be streamlined to make them transparent, more predictable and competitive. A “single-window” system for setting up alternative energy activities should be considered. The single-window would provide information on administrative forms, procedures, approvals, clearances and permissions, reporting, filing, payments and compliances. An electronic system would be advisable, so that different players do not need to visit different physical locations anymore, minimising costs. Drawing from the OECD experience, the most advanced single-window systems, such as the one implemented in Korea, also connect entrepreneurs with financial intermediaries, insurance companies, and ICT specialists to facilitate their operations. The single-window approach would improve governance and minimise the opportunities for corruption. Align energy costs to market prices, as promised to the IMF The distortions caused by the mismatch between domestic and market energy prices need to be removed with a high priority. The government is already committed to implementing semi-annual increases in gas prices and the process of aligning energy prices with international levels needs to continue. Industrial prices are already at market levels, while consumers still enjoy subsidised tariffs. The upward pressures on prices will give consumers a better understanding of what their energy consumption is worth to the economy as a whole, and hence, a stronger incentive to use energy in a more efficient way. The process could also divert attention towards other alternative sources of energy. To protect the poorest segments of the population from sharp rises in energy costs several welfare mechanisms could be introduced. A targeted welfare approach would be more effective than subsidising energy prices for all consumers. Special cash transfers, such as energy vouchers, would be relatively good in terms of targeting, but they would require some degree of administration and co-ordination. Other options such as lifeline tariffs where the lowest block of consumption is charged at a lower price would be simpler to administer but would require a reliable metering system. The relevant stakeholders COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 151 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS need to perform a transparent cost-benefit analysis and select the combination of measures that they would like to adopt in order to offset the impact of the energy price rises. This step is particularly important to ensure that the most vulnerable part of the population does not suffer the greatest losses and ultimately to ensure political stability. Draft a national action plan for the production of energy from biomass, including demonstration projects and possible green tariffs for heating A national strategic plan for the biomass sector needs to be drafted, with clear targets for the short and the long terms and key performance indicators to keep track of the work in progress. Some demonstration projects showing the integration of both supply and use are recommended to draw attention to the sector and raise awareness of its relevant features. The experience drawn from international case studies could be also used as a reference for the implementation of a reliable supply chain. An indication of alternative green tariffs for heating could also be provided in order to support investors in their investment decisions through a clear projection of their future revenues and profitability. Predictability of income streams is an important element that investors consider in their business plans; at the moment there is no long-term certainty about the income flows for private players and the national strategic plan could support foreign and domestic investors in this direction. In 2006, the Energy Strategy of Ukraine to 2030 was approved, in an attempt to formulate a policy strategy for the country. In the baseline scenario presented in the report, power generation by other renewable sources is expected to increase at an average growth rate of 16% per year, from 51 million kilowatt hour in 2005 to 2.1 billion kilowatt hour in 2030. The funding required to finance the alternative energy sources for power generation was estimated to be UAH 7.1 billion in the period 2006-30. Unfortunately, the report has not been followed by a phase of structural reforms and the implementation of new alternative energy sources has stalled. In 2009, the government of the Netherlands supported its Ukrainian counterparts in the preparation of the Biomass Action Plan for Ukraine, outlining a general strategy for bio- energy development in the country, defining the current barriers and suggesting concrete solutions to solve existing issues within a defined time frame. The analysis already conducted could be a framework to support and realise a strategic plan. Politicians have the opportunity to overcome inertia and internal disputes, to build an ambitious project that could have an important impact on the country. The national action plan should also include a communication and promotion campaign, to increase the awareness of the biomass sector’s potential among the business community and end consumers. Poland could be taken as a good case study of a country which has been attempting to reduce its dependence on fossil fuels, particularly its use of coal for the generation of more than 90% of its electricity (Figure 7.19). As part of this effort, the Polish government set targets for the use of renewable energy as a percentage of total energy use. The latest targets, set in 2009 in line with EU directive 2009/28/EC, call for an increase in Poland’s use of renewable energy to 15% of total energy consumption by 2020. The government subsequently introduced a further target of 20% by 2030 in its strategy document “Poland’s energy policy to 2030”, released in November 2009. This longer term strategy also includes a target for a 10% share of bio-fuels in the transport fuel market by 2020. In 2009, renewables accounted for 6.6% of gross energy consumption, mostly biomass, although much of this was used for heat rather than electricity generation. 152 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Figure 7.19. The quick adoption of biomass in Poland has made it a key element in the renewables landscape Electricity production from renewables in Poland (GWh), 2005-09 Wind Biogas Biomass Hydro 9 000 1 034 8 000 295 7 000 806 221 Biomass in 2009 6 000 472 57% of electricity 162 production from 5 000 Biomass in 2005 257 4 863 renewables 36% of electricity 105 117 4 000 135 3.9% of total production 3 267 electricity production 2 343 from renewables 3 000 1 345 1 818 1.1% of total 2 production electricity000 1 000 2 176 2 030 2 253 2 153 2 376 0 2005 2006 2007 2008 2009 Source: International Energy Agency (IEA) (2011), Energy Policies of IEA countries, Poland Review, IEA, Paris; Poland’s Ministry of Economy (2010), “Energy Policy of Poland until 2030”, Presentation delivered by Martin Korolec on 22 September 2010. The government’s strategy for encouraging the use of renewable energy has included both regulation and market mechanisms. The 2005 energy law introduced an obligation on electricity distributors to purchase all of the electricity generated from renewable sources that is offered to them, and to give this electricity priority access to the national grid. Moreover, the government introduced a system of green certificates’ setting quotas for the use of renewable energy and imposing charges on distribution companies not meeting these quotas. In addition, electricity generated from renewable sources and fuels containing bio-components (including transport fuels containing additives such as ethanol) are either exempt from or subject to lower rates of excise duty. Also, since 2006 farmers have been permitted to produce bio-fuels for their own use, subject only to minimum quality requirements, without paying excise duty. The government also provides grants and preferential credits for renewable energy investments through the National Fund for Environmental Protection and Water Management and relevant regional funds, partly financed by EU support. These mechanisms are expected to result in further significant increases in bio-energy production and use. Increase privatisations of energy production and distribution assets to trigger private investment in infrastructures The state-owned enterprises dominating the energy arena need to go through a phase of privatisation. The past experience shows that the control exerted by the long chain of state- owned enterprises is detrimental to the efficient, profitable and sustainable functioning of the energy market. In the medium- to long-term the whole system, if not reformed properly, will become unaffordable with unfavourable consequences in terms of energy security and direct financial effects on the Ukrainian debt burden. A transparent and competitive process of privatisation of the energy generation and distribution companies should be implemented. In 2010, the Ukrainian Minister of Energy and Coal announced a plan to privatise two power generating companies and around five regional power distribution companies in 2011. Then in June 2011, the government announced the privatisation by the autumn of 2011 of two power COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 153 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS Box 7.5. The role of private and foreign investment in the Russian privatisation reforms Prior to the reforms, the Russian power sector was controlled by RAO UES, the state-owned holding company that controlled, but did not fully own, 72 vertically integrated local power companies (oblenergos) accounting for 70% of Russia’s electricity generation. In practical terms, it owned all of the transmission and distribution networks in the country (Solanko, 2011). The scope of the reform of the energy sector was ambitious and could not be financed only with public funds. Therefore it was clear that the reforms needed to provide an attractive environment for private investments, in order to mobilise private and foreign funds. The World Bank’s standard model for reform was followed, including the following points (Besant-Jones, 2006): ● Corporatise power sector enterprises. ● Unbundle, meaning disaggregating the total electric service provided by a power utility into its basic components. ● Create an autonomous, transparent regulator. ● Privatise the generators and distributors. ● Develop power markets. ● Streamline the role of the government. Private and foreign investments in wholesale and territorial generation companies totalled USD 21.5 billion in 2007, including the investments of three major international players, Fortum, Eon and Enel. plants and nine power distribution companies worth around USD 760 million at current market prices. Ukraine has the opportunity to raise funds, which could help the budget deficit, while at the same time attracting private and foreign investment, which could help the modernisation of the energy infrastructure. Review of payment mechanisms and market regulation institutions The energy payment mechanisms need to be redesigned as current tariffs do not cover the real costs of energy supply. Payment collection should be enforced by a dedicated market regulation institution. The regulation should provide incentives for cost reduction and savings. The strengthening of payment discipline will have a positive effect on budget revenues and will also improve energy utilisation efficiency. The co-ordination of enforcement activities should be done at the national level, with a clear and transparent legal framework and strong enforcement standards across all the oblasts. It could be advisable to support the implementation of meter readings in both industrial and residential buildings and to implement tight controls, linked to fines and sanctions. Currently, local authorities play an important role in determining whether customers in arrears are disconnected. However, the set of rules that determines the disconnection of non-compliant consumers needs to be set at a national level and enforced through systematic and targeted controls. Solve existing payment arrears The enforcement of payment collection will have a positive effect on payment arrears: if end consumers pay the full cost of the energy, generation and distribution companies 154 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS will not accumulate arrears. The problem of payment arrears could also be tackled with the introduction of guarantee schemes by intermediaries. The debt spiral starts with the arrears consumers owe to regional power distributors (oblenergos). As a result, the oblenergos do not have enough resources to pay for the power purchased or to maintain and upgrade the distribution network and other assets. The oblenergos pile up debts towards Energorynok, the state company selling power to the oblenergos. At the beginning of 2006, consumers owed UAH 10 529 million to oblenergos. Distribution companies’ debt towards Energorynok was UAH 15 962 million. In the same period, Energorynok’s liabilities to Ukrenergo, the state company which owns and operates the transmission grid, were UAH 18 323 million (Tsarenko, 2007). Prospective investors need to receive a signal that the chain of existing payment arrears has come to an end. In June 2010, the Ukrainian parliament passed a law going in the opposite direction, which wrote off UAH 24 billion of debts owed by energy companies to the state budget. The write off, if not followed by a restructuring of the payment system, would give a further incentive to keep the vicious cycle of payment arrears in place, with harsh consequences for the government’s budget and for the outlook for the Ukrainian energy sector. Bibliography Alter Energy Group (2010), Corporate website www.alterenergygroup.com/content/home.php?lang=en, accessed 15 June 2010. Besant-Jones, J. (2006), “Reforming Power Markets in Developing Countries: What Have we Learnt?”, Energy and Mining Sector Board Discussion Paper, No. 19, World Bank, Washington, DC. 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(1998), “Potential of Biomass and Perspectives of Biomass Conversion Technologies in Ukraine”, paper presented at the European Conference and Technology Exhibition “Biomass for Energy and Industry”, Würtzburg, Germany, June. Hurstboiler (2010), Corporate website www.hurstboiler.com, accessed 15 June 2010. Institute for Economic Research and Policy Consulting (2007), “Bioenergy Production in Ukraine: The Competitiveness of Crops and Other Raw Materials from Agriculture and Forestry”, Policy Paper, No. 11, Institute for Economic Research and Policy Consulting, Kyiv. Institute of Engineering Thermophysics and National Academy of Science in Ukraine (2010), “Biomass Energy Europe (BEE) project of FP7. Assessment of Biomass Potential in Ukraine”, presentation at the VI International Conference on Biomass for Energy, Kyiv, 14-15 September 2010. International Energy Agency (IEA) (2006), Energy Policy Review Ukraine, IEA, Paris. IEA (2007), “Biomass for Power Generation and CHP”, IEA Energy Technology Essentials, Paris. IEA (2009), World Energy Statistics, IEA, Paris. International Farm Comparison Network (2009), Dairy Report 2009, www.ifcnnetwork.org/en/news/2009/ 09/pressrelease_dairy-report_2009.php, accessed 15 April 2009. Author’s calculations based on estimates provided by Milkiland Ukraine, Corporate website www.milkiland.com/en, accessed 15 April 2009. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 155 III.7. ENERGY-EFFICIENCY AND RENEWABLE TECHNOLOGIES: FOCUS ON PRODUCTION OF ENERGY BASED ON BIOMASS IEA (2010), Fossil Fuel Subsidy Database, www.iea.org/subsidy/index.html, accessed 30 September 2011. International Finance Corporation (2009), Investment Climate in Ukraine as Seen by Private Businesses, IFC, Washington, DC. International Monetary Fund (2010), “Country Report No. 10/262”, Country Report Series, International Monetary Fund, Washington, DC. Johansson, B. (2001), “Biomass in Sweden – Historic Development and Future Potential under New Policy Regimes”, Energy and Environmental Systems Studies, Lund University, Lund. OECD (2004), “Biomass and Agriculture: Sustainability, Markets and Policies”, proceedings of the OECD Workshop on Biomass and Agriculture, Vienna, 10-13 June. OECD (2010), Bioheat, Biopower and Biogas. Developments and Implications for Agriculture, OECD, Paris. OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. OECD (2011), “Investment Policy Reviews: Ukraine 2011”, OECD Investment Policy Reviews, OECD, Paris. OECD/FAO (2011), OECD/FAO Agricultural Outlook 2011-2020, OECD, Paris. Petri, M. and G. Taube (2003), “Fiscal Policy Beyond the Budget”, Emerging Markets Finance and Trade, Vol. 39, No. 1. Poland’s Ministry of Economy (2010), “Energy Policy of Poland until 2030”, presentation delivered by Martin Korolec on 22 September 2010. Rabobank (2010), Rabobank Dairy Top 20, Press Room Rabobank Group, Corporate website, www.pressroom rabobank.com/publications/food__agri/rabobank_dairy_top-20.html, accessed 20 June 2010. Scientific Engineering Centre “Biomass” et al. (2004), Ukraine: Market Potential for District Heating Projects in the Ukraine and their Modernisation with Austrian Technology, The Austrian Energy Agency, Wien. Scientific Engineering Centre Biomass (2009), “Biomass Action Plan for Ukraine”, in http://euea- energyagency.org/userfiles/file/BAP_Sep09_Current_ENG.pdf, accessed 15 September 2011. Smeets, E. and A. Faaij (2010), “The Impact of Sustainability Criteria on the Costs and Potentials of Bioenergy Production – Applied for Case Studies in Brazil and Ukraine”, Biomass and Bioenergy, Vol. 34, No. 3. Solanko, L. (2011), “How to Succeed with a Thousand TWh Reform? Restructuring the Russian Power Sector”, FIIA Working Papers, The Finnish Institute of International Affairs, Helsinki, January. Tsarenko, A. (2007), “Overview of the Electricity Market in Ukraine”, Working Paper, No. 1, Center for Social and Economic Research – CASE, Ukraine, Kyiv. Van Holsteijn en Kemna (2002), “Heat from Renewable Energy Sources”, The RES-H Initiative and related Directives, VHK., No. 332, the Netherlands. World Bank (2009), Business Environment and Enterprise Performance Survey (BEEPS), World Bank, Washington, DC. Zhelyezna, T. and V. Leznova, (2008), Presentation of the EC FP7 Project “Biomass Energy Europe”, Presentation at the 4th International Conference on Biomass for Energy, 22-24 September, Kyiv. Zhovmir N. et al. (2007), “Al’ternativnoe teplosnabzhenie za schet ispol’zovanija solomy” (Alternative Heat Supply through Use of Straw), Kommunal’noe khozjaystvo, No. 8, pp. 24-27, December. 156 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Chapter 8 Machinery and transport equipment: Focus on civilian aircraft manufacturing This chapter provides an in-depth analysis of the civilian aircraft manufacturing sector in Ukraine. Examining the demand and supply sides, it explains why the civilian aircraft value chain could be promising for private domestic and foreign investors given domestic and global trends. It identifies the role that foreign investors could play along the value chain. It also presents key issues and policy barriers hindering competitiveness in the sector and proposes a prioritised list of policy recommendations. 157 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Summary The aircraft manufacturing sector is part of the aerospace industry and covers the design, production, maintenance, repair and overhaul of military, civilian passenger, dual-purpose (cargo) transport aircraft and helicopters. This study only includes civilian commercial aircraft manufacturing, excluding military aircraft, business aviation and helicopters. Building an aircraft requires design, engineering, manufacturing and assembly of hundreds of thousands of parts with different levels of sophistication. Suppliers can be divided into four tiers, depending on their role in the production supply chain: tier-1 suppliers act as system integrators; tier-2 suppliers act as suppliers to tier-1 suppliers and usually manufacture sub-systems and complex components; tier-3 suppliers manufacture system elements and components; tier-4 suppliers provide raw materials and other parts. Maintenance, repair and overhaul (MRO) services take part after the sale of the aircraft but are a key component of the value chain: the acquisition cost of a new aircraft accounts for only 20-40% of its lifetime direct operating cost, which is also driven by total time on the ground, fuel efficiency and other factors. The aircraft value chain is coordinated by an original equipment manufacturer (OEM), which acts as lead designer, final assembler and main provider of MRO services. World sales of civilian aircraft are estimated at circa 33 000 units, at a total cost of USD 4 trillion, over 2011-30. About 75% of sales will be made up of passenger aircraft with more than 100 seats, while cargo planes will only account for 6% of sales volume. The aircraft manufacturing sector is global, as manufacturing offers large economies of scale and because client airlines demand MRO at a global level. On the demand side, sector trends are largely determined by the needs of airlines. Aircraft demand is expected to remain high over the next 20 years. About 80% of global demand for aircraft until 2030 will be located in OECD countries and the Asia Pacific region. In OECD countries, the volume of air travel is not expected to increase considerably but many airlines will replace outdated, inefficient airliners. In the Asia Pacific region, high demand will primarily be driven by growth in passenger travel and cargo transportation. On the supply side, increased competition seems the main trend. Currently, four OEMs dominate the passenger aircraft market. Two of them, Airbus and Boeing, are leaders in the middle and large size segments; two others, Bombardier and Embraer, are leaders in the small size segment. Competition is expected to intensify in the coming ten years, with new players in all major segments. Technology will remain key to competing effectively, especially regarding fuel and CO2 efficiency. Two other important differentiating factors are expected to be the quality and reach of MRO services and the ability to finance capital-intensive programmes through government support, bank lending and risk-sharing partnerships. Ukraine is one of the few countries in the world able to produce modern aircraft. Traditionally active in military aircraft production as part of the Soviet military-industrial complex, Ukraine has also developed specific capabilities in the segments included in the scope of this publication. Antonov, the main Ukrainian aircraft manufacturer, is the 158 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING designer and manufacturer of the largest operating cargo aircraft in the world, the An-225 Mriya. More recently, it has also been involved in the civilian passenger segment, launching the An-148 family of regional jets. The Ukrainian aircraft industry is recognised, thanks to the country’s historical presence in the sector, its engineering skills and capabilities, and its relative cost competitiveness. Ukraine inherited a significant part of the former USSR’s capabilities in the aerospace sector, starting with Antonov. It is now a state-owned company, operating under public law and tightly supervised by the defence agency. The country’s education system produces a significant number of well-qualified and skilled aerospace scientists and engineers. Ukrainian aircraft are known for their ability to use unpaved airfields and flexibility of operations. As a result, Ukraine seems to have potential to compete efficiently, at least in some segments, on global markets. However, several challenges exist for the civilian aircraft industry in Ukraine. First, obsolete governance and closed investment policies prevent the implementation of an optimal business strategy based on global best practice. Second, Ukrainian aircraft manufacturers are still not able to provide efficient MRO around the world. Third, Ukrainian manufacturers face a financing challenge, due to the size of their market, the tight government budget and a lack of advanced financing schemes for manufacturers and customers. As a result of all these challenges, the majority of demand for Ukrainian products is currently concentrated in Ukraine and other CIS countries. An industrial strategy for the Ukrainian aircraft manufacturing sector should leverage existing capabilities under economic and political constraints. Investment in Ukraine could be attracted under three options, which could be seen either as strategic alternatives or as successive steps in a long-term industry development plan, resources allowing: ● Long-term option: developing OEM (Antonov) and tier-1 suppliers. This option would mean revamping the OEM, reinforcing MRO, building partnerships and enhancing financing capabilities. This is an ambitious option, which would require considerable resources and involvement from both the government and the private sector. ● Medium-term option: developing high-end tier-2 and tier-3 suppliers. In this option, focus could be put on design capabilities or equally on design and manufacturing. ● Short-term option: focusing on low-end tier-2 and tier-3 components, both basic design and manufacturing. Implementing any of the above options requires several reforms. The most urgent one involves the sector’s governance and investment policy. The sector is closed to foreign investment and would gain considerably from increased openness. At the moment, the governance of the civilian and military aircraft sectors in Ukraine is unified. The military aerospace sector is closely protected and controlled, and the same level of protection and control applies to the civilian aircraft sector. It does not allow for interactions with foreign investors or industrial partners, unless approved at ministerial level or higher, which virtually eliminates all opportunities to implement a business-centred industrial policy. A reorganisation of the supervision of the sector was announced in 2010. It is necessary to translate this announcement into a new governance system with separate branches for the military and civilian sectors. The civilian aircraft manufacturing part of Antonov could become a corporation and be allowed to interact with global suppliers and partners. This would enable closer partnerships and would help solve financing issues. Once this has been done, increased investment promotion could take place to leverage these improvements. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 159 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING The second area for improved competitiveness is human capital. Workforce skills are essential to remain competitive in this high value-added sector. To preserve and enhance workforce skills, action could be taken on initial, vocational and continuing education. Other actions from government are needed. More specifically, a review of state support could be undertaken to tailor the magnitude and type of support awarded to the industry, in compliance with international commitments. A new trade policy would also help the development of the industry, as integration in global supply chains and financing schemes relies on the free flow of goods and services. Why focus on civilian aircraft manufacturing Machinery and transport equipment is a broad sector and includes machinery and equipment, electrical and optical machinery, and transport equipment. A selection process, in consultation with stakeholders, was needed to decide which specific sub-sector to focus on. Ukraine has a strong presence in several sub-sectors. The country is a major producer of heavy machinery and industrial equipment for industries including mining, steelmaking, and chemicals. Significant products also include non-numerically controlled machine tools, large electrical transformers and agricultural machinery. Ukraine also produces automobiles, railway equipment and has sizeable space and aircraft manufacturing industries. Mechanical equipment, electrical machinery, motor vehicles and transport equipment were preselected in consultation with stakeholders (Figure 8.1). The size of each sub-sector, through its share in total domestic output, was used as the key criterion to eliminate the less significant sub-sectors. Figure 8.1. Four sub-sectors were identified on the basis of their share in the national domestic turnover Machinery, electrical and optical equipment, transport equipement Machinery and Electrical and Transport equipment optical equipment equipment Non-transport 0.45% Electrical 0.71% Motor vehicles, 0.36% engines and machinery and trailers and turbines, pumps apparatus – electric semi-trailers and compressors, motors, generators, 0.92% bearing and gears, transformers; valves and taps insulated wires and 0.09% cables; others Ships and boats Agriculture building and and forestry repairing machinery – 0.08% tractors... Radio, TV, communication Railway and Machine tools 0.05% equipment tramway locomotives and Domestic 0.10% 0.19% rolling stock appliances Medical and measuring equipment Aircraft and 0.23% spacecraft Other general Furnaces, furnace purpose blasters machinery Lifting and handling Share in % equipment of the Ukraine overall output, 2009 Non-domestic cooling and ventilation equipment Source: Based on data provided in June 2010 by the Macro-Econolmic Division of Ukraine’s Ministry of Economy and Trade, State Statistics Committee Ukraine, 2010; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. 160 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING After discussions with stakeholders, the civilian aircraft industry was finally selected. This sub-sector ranks high in government priorities, since the country’s capabilities in aeronautics give it a potential competitive advantage. Moreover, the level of technology in the sector, as measured by the OECD technology intensity scale, is higher than in other industries, such as shipbuilding or railroad equipment. Finally, world demand for civilian aircraft and components, according to expert interviews, is expected to be very dynamic over the coming years, providing additional opportunities for this sub-sector (Table 8.1). Table 8.1. Aircraft industry was selected as it presents specific technology and capabilities in Ukraine and high government priority Electrical Other transport equipments: Shipbuilding, Non-transport machinery and railroad equipments, aircraft industry engines and apparatus: turbines, pumps Motor vehicles, Eelectric motors, Criteria Sub-sector indicators and compressors, trailers generators, Ship building Aircratf Railroad bearing and and semi-trailers transformers; and repairing industry equipment gears, valves insulated wired and taps ans cables; others Innovation Technology intensity *** *** *** * **** *** Demand Expected world demand ** ** ** ** **** ** Supply Specific domestic capabilities * * * * **** * Government priorities Priority level for the sector ** * ** ** **** ** Total 7 7 8 6 16 8 Source: OECD (2009), OECD Science, Technology and Industry Scoreboard 2009, OECD, Paris, www.sourceOECD.org/industrytade/9789264063716, accessed 15 December 2009; OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Sector definition and segmentation Definition The aircraft industry is part of the aerospace industry and includes companies involved in research, development and production of airplanes, helicopters, engines, guidance and control units and other parts. It also includes companies providing maintenance, repair and overhaul services. As part of the aerospace industry, aircraft manufacturing is closely linked to the defence and space industries. However, aircraft manufacturing can be subdivided into military and civilian aircraft manufacturing. This study only covers civilian aircraft manufacturing, including commercial passenger and freight aircraft, but excludes business aviation, military aircraft and helicopters. Aircraft production is a capital- and technology-intensive process. The process of new aircraft development can take a number of years and require huge financial resources. The aircraft supply chain involves thousands of companies that can be grouped into the following categories (Figure 8.2): ● OEMs or aircraft manufacturers, such as Airbus and Boeing, acting as designers, integrators, final assemblers of the aircraft and key MRO providers (Figure 8.3). ● Tier-1 suppliers act as system integrators, responsible for production and assembly of major aircraft systems, including engines, avionics, wings, and undercarriage. They often provide substantial MRO services as well. ● Tier-2 businesses are suppliers to tier-1 companies. They manufacture sub-systems and avionic components. ● Tier-3 suppliers manufacture system elements and components – including grid parts, mechanically engineered parts, and other components. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 161 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Figure 8.2. The aircraft manufacturing industry ranges from components to after-sales services Original Maintenance, Fourth-tier Third-tier Second-tier First-tier Equipment suppliers suppliers suppliers suppliers Manufacturers Repair and (OEMs) Overhaul (MRO) R/D R/D R/D R/D R/D Designing Designing Designing Designing Designing Procurement Procurement Procurement Procurement Procurement Production Production Production Production Production After sales After sales After sales After sales After sales Basic elements – System elements – Components – Subsystems Aircraft design and After-sales network raw materials like grid parts, navigation systems, engines, avionic, pod, final assembling Spare parts, training, of subsystems PRODUCTS steel plates or mechanical avionics and aerostructure, power mechanical support plastic parts, engineered parts, mechatronics systems, landing gear, software and cheap metal parts (e.g. hydraulics brakes, in-flight services low complexity combined with entertainment, components computerized systems) interior (e.g. harnesses) ● Bridgestone ● General Electric ● Airbus s, r eds ● GKN Aerospace ● Goodrich ● Boeing OEM r H u n d li e r s EXAMPLES ie F ir s t- t s, upp r eds r of s H u n d li e r s ● Honeywell ● Pratt & Whitney ● Bombardier su p p li e p ft o f sup ● Michelin ● Rolls Royce ● Embraer A ir c r a s ● Siemens ● Thales se r v ic e s com panie ● Telec Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. Figure 8.3. OEMs play a key role in designing, coordinating suppliers, and assembling the final product OEM – Airbus, Boeing, Bombardier, Embraer, Antonov, Sukhoi OEM Engine Avionic POD Aerostructure Power Landing Brakes In-flight Interior systems gear entertainment General Various General General General General General General General contractor suppliers contractor contractor contractor contractor contractor contractor contractor TIER 1 Design, Electronics Design, Design, Design, Design, Design, Design, Design, production and production production production production production production production of key-parts, informatic of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, of key-parts, assembling equipments assembling assembling assembling assembling assembling assembling assembling Various Various Various Various Various Various Various Various Various TIER 2 and 3 suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers suppliers Engine Electronic Electrical Sections of Electrical Subsystems Brackets Softwares, Seats, toilets, subsystems and informatic commands, fuselage and subsystems e.g. dampers subsystems screen, basic oxygen and subsystems exhaust cone metal and electronic containers, components structures components textiles Various Various Various TIER 4 suppliers suppliers suppliers Raw materials, Electrical Raw materials seatings... components e.g. metals HIGH-END COMPONENTS MID-END COMPONENTS LOW-END COMPONENTS Source: PIPAME (2009), Étude de la Chaîne de Valeur dans l’Industrie Aéronautique, PIPAME, Paris, www.industrie.gouv.fr/p3e/etudes/aeronautique/ etudes3.php, accessed 15 September 2011. 162 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING ● Tier-4 suppliers provide raw materials and other parts and components, software and services. ● MRO providers are companies involved in the provision of maintenance, repair and overhaul and after-sales services and typically include OEMs, tier-1 suppliers and pure players. As a general rule, there is a link between the technical complexity of a task and the level of sub-contracting involved. Typically, high-complexity tasks are undertaken by the OEM or a first-tier supplier, whereas low-tech, low value-added components are manufactured by third or fourth-tier suppliers. However, this can vary a lot depending on the part of the plane concerned. As an example, even the producers of basic aero structure parts are usually tier 1 suppliers, as the OEM is responsible for hull assembly. It is also worth noting that aeronautics suppliers often have several specialities, and that they can be suppliers on different levels for different products. For instance, Latecoere produces electrical harnesses for Snecma, acting as a second-tier supplier and at the same time produces fuselage sections for the Airbus A380 as a first-tier supplier. Segmentation Civilian aircraft can be categorised as passenger, cargo or specialised aircraft. Specialised aircraft are not the focus of this study (Table 8.2). Although there are different ways to categorise civilian aircraft, the prevailing basis for segmentation is the combination of seat capacity and body width for passenger airplanes and cargo volume capacity for freight aircraft. Thus, commercial aircraft can be grouped into the following segments: Table 8.2. Segmentation of civilian aircrafts Passenger aircraft Cargo aircraft Narrow body (single aisle) below 100 passengers Small jet freighters (often called regional jets), including turboprop and jets Narrow body (single aisle) above 100 passengers Mid-size freighters Wide body (twin aisle) Large freighters Very large aircraft Source: Airbus (2010), corporate website www.airbus.com, accessed 15 December 2010; Boeing, (2010), corporate website www.boeing.com, accessed 15 December 2010. The narrow-body (single-aisle) aircraft with a capacity of fewer than 100 passengers is characterised by the shortest travel ranges. Often called regional aircraft, they have less than 100 seats or are able to carry less than 10 tonnes of cargo. They are primarily used by regional and feeder airlines. The regional aircraft market is characterised by fierce competition between fuel efficient turboprops and faster, more comfortable, jet engine aircraft. Future rising fuel costs, increased environmental constraints and airport congestion may render turboprops dominant in short haul flights where speed differences are less important. Currently, regional jets dominate the >50 passengers market, while turboprop aircraft dominate the <50 passengers segment and are currently expanding to the <70 passengers market. Industry projections for 2010-29 suggest that turboprops will account for the majority of aircraft in the 61-90 seat category, while demand for regional aircraft will move into the 90-130+ seat category. This assumes that in the smaller seat categories cost reductions will outweigh speed considerations. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 163 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING The larger narrow body (single-aisle) category includes aircraft with capacities of between 100 and 220 passengers. These aircraft are typically operated on short- to medium- range routes with a maximum reach of about 3 700 miles (6 000 km). This is the largest aircraft segment in terms of the number of aircraft in operation. In 2009, there were 11 580 single-aisle aircraft in operation around the globe, representing over 60% of all jet airliners (Boeing, 2010). Wide-body or twin-aisle aircraft can carry 200 to approximately 400 passengers and can fly more than 6 200 miles (10 000 km). These airliners are used on both medium-range and intercontinental flights. The very large aircraft segment includes wide-body aircraft capable of carrying more than 400 passengers over long distances (Table 8.3). Table 8.3. Distribution of selected aircraft by segments Wide body Very Narrow body under 100 seats Narrow body over 100 seats (twin-aisle) aircraft large aircraft Embraer E170, E175, E190, ERJ135, ERJ140, ERJ145 Airbus A318, A319, A320, A321 Airbus A330, A340 Boeing 747 Bombardier CRJ200, CRJ700, CRJ705, CRJ900 Boeing 737-900, 737-800, 737-700, 737-600 Boeing 767, 787 Airbus A380 Antonov An-148 Embraer E195 Sukhoi SuperJet 100 Tupolev TU-334, TU-204SM ATR 42, ATR 72 (turboprops) Note: This table only includes planes in operation as of 2011. Source: Manufacturer websites; ATR website, www.atraircraft.com/products/list.html, accessed 15 December 2010; Embraer corporate website, www.embraer.com/en-US/Pages/Home.aspx, accessed 15 December 2010; Bombardier website, www.bombardier.com, accessed 15 December 2010; Antonov website, www.antonov.com/index.html, accessed 15 December 2010; Airbus website, www.airbus.com, accessed 15 December 2010; Boeing website, www.boeing.com, accessed 15 December 2010; Sukhoi website, http://sukhoi.org/eng, accessed 15 December 2010; Tupolev website, www.tupolev.ru/english/Show.asp?SectionID=82, accessed 15 December 2010. Box 8.1. Three distinct duopolies The global aircraft market is segmented, with three distinct duopolies for regional turboprops, regional jets and for large aircraft (Figures 8.4, 8.5 and 8.6). The European ATR (Alenia-EADS) and the Canadian Bombardier dominate the regional turboprop market, while Bombardier and Brazil’s Embraer dominate the regional jet market. On segments over 100 passengers, Boeing and Airbus constitute a duopoly as well. Figure 8.4. Number of deliveries of regional turboprops, 2002-10 Bombardier ATR Total deliveries 140 120 100 80 60 40 20 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Julian, F. (2011), “Le secteur des avions régionaux au-devant de grands changements”, Air et Cosmos, 17 June, www.air-cosmos.com/home-page.html, accessed 15 July 2011. 164 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Box 8.1. Three distinct duopolies (cont.) Figure 8.5. Number of deliveries of regional jets, 2002-10 Bombardier Embraer Total deliveries 350 300 250 200 150 100 50 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Julian, F. (2011), “Le secteur des avions régionaux au-devant de grands changements”, Air et Cosmos, 17 June, www.air-cosmos.com/home-page.html, accessed 15 July 2011. Figure 8.6. Number of deliveries of large or very large aircraft, 2002-10 Boeing Airbus Total deliveries 1 200 1 000 800 600 400 200 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Airbus corporate website, www.airbus.com, accessed 30 August 2011; Boeing corporate website, www.boeing.com, accessed 30 August 2011. Global trends Demand forecasts over the coming two decades are promising on every segment Aircraft demand depends on demand for air travel, which is itself driven by tourism, business travel and ultimately by increasing living standards, growth and globalisation of the economy. Historically, demand has shown strong growth. According to an ICAO (2010) report, passenger kilometres grew on average by 5.3% per annum between 1979-89, by 4.7% between 1989-99 and by 4.3% between 1999-2009. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 165 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING In the past 15 years, the industry has shown high demand, with more than 800 western-built aircraft deliveries each year since 1996. High demand for aircraft production has been driven by both demand for and supply of air travel. On the demand side, accelerated globalisation of the economy and the accession of tens of millions of people to middle or superior living standards, especially in the Asia Pacific region, have fuelled growth. On the supply side, domestic air market liberalisation, catalysed by the US Airline Deregulation Act of 1978, has allowed competition on price, increased route access and new market entrants. Domestic liberalisation trends have been reinforced by “Open Skies” international agreements which remove barriers to competition between countries, facilitating foreign partnerships and access to international routes. However some large markets, like India, remain tightly regulated. These structural changes have facilitated innovations in the industry. The low-cost carriers are notable new market entrants. These operators have a low cost structure resulting from fast turnaround times, the use of low-cost airports and timeslots, and provision of a “no frills” service. Alliances are airline partnership networks that reduce costs through the sharing of sales offices, maintenance facilities, IT systems, flight codes and bulk purchases. Deregulation of routes has enabled cost reduction by implementation of “hub and spoke” systems. Several key airports are chosen as “hubs” with many smaller “spoke” airports connected through the hub. This allows tailoring of aircraft size to the traffic flow from each “spoke” and consolidation of passengers at the hub to increase capacity utilisation. All of these innovations have translated into cost reductions which have driven down prices and contributed to strong air travel demand. However, this strong growth has been tempered by considerable volatility. The industry suffered a severe blow in 2009 when the total orders for Airbus and Boeing aircraft fell to a total of just above 400 from the highs of over 2 000 in 2007. As the global economy started showing signs of recovery from the financial crisis, net orders increased in 2010. In July 2011, American Airlines, with the aim of creating a new, more efficient fleet, announced the “largest aircraft order in history” of 460 narrow body, single aisle planes split between 200 Boeing 737s and 260 Airbus A320s (American Airlines 2011– press release). According to Boeing (2011), in order to meet the growing demand for air travel, the fleet of commercial aircraft will grow from 14 240 passenger aircraft in 2009 to 30 000 in 2030 (Figure 8.7). Revenue customer kilometres, a measure of volume of revenue- generating passengers for an airline, is forecast to increase 2.5 times, from 4 760 billion to more than 12 000 billion in 2030. Adding the expected freight aircraft demand, the world demand for new aircraft will be high over the coming 20 years and the market for new commercial aircraft will reach around 33 500 units in total, valued at USD 4 000 billion (Boeing, 2011). Demand is shifting to the Asia Pacific region and will be geographically more diversified Air travel has become more diverse geographically and this trend is expected to continue into the future (Figure 8.8). It will result in a shift in demand from OECD to non- OECD countries, especially to the Asia-Pacific region. With the growth of air travel in Asia and other developing regions, the role of Europe and North America will continue to decline. Asia-Pacific, which currently accounts for 23% of the existing fleet, is expected to account for 37% of the forecast demand over the next 20 years (Boeing, 2011). North 166 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Figure 8.7. Total expected demand for civilian aircraft by segment over 2011-30 Expected demand expressed in units (left); in billions of US dollars (right) 25 000 2 500 20 000 2 000 15 000 1 500 10 000 1 000 5 000 500 0 0 Regional Single Twin Very Regional Single Twin Very jets aisle aisle large jets aisle aisle large Source: Boeing (2011), Current Market Outlook 2011-30, www.boeing.com/commercial/cmo, accessed 15 July 2011. Figure 8.8. Asia Pacific and other emerging economies will drive the growth of demand for civilian aircraft Africa Middle East CIS Africa CIS Latin America Latin America Europe Asia Pacific Middle East North America Europe North America Asia Pacific 40 000 4 500 1 210 2 710 4 000 100 35 000 1 400 110 250 3 390 3 500 30 000 450 8 010 3 000 25 000 760 2 500 20 000 680 1 040 1 140 2 000 880 1 150 13 480 15 000 4 380 1 500 10 000 4 410 1 000 1 510 5 000 9 330 500 6 610 0 0 2010 2030 current fleet expected fleet Source: Boeing (2011), corporate website www.boeing.com, accessed 15 July 2011. America, which accounts for 36% of the existing fleet, should see its demand share shrinking to 19% (Boeing, 2011). Competition is expected to intensify as new players are entering the market The growing demand for aircraft has brought about increased competition in the industry, which is expected to intensify in the coming years as new players are entering the market. The duopolies of Boeing and Airbus in the narrow body above 100 passenger and wide-body markets and Bombardier and Embraer in the sub-100 passenger aircraft segments may be challenged in the near future. ● The sub-100 seats segment has already seen the delivery of the first Russo-Italian Sukhoi SuperJet 100 in 2011. The first delivery of the Chinese Comac ARJ21 is expected in 2011 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 167 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Box 8.2. Demand dynamics for civilian aircraft The two components of demand The demand for new aircraft can be broken down into two components: replacement of the existing fleet and expansion of the fleet. Over the next 20 years, fleet expansion should account for between 50 and 60% (Boeing, 2011), which means around 17 000 new airplanes. Each component will be driven by specific factors. The replacement of the existing fleet will be driven by: ● Ageing fleets and the need to reduce operating expenses. Reduction of operational costs, such as fuel, training, maintenance, repair and overhaul, leads to the replacement of older aircraft with high operational costs by new models with lower running costs. ● Need for larger aircraft. The need to ease airport congestion and growth on existing routes adds pressure for replacement of the existing fleet by larger aircraft in each size category. ● Environmental protection requirements. Increasingly demanding environmental standards and consciousness will lead to the replacement of older and less efficient aircraft by newer, greener planes. Fleet expansion will be driven by: ● Air travel demand. The growth of the global economy and increasing incomes will contribute to the growth of air travel. ● New low-cost carriers. The growing number of low-cost carriers will create new demand for passenger travel. ● Route liberalisation. Increased route liberalisation will create new airline networks, increase competition, drive prices down and increase demand on those routes. Demand dynamics by segment over the next 20 years The single aisle with less than 100 passengers segment is forecast to grow. In spite of the high number of aircraft expected to be built, this segment will only account for about 2% of the total market in value. The 80 to 100 passengers sub-segment is expected to be more dynamic than the 30 to 50 and 50 to 80 passenger segments. The single aisle with more than 100 passengers segment is expected to account for about 23 300 new aircraft, by far the largest segment in terms of units with 48% of the total market. Demand will be fuelled by large emerging countries’ domestic and continental flights and the expansion of low cost carriers. The twin aisle aircraft segment will also account for around 44% of the total market in value. The demand in this segment is primarily driven by the need for fuel efficiency improvements. The very large aircraft segment will account for less than 1 000 units over the next 20 years, but the high unit price makes this sector sizeable in value. The freighter market makes up only about 6% (or USD 250 billion) of the total future market for new aircraft. The majority of demand in this market will be met by conversions from former passenger aircraft, which is expected to meet around 70% of freighter demand. Growing world trade, increasing demand for transport of perishable and time- sensitive commodities, and the need to replace ageing airplanes will be the main drivers of demand. Source: Boeing (2011), Current Market Outlook 2011-30, www.boeing.com/commercial/cmo, accessed 15 July 2011. 168 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING and that of the Japanese Mitsubishi MRJ in 2013. The Ukrainian Antonov is trying to position itself with its An-148/158. ● In the disputed 100 to 150 seat sub-segment, Boeing and Airbus are facing new competition from Embraer with the E-190/195 and Bombardier with the CS100 and CS300. ● In the above 150 seats single-aisle segment, the Airbus-Boeing duopoly will face the Russian Irkut MS-21 and Chinese Comac C919, which are expected to enter the market in 2016. The causes behind the increased number of key global competitors, beyond the attraction of booming global markets, are numerous. Developing a strong aeronautics industry seems to have moved up the political agenda in several countries. In Russia, virtually all aircraft manufacturing capabilities were consolidated within the United Aircraft Corporation (UAC) in 2006. Renewed interest in the development of aeronautics in Russia was further demonstrated by UAC’s commitment to participate in seven new civilian and military projects in the coming years. In this regard, UAC expects considerable government support: “the aviation industry is one of the priority sectors of the Russian economy, state support […] through various federal target programs in 2011-20 will be aimed at intensive development of priority programs and technological modernisation” (UAC, 2010). In China, Comac was created in 2008 with the explicit goal of developing the C-919, a future competitor of the B737 and the A320 family. At the same time, skills development enabled other OEMs or contractors to compete outside of their original area of expertise. Embraer and Bombardier’s experience with turboprops and small jets has enabled them to consider moving up to larger capacity planes. Similarly, Mitsubishi Heavy Industries, a traditional high value-added partner for Boeing, has teamed up with Toyota to manufacture its own aircraft. Minimizing purchase price, operating costs and financial costs Over the last 30 years, operating costs have replaced technology as the key factor that airline companies focus on prior to the purchase of an aircraft. Global aircraft manufacturers have adapted their strategy and now promote a cost-effective package of features, instead of underlining technological evolutions in their products. Airline or leasing companies look first and foremost at the total cost of ownership (TCO) of the aircraft they might purchase. Key variables used to calculate the TCO include the initial purchase price of the aircraft, the aircraft’s operating costs and financing costs. Today, the acquisition cost of a new aircraft accounts for approximately 20-40% of the TCO. Among other things, operating costs include fuel consumption and maintenance costs and are a key factor in the purchase decision. As a consequence, when developing a new aircraft, a manufacturer must assess the cost of incorporating new technologies against the cost savings the aircraft will realise through those new technologies. In essence, civilian aircraft producers now use demonstrable cost- effectiveness as a key driver for developing and applying new technologies. Higher fuel prices cause higher operating costs during the aircraft lifecycle, therefore making fuel efficiency increasingly important in the purchasing decision (US International Trade Commission, 1998). In fact, fuel efficiency may have replaced pure performance as a key innovation driver in civilian aeronautics. The two evolutions planned for the Airbus A320 aircraft may reflect this shift. From 2012, new “sharklet” wingtip fences will be added to reduce fuel consumption by 3.5%. From 2016 on, Airbus will offer a new engine COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 169 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING option for the aircraft, known as A320neo. According to the company, this version will burn 16% less fuel. While past improvements have focused on comfort and performance, these two future innovations focus purely on fuel efficiency. In reaction to increased customer focus on TCO, some manufacturers promote an integrated offering, bringing together manufacturing and MRO. In July 2011, Airbus announced the acquisition of Danish company Satair, a leading global distributor of spare parts, for a price equivalent to USD 504 million. Didier Lux, Executive Vice President of Airbus Customer Services, declared: “This acquisition is a logical step towards our vision to become one of the leading companies in integrated aftermarket services for our customers.” Financing costs are also coming under scrutiny. Aircraft purchases have long been subject to advanced financing schemes, including direct syndicated loans and operational or finance leasing. As for operating costs, airlines are increasingly evaluating the total cost of financing the plane when making purchase decisions. The supply chain is going global The aeronautics industry is becoming increasingly global. The historical business model was centred on vertically-integrated national supply chains, occasionally integrating pieces or subassemblies from foreign suppliers, themselves vertically- integrated locally. Multinational co-operations have taken place, especially for Airbus in Western Europe and more recently for Boeing in Japan. However, since the beginning of the 2000s, the industry has moved well beyond that stage by integrating engineering, manufacturing and after-sales services across multiple locations on a truly global basis. Reasons commonly cited to explain this drive are numerous. First and foremost, going truly global enables OEMs to leverage productivity, talent and cost differentials worldwide. The level of competition caused by new entrants and increased customer demands have made this approach difficult to ignore. Given the increasing weight of BRIC carriers as clients, globalising production may also be a way to secure access to these markets. Other factors, such as the opening of CIS countries, falling trade barriers and communication costs have also been instrumental in making such an organisation possible. What some called “globalisation 2.0” (AeroStrategy, 2009) has been driven by OEMs but also by their tier-1 suppliers. To minimise costs of development and better share risk, OEMs have started relying more heavily on a handful of reliable tier-1 suppliers. Much of the design, integration and co-ordination once only offered by OEMs are now carried out by tier-1 suppliers. Just as much as the OEMs, these suppliers look for the best skills and the lowest costs worldwide. The increasingly global structure of the civilian aircraft manufacturing industry is illustrated by the trend of foreign content observed over the last 50 years. Boeing reported that, apart from engines, the foreign content of the 727, launched in 1959, was less than 2% (US International Trade Commission, 1998). The foreign content of the 767, launched in 1978, varied from 10 to 26%. The 777, launched in 1990, included between 15 and 29%, depending on the customer’s choice of US or foreign engines. Experts speculate that for the 787, foreign content might run as high as 70% (Pritchard and MacPherson, 2005). Aircraft manufacturers look globally for high-quality, competitively-priced parts suppliers (US International Trade Commission, 1998). Figure 8.9 shows that Airbus also leverages a wide network of suppliers across the world, while performing the final assembly both in Europe and China. 170 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Figure 8.9. Example of Airbus A380 global supply-chain Aerostructure Raw materials Equipment and systems Propulsion systems Cabin Final assembly Source: Airbus (2010), corporate website, www.airbus.com, accessed 15 December 2010. Aircraft purchases are still influenced by political and strategic factors Aircraft sales are still not pure economic decisions. Even in a context of higher competition, higher pressure on costs and globalisation, aircraft purchases do not only reflect economic value. Carriers of countries with aircraft production capability are heavily biased towards their domestic manufacturer (Table 8.4). Table 8.4. Active fleet by carrier, Airbus vs. Boeing Carrier Boeing/MD % Airbus % Total Air France 74 29 179 71 253 Lufthansa 111 37 238 63 301 Delta Airlines 540 77 158 23 698 American Airlines 619 100 0 0 619 Note: These figures only include aircraft which can be attributed to the airline and some leased aircraft may be omitted. Source: Airfleets (2010), corporate website, www.airfleets.net, accessed 15 December 2010. However, two factors tend to make economic calculations more important than before. The financial constraint on carriers has increased, due to growing competition and higher fuel costs. Also, low cost carriers have emerged. In many countries, they are less connected to government than incumbent national carriers and, due to their business model, are more likely to purchase aircraft on purely cost-of-ownership grounds. Sources of competitiveness Long tradition and existing capabilities in design and manufacturing Ukraine has a long tradition in designing and building aircraft, which few countries have. It has the capacity to manufacture modern aircraft with most of the elements of the production cycle, from conception to commercial production. Design capability, including the ability to integrate all systems and parts, has been developed over time with significant amounts of capital, research and development, and labour. Manufacturing infrastructures, COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 171 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING including a skilled and highly-educated labour force, aeronautical R&D facilities, aerospace manufacturing facilities and equipment, also already exist in Ukraine. More specifically, Ukraine enjoys a strong reputation in aerodynamics, including wing design. Antonov (2007) revealed in a press release that it had been involved in wing design and wind tunnel testing of Comac’s ARJ21. Ukraine, with a sizeable metallurgy sector, is also competitive on basic and advanced metal parts. Finally, Ukrainian manufacturers are also known for turboprop engine technology. However, despite Antonov’s historical participation in the industry, reliability issues exist. Table 8.5 compares total accidents to total aircraft production for a selection of aircraft and shows Antonov at a clear disadvantage. This is just illustrative, as small production lines, especially for the An-148 and differences in the age of aircraft prevent comparisons from being statistically significant. Table 8.5. Total accidents/Total aircraft production % of key aircraft competitors Aircraft model Number of accidents Production % of accidents/Production Aircraft size ATR 72 12 739 1.6 Narrow body < 100 pax Embraer 190/195 1 100 1.0 Narrow body < 100 pax Antonov An-148 1 12 8.3 Narrow body < 100 pax Boeing 737-500 5 392 1.3 Narrow body > 100 pax Airbus A320 15 4 000 0.4 Narrow body > 100 pax Airbus 330 3 792 0.4 Wide body/VL aircraft Boeing 747-400 5 1 381 0.4 Wide body/VL aircraft Airbus A340 3 792 0.4 Wide body/VL aircraft Antonov An-124 4 56 7.1 Wide body/VL aircraft Source: Aircraft Crashes Record Office (2011), corporate website, www.baaa-acro.com, accessed 15 December 2010. The extent to which Ukraine’s aeronautical history presents an advantage in reaching a world-class OEM position compared to emerging nations without an aircraft manufacturing tradition is still open to discussion. Technological catch-up by countries and companies without an aircraft manufacturing tradition typically involves 3 stages, as described by McGuire (2011): 1) exposure to the new technology through FDI; 2) an understanding of the technology by domestic firms; and 3) domestic possession of technological expertise capable of manipulating and improving the original technology. However McGuire (2011) suggests that technological latecomer strategies cannot be employed as easily in the aerospace sector as in other industries. This is due to the huge variation in world aircraft demand, high capital investment requirements and long payback periods which discourage private investment. Further, a high international standard in safety certification necessitates immediate production of a high quality product upon entry to the market. China, Russia and Japan have followed different strategies to become the key new entrants to the OEM market. China and Russia have consolidated their scientific expertise of multiple competing design operations into two “national champions”, the Russian UAC and the Chinese AVIC. China’s large domestic market has also provided significant bargaining power in foreign partnerships and facilitated traditional technology catch-up in the form of FDI knowledge transfers. Japan has gained entry to the OEM market through a production partnership with Boeing, most recently by leveraging an expertise in the development and application of composites. 172 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Despite some reduction in the Boeing/Airbus duopoly, McGuire (2011) suggests that the current market incumbents will be difficult to displace due to their experience in international safety regulation, vast innovation network and high levels of R&D expenditure. The implications for the Ukrainian industry and Antonov are difficult to gauge at this stage, as Antonov has both considerable experience and considerable issues. The Antonov design bureau was founded in 1946 and since then has designed and manufactured hundreds of aircraft of different types and classes. The rest of Ukraine’s civil aircraft sector consists of many enterprises, including Kyiv Aviation Plant “Aviant”, Zaporozhye Machine-Building Design Bureau “Progress”, SE Ivchenko-Progress, JSC “Motor Sich”, Kharkov State Aircraft Manufacturing Company, and privately-held Aeros, Aeroprakt, and Aerokopter. Antonov designed two of the largest cargo airplanes in the world, the An-124 Ruslan (Condor) and An-225 Mriya (Cossack). The An-124 is the largest serially-produced cargo aircraft and is capable of carrying up to 120 tonnes of cargo. The recognised competitive advantages of Antonov products include: quality of aerostructure design, ability to use unpaved airfields, and flexibility of operations. Ukraine’s Ivchenko-Progress and MotorSich produce a variety of aircraft engines, such as turbofans, (An-124’s Progress D-18T or An-148’s Progress D-436), and they also have the technology to produce propfan engines (Progress D-27), and turboprop engines. Other aircraft manufacturers equipped with Progress engines include Beriev and Tupolev. A favourable cost position Ukraine in general benefits from low labour costs. Even in Kyiv, where salaries are considered the highest in the country, wages are still much lower than in comparable cities in advanced economies: on a subset of high value-added jobs, wages in Kyiv are estimated to be 86% lower than in Chicago or 85% lower than in Montréal (UBS, 2010). Even compared to emerging economies and new EU members, wages still stand at one third of Sao Paulo’s and at about half of salaries in Warsaw. However, cost competitiveness can easily be eroded. A good way to assess competitiveness dynamics is to look at the evolution of relative unit labour costs, which weighs productivity growth against labour cost increases. From 2005 to 2008, unit labour cost increased by 22.2% per year on average. It then dropped by 15.1% in 2009, mainly due to the depreciation of the hryvnia, and moved back up by 18.6% in 2010 (Havlik, 2010). For these reasons, improvements in capabilities, rather than a simple reliance on cost competitiveness, will be necessary in order to compete successfully on global markets in the future. The role of foreign investors in the civilian aircraft value chain The strategy for the Ukrainian aircraft manufacturing sector could leverage existing capabilities to design and manufacture a wide range of products, such as basic components, complex subsystems, and aircraft assembly. Investment in Ukraine could be attracted according to three strategic options: ● Long term option: Developing OEM and tier-1 suppliers. This option would require revamping the Original Equipment Manufacturer role through reinforcement of the Maintenance, Repair and Overhaul service, and building capabilities to offer financial facilities for the purchase of aircraft. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 173 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING ● Medium term option: Developing high-end tier-2 and tier-3 suppliers. ● Short term option: Focusing on low-end tier-2 and tier-3 components. Conceptually, these three options are not exclusive. However, they all require financial resources as well as involvement from both the government and the private sector. They can then be seen either as strategic alternatives or as successive steps in a long-term industry development plan. In such a plan, resources, networks and credibility created by short term, low-technology options could be used to develop longer term, more ambitious objectives. The first option, acting as a world-class integrator of complex aircraft products is an ambitious objective with high financial risk. Ukrainian companies would have to focus on coordinating design, production and MRO of commercial aircraft in an integrator role. Alternatively, as a tier-1 supplier, they could design, produce and provide MRO for high- complexity aircraft modules, such as engines. The advantage of such an option is that the commercial returns would be high. The interest for foreign investors would relate to the potential for further improvement of existing Ukrainian capabilities in integrating complex subsystems (Box 8.3). However, there are risks to this option due to the massive development Box 8.3. A world-class integrator strategy – Russia’s Sukhoi Superjet 100 In 2000, Russia’s Sukhoi launched a project to design a 75-to-95 seat regional jet airliner. In 2008, the Sukhoi SuperJet 100 made its maiden flight and in 2011 it was certified to fly in the CIS. As of summer 2011, it is still awaiting certification to fly in the EU. To develop the SuperJet 100, Sukhoi had to overcome two of the hurdles that the Ukrainian industry could face when trying to play a global integrator role: integration of systems and components from partners worldwide and development of worldwide MRO services. To ensure the SSJ 100 is competitive, deep collaboration with foreign partners has taken place. Alenia Aeronautica, a subsidiary of Italian firm Finmecannica, is a strategic partner. It owns a 51% stake in SuperJet International, the MRO and global marketing entity of the programme. Engines are designed by PowerJet, a joint-venture between Russian manufacturer Saturn and French company Snecma. Other equipment manufacturers include many well- established names such as Thales for avionics, Goodrich for brakes, Honeywell for APU and Messier-Dowty for landing gear. Special attention was given to delivering MRO services on a par with competitors Bombardier and Embraer. The SuperCare plan provides maintenance on key elements for a fixed rate per flight hour, transferring some of the reliability risk from the operator to SuperJet International. Additional modules include leasing of an on-site stock of spare parts and ground support equipment and tools. Services are also available, including on- site engineering maintenance support. MRO partners have been selected in more than 21 locations worldwide. Main spares centres are located in Frankfurt (operated by Lufthansa Technik Logistik) and Moscow. Pilot training is provided in Venice and Moscow. Whether such a strategy is replicable in the case of Ukraine mainly depends on whether the domestic industry can overcome two key differences with the Russian example: a small domestic market and limited financing capabilities. The future launch of Chinese and Japanese competing aircraft could also mean a closing window of opportunity for an OEM without a strong recent track record. Source: United Aircraft Corporation (2010), corporate website, www.uacrussia.ru/en, accessed 15 December 2010; Sukhoi (2010), corporate website, http://sukhoi.org/eng/planes/ssj100, accessed 15 December 2010; Superjet International (2010), corporate website, www.superjetinternational.com, accessed 15 December 2010. 174 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING costs required when launching a new programme or project, while Antonov’s credibility in the global market may be questioned. The task would be even more challenging for Ukraine given the need to build and finance MRO capabilities in potential client countries. This is an essential yet still missing step to ensure exportability of products. It would require developing spare parts, storage facilities, on-site training, specialised personnel, and round- the-clock maintenance services. Finally, the complexity of global supply-chain management makes this option the highest risk-return combination. The second option, which entails manufacturing high-value components for foreign OEMs and suppliers, entails a moderate financial risk. As a supplier to foreign OEMs or their tier-1 suppliers, Ukrainian manufacturers would participate in designing and manufacturing technically advanced components (e.g. advanced aero-structure parts or engine components), without playing a central role as an integrator or an MRO provider. The advantages of this option are a relatively high return, the opportunity to leverage Ukraine’s capabilities in design and production of highly-engineered components, and the more limited commercial and financial risks, since MRO services are provided by the integrator. The disadvantages of this option are the barriers to entry in global supply chains. If the high-value manufacturer position was chosen, production processes would have to be adapted to conform to global practices for certification and standardisation. The third option examined, the production of low- to mid-tech parts for foreign players is a low-risk possibility with lower potential returns. As a supplier to foreign suppliers (i.e. as a tier-2 to tier-4 supplier), Ukrainian manufacturers would produce mid- to low-tech parts at an attractive cost. If it chose this option, Ukraine could take advantage of a strong industrial base and an existing credibility, especially with regard to metal parts. Box 8.4. Focusing on low-end tier-2 and tier-3 components – Romania and EADS Romania has historically been involved in aeronautics, even if not at the same level as Ukraine. Romanian aeronautics date back to the creation of Industria Aeronautică Română (IAR) in 1925 as a manufacturer of military aircraft for the Royal Romanian Airforce. At the end of the 1960s, its production shifted to helicopters and more recently to helicopter maintenance. Eurocopter, part of EADS, has been instrumental in this shift as a key partner to IAR. Eurocopter Romania was established in 2001 to provide MRO services for Eurocopter helicopters in the region. The company remains of modest size, with 126 employees and a 2010 turnover of EUR 29 million. Romania has also been active in avionics software components. In 2011, EADS activities in Romania were extended to production and assembly of metal components for Airbus aircraft. EADS subsidiary Premium Aerotec invested in a production facility in Ghimbav costing a total of EUR 40 million. The company aims to reach 1 000 employees. However, based on public information, it seems that design is still fully located in Germany. This case is an example of a country using mid-to-low complexity components and services to establish strong ties with foreign OEMs and then build on that relationship. The Romanian government has expressed its plan to develop its aerospace industry further and EADS CEO Louis Gallois declared in July 2011: “We are determined to create a global excellence centre for MRO […] and integrate Eurocopter Romania in the global supply chain.” Source: EADS (2011), corporate website, www.eads.com/eads/int/en.html, accessed 30 August 2011; Le Monde (2011), “EADS ouvre sa première usine en Roumanie”, article published on 12th July 2011, www.lemonde.fr/ economie/article/2011/07/12/eads-ouvre-sa-premiere-usine-en-roumanie_1547924_3234.html, accessed 15 July 2011. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 175 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Another advantage would be the possibility to work with a wide range of clients from Western and emerging economies (Box 8.4). However, the shortfalls of this option would be the rather limited value captured, direct competition for FDI with very competitive low- cost economies, and the limited leverage of existing engineering skills. Key issues and policy barriers A small domestic market Access to a large domestic market constitutes an important strategic advantage for civilian aircraft manufacturers. This gives the opportunity for economies of scale in both production and maintenance. Both Boeing and Airbus have access to sizeable domestic markets and this also enables countries to secure offset arrangements, offering market share on the domestic market in exchange for location of some of the production. Compared with neighbouring countries, the Ukrainian domestic market is relatively small: the domestic civilian fleet is a quarter of the size of the Russian fleet by number of aircraft (Table 8.6) and it is equivalent to 8% of the Chinese fleet or 2% of the American fleet. Under these conditions, access to foreign markets becomes of critical importance. Table 8.6. Active fleet by country, selected countries Number of carriers Number of aircraft Ukraine 16 123 Russia 37 495 China 41 1 639 United States 103 6 513 Source: Calculations derived from Airfleets website, Airlines List Database; www.airfleets.net, accessed 15 December 2010, (excluding civilian aircraft operated by militaries, including civilian aircraft used by passenger carriers, freight companies and businesses). The lack of access to a large domestic market can be overcome. For example, Embraer sold relatively few turboprops in Brazil and only began selling regional jets domestically after winning an order from carrier Azul in 2008. Low market share and lagging MRO network are two mutually reinforcing issues The most recent Ukrainian civilian aircraft, Antonov An-148, is a regional passenger jet with a 75 passenger capacity. The An-158 aircraft is an extended version of the An-148 with a higher passenger capacity of 99 seats. The first AN-148 was delivered in 2009 and at the end of the 2nd quarter of 2011, Antonov reported that there are 9 aircraft delivered and operating in Russia and Ukraine. By comparison, the world regional jet deliveries of Bombardier and Embraer reached 323 in 2009-10, which indicates that Antonov has less than 3% of market share in this segment. Antonov recently reported that the total number of firm orders and options for the An-148 and the An-158 version has reached 150 (Antonov, 2011), which would correspond to approximately USD 4 billion, to be compared to a commercial order book backlog of approximately USD 16 billion for Bombardier or Embraer. On the domestic market, Ukrainian airline companies often prefer to purchase foreign-made aircraft, due to the costs and risks of switching to a new model that has not been proven reliable yet. Moreover, airline companies are willing to focus on specific models, due to the scale advantages in terms of staff training or spare parts procurement. For instance in April 2011, a Ukrainian airline company (UTair Aviation) concluded a 176 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Box 8.5. A close strategic and industrial relationship with Russia Formerly a key part of the Soviet military-industrial complex, the Ukrainian aeronautical industry has gained some independence in the last 20 years but significant strategic and industrial ties remain with Russia. The Ukrainian and the Russian civilian aircraft industries are interconnected. For production of the An-148, on top of the Kyiv assembly line, much of the assembly is made at the VASO factory in Voronezh, Russia. A majority stake in the factory is owned by state conglomerate UAC through Ilyushin. Russia also represents the bulk of orders for Antonov planes. The first customer for the An-148 was Rossiya, a Russian carrier. Russian carriers account for more than 40% of orders for An-148 aircraft. The relationship between Antonov and UAC has seen some recent developments, the exact reach of which is still unclear. In October 2010, an agreement was signed between UAC, Antonov and Russian bank VneshEkonomBank (VEB) to start a joint-venture financed by VEB. It has not yet been made public what proportion of Antonov’s activities will be transferred to the joint-venture with UAC. Moving closer to Russian partners is in principle compatible with integration in global supply chains. UAC itself is a good example, consolidating the Russian aircraft industry while partnering with many Western firms on the Sukhoi SuperJet 100 programme. However, further integration with UAC could also delay the necessary governance, management and operational reforms needed and thus impede the integration of Antonov into global supply chains. Source: United Aircraft Corporation (2010), corporate website, www.uacrussia.ru/en, accessed 15 December 2010. contract with ATR for the delivery of 20 new ATR 75-500 regional turboprop aircraft. UTair has been operating ATR aircraft for several years now and the number of these aircraft in its fleet is continually growing. Efficient after-sales services are essential to sell aircraft, and even more so for exports. As stated above, airlines are increasingly looking at the total cost of ownership. One of the key factors influencing this cost is the utilisation rate of the aircraft. To optimise utilisation, efficient maintenance, repair and overhaul (MRO) services have to be provided. In the past, Antonov customers have publicly complained about the poor quality of MRO services. In May 2010, General Director of Rossiya Sergei Belov stated that to generate an “acceptable level of profitability”, the Antonov 148 had to be flown 10 to 12 hours a day and that would be “difficult” without more involvement from Antonov and its suppliers. Several reasons explain the weakness of Antonov in MRO services. Antonov has historically been active in military transport aircraft. In that segment, utilisation rates are not as sensitive an issue as for commercial aircraft and logistics are often taken care of by the client military. Another reason may be the cost behind setting up an MRO network. To be financially viable, an investment in MRO capabilities should be spread across a sufficient number of aircraft in the area covered by the MRO centre. However, to sell aircraft to airlines operating in the area, offering efficient MRO services is essential. In that respect, investment in MRO can be described as a chicken-and-egg issue. A possible option to develop MRO without bearing the whole cost is to partner with foreign players, as Sukhoi experienced with Alenia for the SuperJet 100. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 177 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Closed governance, burdensome legal status and lack of risk-sharing partnerships with suppliers The governance of Antonov and of the civilian aircraft sector in general hampers its competitiveness (Box 8.6). The Ukrainian civilian aircraft sector is as tightly regulated as military activities. In fact, it has been regulated in the same way by the same Agency for the Military-Industrial Complex. Such governance pushes for an exclusive focus on security instead of a business-centred management, which is a potential obstacle to increasing competitiveness. Officially, the government has decided to separate civilian and military activities. According to a decision at the end of 2010, Antonov is to be monitored by the Agency on State Property and Corporate Rights. However, this change has yet to be implemented. Box 8.6. Issues deriving from the legal status of Antonov – Public procurement and joint ventures Procurement by Ukrainian state bodies and state-controlled entities is tightly regulated. Tender processes are mandatory and are often lengthy and costly to implement. Ukrainian state owned enterprises (SOEs) are also forbidden to establish joint ventures pursuant to the Decree of the Cabinet Ministers on Special Issues of State Property Management (31.12.1992). The original purpose of this legislation was the prevention of SOE management corruption during the early 1990s. The law is an outdated and unwieldy tool which presents an obstacle to participation in joint ventures. In July 2011, the state amended its public procurement law with the intention of mitigating these administrative inefficiencies. This law will be effective from September 2011. Under certain circumstances, the amendment allows state-owned companies to bypass the tender process and purchase goods or services through the procurement from a single supplier procedure. To prevent corruption associated with the single supplier’ procedure, deals are overseen by a controlling body of the Cabinet of Ministers. Although the new law may increase procurement efficiency, the single supplier clause has been sharply criticised by the EU as a mechanism that fuels corruption and that is out of synch with EU criteria. Antonov, due to its special tax status, is not included under the scope of the amendment and continues to apply previous tender procedures. These procedures reportedly take 4-8 months in total. This can result in a chain effect as Antonov often sources parts, for example engines, from other state-owned enterprises, which must also undertake their own tender procedures. This requires Antonov’s management to devote time and attention to sourcing procedures, in an industry where the creation and management of strategic partnerships and complex supply chains are the keys to success. Antonov’s SOE status could be reviewed alongside an analysis of more efficient legal mechanisms to simultaneously control corruption and facilitate partnerships. Reform and streamlining of procurement law is needed strike the balance between preventing corruption and increasing process efficiency. Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. International examples show that other countries that also cherish their national independence have organised their aeronautics sectors differently. In the United States, Boeing is active in both civilian and military activities in roughly equal proportions. It is still a standard corporation, listed on the New York Stock Exchange. The necessary processes have been put in place to guarantee a “Chinese wall” between civilian and military activities, including setting up two different headquarters in Washington State and Missouri. 178 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING To reduce their own financing needs, global aircraft manufacturers have increasingly involved a selection of tier-1 suppliers as risk-sharing partners. These risk-sharing partners are involved from the design phase and finance a part of the development cost of the programme. For Boeing’s 787 programme, Japanese risk-sharing partners alone will invest a total of USD 3 billion (Table 8.7). Table 8.7. Investment in the Boeing 787 programme by Japanese risk-sharing partners Companies Components Investment (USD m) Mitsubishi Heavy Industries Wings and engines 900 Fuji Heavy Industries Airframe 400 KHI Airframe and engines 650 Ishikawajima-Harima Heavy Industries Engines 350 ShinMaywa Industries Airframe 150 Toray Composite material 250 Second-tier suppliers Equipment and systems 300 Total 3 000 Source: Pritchard, D. and A. MacPherson (2005), “Boeing’s Diffusion of Commercial Aircraft Design and Manufacturing Technology to Japan: Surrendering the US Aircraft Industry for Foreign Financial Support”, Canada-United States Trade Center Occasional Paper, No. 30, State University of New York, Buffalo, www.custac.buffalo.edu/content/ documents/OccasionalPaper30.pdf, accessed 15 September 2011. The Ukrainian civilian aircraft industry is too centralised around Antonov and too closed to international collaborations for this type of risk-sharing partnership to take place. At present, integration with the Russian aircraft industry is more an industrial partnership than a genuine risk-sharing one. Antonov currently bears the financial burden of new programme development on its own. Sustainability of skills in question The sustainability of the skills necessary to maintain and improve the level of excellence of the Ukrainian civilian industry may not be assured in the medium to long term. As with other sectors of the economy, the civilian aircraft sector is suffering from an ageing workforce. Younger generations are less numerous and brain drain’ to western countries is an additional issue, especially for the most skilled employees. Production jobs may be the biggest problem. In the OECD Country Capability Survey conducted in 2011, 55% of the responding companies declared that they faced a major or a minor skills gap at the production worker level. 46% reported the same issue for supervisors and only 36% for engineers. While the education of top-level specialists seems to be satisfactory, standards are not always met for mid- to low-level jobs (Figure 8.10). This has been confirmed in interviews with Antonov management, who expressed concerns about the availability of competent floor workers and supervisors. Access to financing is restricted for both manufacturers and potential customers. Limited financing in the development phase Aircraft manufacturing, especially in the development phase, requires a large amount of investment. These financing needs are usually addressed through banks and financial markets, risk-sharing partnerships and various kinds of government support. The Ukrainian civilian aircraft industry is currently lagging on all these dimensions. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 179 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Figure 8.10. Surveyed entrepreneurs assessed the skill gap in the aircraft segment Replies to the question “In which areas do you feel the presence of a skill gap?” Légende Légende % 60 50 40 45 30 42 20 25 13 10 7 13 9 10 7 0 3 Managers Engineers Salespeople Supervisors Production floor and designers and marketing workers Source: Calculations based on OECD (2011), Country Capability Survey, internal working document, OECD, Paris. Western aircraft manufacturers and their suppliers rely heavily on debt financing by banks and financial markets, as firms from other capital-intensive sectors do. As an example, the EADS corporate website indicates that the group’s financial toolbox comprises: ● Cash. EADS set an objective of holding EUR 3 billion of “strategic cash” on hand at all times. This cash is the result of both accumulated profits and debt issuance. ● Bank revolving credit facilities of up to EUR 3 billion. This facility, typically not drawn, gives some additional financial space to the company. ● French commercial paper of up to EUR 2 billion. This is a short-term debt security maturing within 12 months of issuance. ● Bonds (Euro Medium-term Note programme) of up to EUR 3 billion. This long-term financing line has been partly drawn, up to a current total of EUR 1.5 billion, maturing in 2016 and 2018. ● Other financial instruments, including derivatives. Aircraft manufacturers bear currency, counterpart and other risks that can be partly hedged through financial instruments. Antonov, by contrast, can only access some domestic bank financing. As a state- owned company of special status, it is barred from capital and debt markets. Financing by international banks is also hampered by this status. Antonov therefore has to rely on its own cash generation or on the government budget. Lagging customer financing The financing needs of the industry include not only financing of aircraft development, but also financing of aircraft purchases. There again, there is a gap between western companies’ practice and the situation of clients of the Ukrainian industry. The financing of aircraft purchases can take several forms: ● Syndicated loans. A group of banks issues a loan to the airline for the purchase of the aircraft, using the aircraft as collateral. 180 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING ● Operating leases. Companies such as the International Lease Finance Corporation (ILFC) or GE Commercial Aviation Services (GECAS) purchase aircraft and then lease them to carriers. ● Finance leases. Generally involving the creation of an ad hoc financial vehicle, this more engineered type of lease is financed through equity and debt issuance on international financial markets. Regarding these financing schemes, the Ukrainian industry faces several difficulties. Ukrainian banks cannot match foreign syndicates in their ability to finance large projects such as aircraft purchases. More importantly, the two major operating leasing companies are not Antonov customers. The ILFC only leases Boeing and Airbus planes, while GECAS relies on Airbus, Boeing, Bombardier and Embraer. This is key, as Antonov’s primary customers remain Ukrainian and Russian carriers that are not always deemed credit- worthy enough to access other financing solutions. Regarding finance leases, the level of development of financial markets and of macroeconomic stability in Ukraine hampers the competitiveness of the Ukrainian industry. The Ukrainian government is well aware of this issue. Deputy Prime Minister Kolesnikov, when interviewed in 2011 about the possible sale of 15 An148/158 to Aerosvit, declared: “airlines will buy these aircraft only if the government is able to provide world- class financing terms, that is leasing costs below 2%”. Lack of overall government support The aircraft industry in most countries has been supported by governments in a series of ways, both on the manufacturer side and on the customer financing side. Direct support from governments to manufacturers has often taken the form of R&D and innovation incentive schemes. In the case of Europe, Airbus has secured several loans from the European Investment Bank. As late as July 2009, the EIB awarded Airbus a EUR 800 million loan to finance research and development projects aimed at reducing aircraft fuel consumption and CO2 emissions. Even in countries hosting only risk-sharing partners of foreign OEMs, there has been some direct government support. In Japan, Pritchard and MacPherson (2005) have estimated that government support for the Boeing 787 programme will total USD 1.6 billion. After reworking of the plan due to the concerns of the WTO, Pritchard and MacPherson (2005) estimate that 70% of this support will be reimbursable loans, while the remaining 30% will be made up of non-refundable grants. The current situation of Ukraine leaves little financial space for the government to provide financial support to its domestic industry. The current fiscal deficit, excluding bank recapitalisations, reached 8.7% in 2009, 7.4% in 2010 and is expected to be 3.5% in 2011 (World Bank, 2011). IMF intervention was requested by the government of Ukraine and an IMF loan equivalent to USD 14.9 billion was granted. As this loan is subject to regular performance reviews at the disbursement of each tranche, it is likely that the government budget will remain tight and that no large-scale support to the civilian aircraft industry will be provided. Government support to the industry can also be indirect, through customer financing schemes. Export Credit Agencies (ECAs) play an especially important role. Coface in Europe and the US Export-Import Bank provide financing for many aircraft purchases. Acting as guarantors, they lower the cost of. Historically, such schemes have been used in ways that have distorted competition. Today, the importance of such schemes is decreasing as the Arrangement on Officially Supported Export Credits, negotiated at the OECD, restricts COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 181 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING conditions that can be offered by exporting countries. Still, Ukraine, not having such a powerful financing tool, is at a disadvantage compared to its global competitors. Policy recommendations The governance of Antonov needs to be reformed and corporatisation promoted The governance of the civilian aircraft sector is currently unsatisfactory. Ukraine, as various OECD and non-OECD countries do, may wish to retain control of activities related to the military, including military aircraft manufacturing. However, the civilian aircraft sector needs private and foreign investment. The government could therefore separate governance of civilian and military activities. In this regard, the initiative of putting Antonov under the sole supervision of the Agency on State Property and Corporate Rights is a positive step, but it now has to be translated into action. Changing the governance of the sector would also mean changing the governance of Antonov. The OECD Guidelines on Corporate Governance of State-owned Enterprises states that “governments should strive to simplify and streamline the operational practices and the legal form under which SOEs operate. Their legal form should allow creditors to press their claims and to initiate insolvency”. More concretely, the government may want to consider the “corporatisation” of Antonov, i.e. its transformation into a corporation of standard status. This would have positive consequences on several dimensions: ● Better access to financing on domestic and international financial markets. ● More possibilities for international collaboration. The company’s status would be more transparent to potential partners and potential disputes could be resolved before ordinary courts. ● More operational freedom. In particular, this would be an incentive to adopt the most efficient governance and business processes. It would also enable better strategic decisions. Need to improve the investment policy and promotion of the sector The Ukrainian government needs to implement changes in its investment policy, opening up the sector to foreign and private investors. This would help solve financing issues, as foreign investment could provide significant capital inflows. In particular, investment policy reform is necessary to shift to a risk-sharing partnership model. It could also help build relations with the international financial system, allowing better financing of companies and customers. A more open sector is also key to the development of MRO networks, which would be virtually impossible without a partnership with an already well- established partner. Finally, it would help to hardwire governance changes (Box 8.7) and switch to a business-centred policy. Investment in the civilian aircraft sector could be encouraged by specific investment promotion measures. Putting in place support mechanisms would only prove efficient after the suggested investment policy reform and governance reforms have been. InvestUkraine could be one of the lead bodies in this effort. There are a number of steps that could be taken to actively promote the sector to foreign investors. For example, the civilian aircraft industry could be included as a top priority in the overall investment promotion strategy of Ukraine. Secondly, a sector-specific 182 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Box 8.7. Investment policy actions recommended for Ukraine 1. Several Ukrainian laws refer to national security and strategic sectors, which – according to the Commercial Code (Article 117) – could justify sectoral and territorial restrictions on FDI. The law “On the Fundamentals of National Security of Ukraine” provides the following definition of economic threats to national security: “critical dependence on the business cycles of international markets” and “increases in the share of foreign capital in the strategic sectors of the Ukrainian economy such that they jeopardise its economic independence” (Article 7). 2. Neither domestic nor foreign investors may participate in a number of activities defined as “strategic” which have to remain in the hands of more than 1 000 state-owned enterprises and are therefore excluded from privatisation. The 1992 privatisation law established that participation of foreign investors in privatisation of “strategic” enterprises (the so-called G- group) requires a special permit from the Parliament and the Cabinet of Ministers but does not specify the authorisation procedures. This incomplete legislative framework has opened the possibility of non-transparent privatisation deals, enabling certain investors from countries with better local connections to get stakes in key industries deemed to be strategic, such as the oil industry or the gas transport network (Dubrovskiy et al., 2007). 3. As already mentioned, the economic reform programme for 2010-14 underlines the role of privatisation and encourages participation of foreign investment in modernisation of the national economy. On one hand, it sets the objective of defining clearly the sectors and enterprises in which the state will maintain exclusive or majority ownership and, on the other hand, of fostering privatisation in other sectors, including with the participation of foreign investors. The new law on privatisation currently under preparation intends to introduce a methodology for determining the “critical” level of foreign ownership in “strategic” sectors, which would then be used by state agencies managing state property to define the level of foreign ownership in these sectors. 4. Ukraine’s current legislation therefore refers to “national security” and “strategic sectors” in relation to foreign investment in different contexts without clearly defining the sectors concerned or specifying relevant authorisation procedures for participation by foreign investors. New legislation in preparation is supposed to define with more precision the notion of “strategic sectors” in the context of privatisation. But the planned procedures for selecting sectors and determining the level of authorised foreign participation in the privatisation process still appear to leave considerable room for administrative discretion. 5. The Ukrainian authorities should consider adhering to the recommendations of the OECD Guidelines for Recipient Country Investment Policies relating to National Security (OECD, 2009c), which were adopted by the OECD Council in May 2009. These Guidelines help countries to design and implement national security goals with the smallest possible impact on investment flows by complying with the principles of non-discrimination, proportionality, transparency and accountability. In particular, the Guidelines recommend that governments treat similar investors in the same way, make transparent their regulatory objectives and practices, clearly publish relevant laws and consult interested parties when considering legal or regulatory changes. To ensure procedural fairness and predictability, the review or authorisation procedures for foreign investment should be based on clear criteria and specify the modalities, including the documents to be submitted by applicants, the timeframe for replies by relevant authorities, and the possible appeal or redress procedures against administrative decisions. Such measures would help to reduce the current legal and regulatory uncertainty not only in the area of strategic sectors and national security but also, more generally, enhance the transparency and predictability of the investment regime in Ukraine. Source: OECD, (2011) Investment Policy Reviews: Ukraine, Paris. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 183 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING investment promotion strategy would need to be defined and an action plan detailed. The dialogue with international investors could be fostered through international events. Finally, a dedicated team in charge of investors in the aeronautical industry could be created, acting as a one-stop-shop before and after investment. Review trade policy In a second phase, it could be useful to review trade policy and how it impacts the operations of companies in the sector. Trade barriers do not seem to impact the industry today, as integration in international supply chains is low. In the future, the implementation of other policy reforms could make a review of trade policy extremely useful to tap the full potential of opening the sector to international investors, ideas and practices. Skills sustainability The government of Ukraine might want to take action to preserve and enhance aeronautical skills. Box 8.8 describes the Brazilian experience in this area and it shows that enhancing training and R&D has been an important step in sustaining competitiveness. To do so, several types of reform could be considered: ● Reforming initial education. Reforming curricula through public-private dialogue could be an appropriate first step. It would greatly impact the quality of the education of aeronautical specialists, while also involving local and foreign manufacturers. Additionally, it could pave the way for more ambitious reforms of universities’ organisation, management and funding. ● Reforming vocational education and training. Specific action on secondary technical education and its relevance to business needs could be considered. Similarly, strong involvement of businesses in curriculum design would be helpful. ● Reinforcing continued education. The development of efficient, aeronautics-specific programs could also be useful in preserving and enhancing the skills of workers and engineers. Acting on continued education would yield two specific benefits. It could first be targeted at specific groups of people, namely floor workers and supervisors. Second, it would yield quicker benefits than reforming initial and vocational education. State support to the industry and its clients needs to be reviewed The government might want to be cautious in extending support to the aircraft industry, as no industry, including strategic ones, should be granted automatic, unqualified state support. However a thorough review would be a useful instrument to refine the state’s industrial strategy and direct funds to where they can be utilised most efficiently. A review would enable efficient implementation of governance reform. It would also be useful to make sure that the government defines an appropriate strategy for maximal development of its civilian aircraft sector, under two main constraints: tightly controlled government expenditures and fair competition under WTO and other international rules. As part of this process, the government might want to consider becoming a participant in the OECD Sector Understanding on Export Credits for Civil Aircraft.* This Working Group currently includes Australia, Brazil, Canada, the European Union, Japan, Korea, New Zealand, Norway, Switzerland and the United States. Joining this process would act as a catalyst for reform in the sector while reinforcing links with international aircraft- producing countries. * www.OECD.org/officialdocuments/displaydocumentpdf?cote=tad/pg(2011)3&doclanguage=en. 184 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Box 8.8. Brazil – An array of educational, training and research institutions for competitiveness in aeronautics To support the development of Embraer, an array of educational, training and research institutions are active in the region of Sao Paulo: Initial education relies mainly on two types of institutions: ● The Aeronautic Technology Institute (ITA) trains aeronautical engineers, including several Embraer CEOs. ● Sao Paulo State technical colleges (FATECs) train technology specialists. Research and development, consulting and continuing education is managed by the Aeronautics Technological Center (CTA), which is part of the Aeronautics Ministry. Several institutions play a key role: ● The Institute of Advanced Studies (IEAv) is mainly responsible for fundamental research. ● The National Institute for Space Research (INPE) provides post-graduate training. ● The National Industrial Learning Service (SENAI) trains apprentices. ● The Industrial Foment Institute (IFI) provides consultancy services. Source: Embraer (2010), Annual Reports, http://ri.embraer.com.br/show.aspx?idCanal=iM2P2p1lloUsWi5mzDbdbA, accessed 15 December 2010. Bibliography AeroStrategy (2009), “Aerospace Globalization 2.0: Implications for Canada’s Aerospace Industry”, discussion paper, AeroStrategy, Ann Arbor. Airbus (2009), Flying Smart, Thinking Big, Global Market Forecast 2009-28, Airbus, Blagnac. Airbus (2011), Corporate Site, www.airbus.com, accessed 15 September 2011. Aircraft Crashes Records Office (2011), Aircraft Crashes Records Office website, www.baaa- acro.com/statistics.html, accessed 15 December 2010. Airfleets (2010), Airlines List Database corporate website, www.airfleets.net, accessed 15 December 2010. American Airlines (2011), “AMR Corporation Announces Largest Aircraft Order In History With Boeing and Airbus”, American Airlines news release, www.aa.com/i18n/amrcorp/newsroom/fp_amr_fleet_ agreement.jsp, accessed 25 August 2011. Antonov (2011), corporate site, www.antonov.com, accessed 15 September 2011. ATR(2010a), corporate website, www.atraircraft.com/products/list.html, accessed 15 December 2010. ATR (2010b), Regional Market Outlook Turboprop Perspectives 2010-2029, ATR, Blagnac. Boeing (2011), corporate site, www.boeing.com, accessed 15 September 2011. Boeing (2010), Current Market Outlook, 2010-2029, Boeing Commercial Airplanes, Seattle, www.boeing.com/ commercial/cmo/pdf/Boeing_Current_Market_Outlook_2010_to_2029.pdf, accessed 15 September 2011. Bombardier (2010), Turning Obstacles into Opportunity. Annual Report 2010, Bombardier, Montréal. Bombardier (2010), corporate website, www.bombardier.com, accessed 15 December 2010. EADS (2011), corporate website, www.eads.com/eads/int/en.html, accessed 30 August 2011. Embraer (2010), corporate website, www.embraer.com/en-US/Pages/Home.aspx, accessed 15 December 2010. Embraer (2010), Annual Report 2009, Embraer, São José dos Campos, http://ri.embraer.com.br/show.aspx? idCanal=iM2P2p1lloUsWi5mzDbdbA, accessed 15 December 2010. Ericsson, K. and L. Nilsson (2006), “Assessment of the Potential Biomass Supply in Europe Using a Resource-focused Approach”, Biomass and Bioenergy, Vol. 30, No. 1. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 185 III.8. MACHINERY AND TRANSPORT EQUIPMENT: FOCUS ON CIVILIAN AIRCRAFT MANUFACTURING Havlik, P. (2011), “Unit Labour Costs, Exchange Rates and Responses to the Crisis in CESEE”, unpublished, the Vienna Institute for International Economic Studies, Vienna, www.dcenter.ru/news_main/ULC.pdf, accessed 15 September 2011. ICAO (2010), “ICAO Environmental Report”, Aviation Outlook, ICAO, Montreal, www.icao.int/icao/en/env2010/ Pubs/EnvReport2010/ICAO_EnvReport10-Outlook_en.pdf, accessed 15 September 2011. Julian, F. (2011), “Le secteur des avions régionaux au-devant de grands changements”, Air et Cosmos, 17 June, www.air-cosmos.com/home-page.html, accessed 15 July 2011. Le Monde (2011), “EADS ouvre sa première usine en Roumanie”, article published on 12th July 2011, www.lemonde.fr/economie/article/2011/07/12/eads-ouvre-sa-premiere-usine-en-roumanie_1547924_ 3234.html, accessed 15 July 2011. OECD (2009), OECD Science, Technology and Industry Scoreboard 2009, OECD, Paris, www.sourceOECD.org/ industrytade/9789264063716, accessed 15 December 2009. OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. OECD (2011), Country Capability Survey, internal working document, OECD, Paris. OECD (2011), Investment Policy Reviews: Ukraine, OECD, Paris. PIPAME (2009), “Étude de la Chaîne de Valeur dans l’Industrie Aéronautique”, PIPAME, Paris, www.industrie.gouv.fr/p3e/etudes/aeronautique/etudes3.php, accessed 15 September 2011. Pritchard, D. and A. MacPherson (2005), “Boeing’s Diffusion of Commercial Aircraft Design and Manufacturing Technology to Japan: Surrendering the US Aircraft Industry for Foreign Financial Support”, Canada-United States Trade Center Occasional Paper, No. 30, State University of New York, Buffalo, www.custac.buffalo.edu/content/documents/OccasionalPaper30.pdf, accessed 15 September 2011. Steenhuis, H. and E. de Brujin (n.d.), “High technology in developing countries: analysis of technology strategy, technology transfer, and success factors in the aircraft industry”, paper presented at International Association for Management of Technology (IAMOT) Conference. Sukhoi (2010), corporate website, http://sukhoi.org/eng/planes/ssj100, accessed 15 December 2010. Superjet International (2010), corporate website, www.superjectinternational.com, accessed 15 December 2010. Tupolev (2010), corporate website, www.tupolev.ru/english/Show.asp?SectionID=82, accessed 15 December 2010. United Aircraft Corporation (2010), corporate website, www.uacrussia.ru/en, accessed 15 December 2010. UAC (2010), Annual Report of JSC United Aircraft Corporation for 2009, UAC, Moscow, www.uacrussia.ru/common/ img/uploaded/disclosure/Annual_Report_2009e.pdf, accessed 15 September 2011. UBS (2010), “Prices and Earnings, A Global Purchasing Power Comparison”, UBS Wealth Management Research, Zurich, www.ubs.com/1/e/wealthmanagement/wealth_management_research/prices_ earnings.html, accessed 15 September 2011. State Statistics Committee of Ukraine (2011), State Statistics Services website, www.ukrstat.gov.ua, accessed 15 September 2011. US International Trade Commission (1998), “The Changing Structure of the Global Large Civil Aircraft Industry and Market: Implications for the Competitiveness of the US Industry”, US ITC, Washington, DC, www.usitc.gov/publications/332/pub3143.pdf, accessed 15 September 2011. World Bank (2011), “Ukraine Economic Update”, 21 June, World Bank, Washington, DC, www.flightglobal.com/articles/2010/05/29/342577/rossiya-an-148-is-costly-and-needs-better- support.html, accessed 15 September 2011. 186 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 Competitiveness and Private Sector Development: Ukraine 2011 Sector Competitiveness Strategy © OECD 2012 Conclusion and roadmap for implementation phase This chapter summarises the strategic recommendations. It presents a framework to prioritise among sector specific policy recommendations, based on the country’s strategic advantage and the areas of intervention that the government can leverage. A final section discusses the next steps needed to start the implementation phase and to build-up long term capabilities. 187 III.9. CONCLUSION AND ROADMAP FOR IMPLEMENTATION PHASE A roadmap for creating a favourable business environment and attracting investment This study provides a prioritised list of policy issues for consideration by the Ukrainian government that aims to foster private sector development and create a favourable business environment attractive to foreign investors. It analyses firstly the investment environment at a general level and then proposes some specific recommendations based on a sectoral assessment of the structural issues affecting growth in four selected pilot sectors. Economy-wide measures are the keystone of the reform agenda Although necessary macroeconomic reforms are not analysed here, they remain the keystone for establishing credibility and securing the long-term stability demanded by domestic and foreign investors. The new lending programme worth USD 15.2 billion signed with the IMF in July 2010 eased concerns over the country’s sovereign risk; however, cooperation with the Fund and disbursement of the third tranche of credit (originally due in February 2011 and then frozen due to lack of reforms) depends on the government’s ability to respect the requirements of the IMF’s package. The reform agenda urgently needs to address deeper fiscal measures. In this direction, in July 2011 the parliament approved pension reform legislation, which gradually increases the retirement age for women from 55 to 60 and introduces a new cap on pensions. A second intervention considered as a priority in the IMF’s deal is the gradual increase of gas tariffs for households and heat suppliers, nevertheless there has been no progress on this point. It is crucial to maintain the reform momentum and strengthen the fiscal position of the country. The delay in receiving the third tranche, which is now expected to be disbursed by the end of 2011, could put further pressure on the country risk premium and on the government’s credibility regarding respect for international commitments. Within the context of this broad reform agenda the OECD Investment Policy Review of Ukraine proposes investment policy advice based on the Policy Framework for Investment (PFI) in order to ameliorate the still-challenging business climate (OECD, 2011). A first set of general investment policy recommendations includes, among other things: ● the abolition of the moratorium on land ownership and the implementation of a unified registry of land and real estate; ● the lifting of outstanding foreign investment and trade restrictions in line with the WTO commitments; ● the observation of the principles of non-discrimination, proportionality, transparency and accountability in implementing investment measures related to national security, in line with the 2009 OECD Guidelines for Recipient Country Investment Policies relating to National Security. 188 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.9. CONCLUSION AND ROADMAP FOR IMPLEMENTATION PHASE A second set of recommended measures aimed at improving the investment climate focuses on: ● finalisation of the VAT arrears refunding and the improvement of the VAT administration; ● the development of public-private consultation on business-related legislation and regulations with the business community, including foreign investors, notably within the Council of Local and Foreign investors. Thirdly, some specific measures were identified in the field of energy efficiency investment, including: ● the phasing out of the energy tariff subsidies before the end of 2012, the launch of privatisation in the energy sector, the unbundling of Naftogaz and the establishment of an independent energy regulatory agency; ● the setting up of a transparent legal and regulatory framework to mobilise investment in energy efficiency and energy production from alternative sources. Targeted interventions are recommended to build long-term capabilities in promising sectors Four pilot sectors have been identified as a focus of the analysis, according to the Sector Prioritisation Framework and extensive consultations with the relevant stakeholders. The previous chapters contain an assessment of the drivers of these sectors in the short- and medium-term and of the policy barriers hampering their growth. Several specific areas of improvement have therefore been identified. In order to develop a prioritised reform programme and a roadmap for the implementation phase of the Sector Competitiveness Strategy for Ukraine project (Phase II), the proposed recommendations have been assessed according to two dimensions: ● Strategic Advantage: distinguishing between static comparative advantage and dynamic comparative advantage (Krugman 1987; Lall, 1990). As explained in the methodology (Chapter 1) a static comparative advantage is based on natural endowments and short term drivers, such as low labour costs which might be difficult to sustain over time. A dynamic comparative advantage leverages long-term strategic positioning, being rooted in learning-by doing and higher-value activities. ● Areas of Intervention: the government can have an impact through either rules or capabilities. Rules and regulations build the framework for a sector; however they can easily be reversed. Capabilities can be broadly defined to refer to the entire complex of skills, capital resources and technology which an economy can build over time. Both rules and capabilities are important, however capabilities create positive externalities for the economy. The proposed framework provides the government with an instrument to implement strategic policy-making. However, alternative strategies are not mutually exclusive. In the agribusiness sector the areas of intervention selected for the next implementation phase are: Access to Finance (for the grain value-chain) and Human Capital Development (for the dairy value-chain) (Figure 9.1). Regarding energy production from alternative sources, the selected areas of intervention are Investment Policy and Promotion (Figure 9.2). As explained earlier (Chapter 1) interventions belonging to the quadrant Rules-Static Comparative Advantage, such as the COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 189 III.9. CONCLUSION AND ROADMAP FOR IMPLEMENTATION PHASE Figure 9.1. Selected areas of interventions in the Agribusiness sector Access to finance and Human Capital Development have been selected for next phase Strategic advantage Investment Access to finance Dynamic policy Human capital comparative – Co-operative banks advantage Quality standards – Attract FDI in the – Supply chain financing, – Initial education dairy processing warehouse receipts – Vocational education Based on – Food safety regulation industry – Leasing – Continued education high-value added – Streamline of controls – Geographical – Match the needs – Credit guarantee schemes long term – Certifications export diversification – Microfinance of the private sector Infrastructures Static Land reform comparative – Road system advantage – Grain carriers – Land reform completion – Port infrastructure Based on – Lift the moratorium on land sale – Storage facilities natural ressources – Cold chain labour cost short term Rules Capabilities Area of intervention Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris; Framework based on Krugman (1987) and S. Lall (1990); P. Krugman, (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Tatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 41-55; Lall, S. (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. Figure 9.2. Selected areas of interventions in the Energy production from alternative sources sector Investment Policy and Promotion have been selected for next phase Strategic advantage Investment Policy – Attract FDI along the biomass Investment promotion Dynamic Privatisation value-chain comparative – Privatisation of State-Owned – Incentives to alternative energy – National Action Plan production of biomass sector advantage utilities, power and distribution assets – Streamline administrative – Communication and Based on Promotion – Entry and exit of players hurdles to investment high-value added – Increase public awareness – Incentives to technological long term upgrade Payment Institutions Infrastructures Static mechanisms comparative – Autonomous market – Modernisation of distribution – Enforcement of regulator authority advantage payment collection infrastructure – Transparency of Based on – Design of new regulation natural ressources mechanisms labour cost – Solve payment arrears short term Rules Capabilities Area of intervention Source: OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris; Framework based on S. Lall (1990); P. Krugman, (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Tatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 1, pp. 41-55; Lall, S. (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. review of payment mechanisms, are urgently needed and are a prerequisite to developing a green growth strategy. However, the areas of Investment Policy and Promotion have been prioritised as these will enable a transfer of necessary capabilities from the OECD experience. These capabilities will allow the alternative energy sector to maintain a sustainable advantage over the long-term. Other renewable sources of energy, such as small hydro, wind or solar energy, might also have an economic potential in Ukraine. Finally, in the aircraft sector the implementation phase will focus on the sector’s governance and investment policy. 190 COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 III.9. CONCLUSION AND ROADMAP FOR IMPLEMENTATION PHASE The recommended next steps include the establishment of three public-private working groups, focusing on agribusiness, production of energy based on biomass, and civilian aircraft, respectively. These working groups will become permanent bodies in charge of designing and implementing the needed reforms for each sector, beyond the timeframe of the OECD project. Finally, it is recommended that the government of Ukraine include a sub-national dimension in its efforts to improve its sectoral competitiveness. At present, an uneven distribution of FDI persists between regions: two-thirds of Ukraine’s FDI stock is currently concentrated in six regions. A first step in this direction is the OECD Territorial Review of Ukraine, started in 2011. The Territorial Review is a national-level diagnosis providing evidence-based and detailed analyses of regional policies. A subsequent specific effort on the development of a strategy at the sub-national level should also be pursued. Bibliography Krugman, P. (1987), “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Tatcher. Notes on Trade in the Presence of Dynamic Scale Economies”, Journal of Development Economics, Vol. 27, No. 1, pp. 41-55. Lall, S. (1990), Building Industrial Competitiveness in Developing Countries, OECD, Paris. OECD (2010), Ukraine Sector Competitiveness Review, internal working document, OECD, Paris. OECD (2011), “Investment Policy Reviews: Ukraine 2011”, OECD Investment Policy Reviews, OECD, Paris. COMPETITIVENESS AND PRIVATE SECTOR DEVELOPMENT: UKRAINE 2011 © OECD 2012 191 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT The OECD is a unique forum where governments work together to address the economic, social and environmental challenges of globalisation. The OECD is also at the forefront of efforts to understand and to help governments respond to new developments and concerns, such as corporate governance, the information economy and the challenges of an ageing population. The Organisation provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies. The OECD member countries are: Australia, Austria, Belgium, Canada, Chile, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The European Union takes part in the work of the OECD. OECD Publishing disseminates widely the results of the Organisation’s statistics gathering and research on economic, social and environmental issues, as well as the conventions, guidelines and standards agreed by its members. OECD PUBLISHING, 2, rue André-Pascal, 75775 PARIS CEDEX 16 (25 2011 05 1 P) ISBN 978-92-64-12878-1 – No. 59699 2012 Competitiveness and Private Sector Development UKRAINE SECTOR COMPETITIVENESS STRATEGY Contents Part I. Methodology Chapter 1. Approach and methodology Part II. Economic overview and ﬁndings of the Investment Policy Review of Ukraine Chapter 2. Economic overview Chapter 3. 2011 OECD Investment Policy Review of Ukraine: Key ﬁndings Part III. Sector-speciﬁc analysis Chapter 4. Agribusiness Chapter 5. Focus on the grain value chain Chapter 6. Focus on the dairy value chain Chapter 7. Energy-efﬁciency and renewable technologies: Focus on production of energy based on biomass Chapter 8. Machinery and transport equipment: Focus on civilian aircraft manufacturing Conclusion and roadmap for implementation phase Related reading OECD Investment Policy Reviews: Ukraine 2011 (2011) Competitiveness and Private Sector Development: Central Asia 2011: Competitiveness Outlook (2011) Development in Eastern Europe and the South Caucasus: Armenia, Azerbaijan, Georgia, Republic of Moldova and Ukraine (2011) Competitiveness and Private Sector Development: Kazakhstan 2010: Sector Competitiveness Strategy (2011) Please cite this publication as: OECD (2012), Competitiveness and Private Sector Development: Ukraine 2011: Sector Competitiveness Strategy, OECD Publishing. http://dx.doi.org/10.1787/9789264128798-en This work is published on the OECD iLibrary, which gathers all OECD books, periodicals and statistical databases. Visit www.oecd-ilibrary.org, and do not hesitate to contact us for more information. ISBN 978-92-64-12878-1 25 2011 05 1 P -:HSTCQE=VW]\]V:
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