НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2018 рік) - 6

OPERATIONS

ANNUAL REPORT 2018

2018

UKRNAFTA PJSC

In 2017, the validity period of 9 permits issued to Ukrnafta expired. Attempts by the company to continue the validity of the special permits were blocked by State Geological Survey of Ukraine, and from April to June 2017

Ukrnafta had to stop oil and gas production at 6 oilfields. The company won a number of lawsuits, challenging the inaction of the regulator in prolongation of special permits. In late October and November, after the special
permits were prolongated, Ukrnafta was able to resume oil and gas production. By the end of 2017, Ukrnafta filed an application to State Geological Survey of Ukraine for the prolongation of 27 special permits, which expire in
2018 and which accounts for 24% of the company’s annual oil production and 18% of annual gas production.

NOPLAT – adjusted operating profit / (loss) for one-time and / or non-typical transactions, as well as income tax calculated at nominal rates, according to the consolidated financial statements of Naftogaz for 2018.

ROIC is calculated as NOPLAT divided by invested capital, which is determined as the sum of capital invested in fixed assets and net working capital. The capital invested in fixed assets is calculated based on the company’s

proprietary estimate of opportunity cost of hydrocarbon resources and the value of petroleum fuel stations' network.

https://www.ukrnafta.com/u-2018-ukrnafta-splatila-15,3-mlrd-grn-podatkiv

As a result of an audit of hydrocarbon reserves carried out by DeGolyer & MacNaughton, the proved and probable reserves of liquid hydrocarbons за PJSC Ukrnafta amounted to 24.14 million tonnes, of which 9.66 million

tonnes are undeveloped thus could be a prime target for short- and medium-term increase of oil output.

According to the results of 2018, Ukrnafta

recorded an annual growth of oil and

condensate production. At the same time,

2017 is not a particularly relevant base

for comparison, since in 2017 the process

of prolongation of the company’s special

permits was blocked by Derzhgeonadra

which became a temporary one-off factor

impacting the decline in production.

At the beginning of 2018, Ukrnafta

identified 100 most promising production

targets within 33 fields for further

extensive campaign aimed to run

stimulation operations, re-perforations,

recovery of idle wells, updating subsurface

equipment and other works to increase

output. Due to these operations, Ukrnafta

managed to achieve an observable

increase in average daily natural gas

production from the second half of

2018. At the same time, the company's

declared growth was made compared to

2017, when Ukrnafta reduced its natural

gas production by 14.8% to 1.1 bcm

(compared to 2016).

In 2018, the Ukrnafta return on

investment capital (ROIC)

improved

from 5.0% to 10.8%, but still remains

twice lower than the cost of capital rate

estimated at 21.8%. This means that

Ukrnafta’s businesses of hydrocarbons

extraction and production as well as

petroleum products sales still do not

generate the value to the company in a

financially sustainable way.

In 2018, Ukrnafta paid UAH 15.3 billion

of taxes to the state budgets of all levels,

including UAH 1.2 billion as repayment of

an overdue tax debt. The amount of tax

payments for the past year exceeded the

corresponding figure in 2017 by 45.7%

(UAH 10.5 billion), and in 2016 by 88.9%

(UAH 8.1 billion). In 2018, the company

fully paid its current tax liabilities, while

repaying its past due tax on a regular

basis.

Over 2017-2018, Ukrnafta reduced its

tax liability to UAH 11.9 billion (of which

89% was overdue

), however, due to the

accrued fines and penalties for past due

of taxes and duties, the total debt grew

by UAH 4.5 billion to UAH 29 billion as of

the end of 2018. The average effective

rate of fines and penalties accrued on the

principal amount of tax debt is 23.4% per

annum, which exceeds the Ukrnafta's cost

of capital, which is 21.8%. This indicates

that ignoring the issue of repayment of

Ukrnafta’s tax debt leads to the destruction

of the company's value.

In addition to improving operational

performance compared to 2017,

Ukrnafta also increased revenue by 1.3

to UAH 36.1 billion and its net operating

profit after tax (NOPLAT

) by 2.3 times to

UAH 9.3 billion in 2018. This improvement

was mostly caused by an increase in the

market price of oil and condensation is

almost 40%.

The issue of tax debt is probably the

main risk for the further effective

operations of the company. In view

of the fact that Ukrnafta is one of the

leading taxpayers to the state budget

and the available confirmed potential

to increase hydrocarbons production by

the company

, the financial recovery of

Ukrnafta is a matter of public interest.

In order to bring Ukrnafta out of crisis

and to achieve the financial stabilization

of one of the largest enterprises in the

oil and gas industry in Ukraine without

applying bankruptcy and sanction proce-

dures, including to reduce social tension

and retain its personnel capacity, the

company's management has repeatedly

appealed to the executive authorities

requesting to restructure its tax debt. To

support the implementation of the com-

pany’s financial recovery plan, in March

2019, an extraordinary general meeting

of shareholders of Ukrnafta discussed a

number of issues related to the compa-

ny management and operations. In par-

ticular, the decisions of the shareholders

included the approval of changes that

brought the company's corporate gov-

ernance system into line with the best

international standards and OECD rec-

ommendations, and also agreed to enter

into the contracts between Ukrnafta

PJSC and NJSC Naftogaz of Ukraine on

the sale and purchase of natural gas for

a total of 4.062 bcm.

The contracts stipulate that Naftogaz will

acquire 2.062 bcm of Ukrnafta gas from

underground gas storage, as well as 2 bcm

of gas that will be extracted in the future.

Payments are to be made by the funds

received by Naftogaz from the CMU as

compensation for the fulfillment of special

gas supply obligations for the needs of

households and district heating companies.

In turn, Ukrnafta will use the money

received solely to repay its tax debt,

as well as other tax liabilities that will

arise during the fulfillment of the

contracts.

ill

n t

2013

2014

2015

2016

2017

2018

2,0

1,0

0,5

1,5

2.0

1.9

1.7

1.5

1.4

1.5

-7.0%

-11.5%

-9.2%

-4.6%

Ukrnafta’s production of oil and condensate in 2013-2018

January 2017

Mar

ch 2017

Mar

ch 2018

y 2017

y 2018

July 2017

July 2018

Sep

tember 2017

Sep

tember 2018

vember

2018

vember 2017

January 2018

3 800

3 600

3 400

3 200

3 000

2 800

2 600

2 400

2 200

2 000

tcm

-13%

Ukrnafta's average daily gas production, 2017-2018

2017

2018

2017

2018

26.9

5.0%

10.8%

21.8%

36.1

9.3

4.1

Sales revenue, UAH billion
NOPLAT, UAH billion

ROIC
Cost of capital

Ukrnafta financial results

in 2017-2018

UAH denominated

ROIC vs cost of capital, %

31.12.2016

31.12.2017

31.12.2018

24.5

26.9

10.6

11.9

29.0

17.1

14.1

11.2

13.3

12.8

Provision for fines and penalties, UAH billions
Ukrnafta's tax liabilities, UAH billions

-4,6%

+4.5 UAH billion

Change in Ukrnafta’s tax liabilities and provision for fines and

penalties in 2017-2018, UAH billion

Including overdue as of 31 December 2018

Source: Ukrnafta

Source: Ukrtransgaz’ operational data

Source: Consolidated financial statements

of “Naftogaz of Ukraine” for 2018

Source: Consolidated financial statements of Naftogaz of Ukraine for 2018-2017, Ukrnafta

Source: Naftogaz calculations

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OPERATIONS

ANNUAL REPORT 2018

2018

NEW BUSINESSES. ENERGY SERVICE

Modernization of individual and district heating systems

Increasing energy efficiency is the most

important way to increase the energy

security of Ukraine. Given the significant

share of total energy expenditure on

heating where gas is the predominant

fuel, reducing gas use by installing

efficient heating systems would bring

the country closer to this goal. Given

the global volatility of energy prices, this

would increase consumer protection

from energy poverty, and offer particular

protection to socially vulnerable

consumers.

Naftogaz group is implementing

several energy efficiency programs for

households. For example, the Chernihiv

region implements "Affordable Heat

for employees". The project aims

to enhance the efficiency of gas

consumption to heat the homes of

Naftogaz group employees and in the

cities and villages where the group is

present.

In recent decades, small settlements

have accumulated serious problems

related to the district heating system

caused by unsystematic disconnection

of individual apartments from district

heating systems. Since 2018, in the

village of Mryn, Chernihiv region,

apartments in two- to three-storied

multi-apartment buildings began to shift

to individual heating. This would enable

the shutting down of the boiler plant in

2019, which brought losses to Naftogaz

group of at least UAH 500 000 per year.

Following the modernization

of their heating equipment,

consumers have been saving

80% on heating.

The residents of the village of Mryn

enjoyed a corporate discount of 40%

for new heating equipment provided

by producers under cooperation

agreements with Naftogaz. Moreover,

some consumers, supported by

SE Naftogaz-Energoservis, received

additional compensation of 35% for

expenses incurred during the installation

of energy-efficient equipment under the

EBRD IQ Energy program.

In 2018, the Affordable Heat program

was implemented by Naftogaz Group

in two areas: energy services for the

residents of the city of Kropyvnytskyi

and Kirovohrad region, and installation

of individual heating equipment for the

residents of Kropyvnytskyi jointly with the

municipality. For the convenience of the

residents of the region, an energy service

center was set up in Kropyvnytskyi. This

center provides professional advice,

accepts requests for "turnkey" projects

to upgrade the heating system of houses,

and provides support obtaining the

required permits. In addition, Naftogaz

group companies together with the local

authorities of Kropyvnytskyi are engaged

in the transformation to individual

heating in 95 residential houses in the

city. Low-income citizens have already

benefited from this program and received

guaranteed compensation from local

authorities at a rate of 50%, or from the

EBRD IQ Energy program, and received

an additional 35% compensation for

purchased services, components and

equipment.

In 2018, under the "Affordable Heat"

program, heating systems in 704 houses

underwent upgrades. Customers who

have switched to individual heating have

cut their heating costs by half or more.

Customers who have upgraded obsolete

individual heating systems reduced their

costs by 10% to 60%.

The implementation of the

"Affordable Heat" program

made it possible to reduce

gas consumption by more

than 200 tcm for the period

from November 2018

to March 2019.

Naftogaz considers opportunities to

extend the energy service and energy

efficiency program for the household

segment. The company also seeks to

increase renewable generation.

Estimated budget for the energy modernization of housing in Ukraine, USD bn

10.3

14.0

3.7

15.9

18,3

3.7

2.0

1.7

2.4

15.9

Insulation of
private houses

Upgrading of heating systems
for heat producers

Upgrading networks
of heat producers

Metering and thermoregulation
in apartment buildings

Insulation of apartment
buildings

DHCs

Private

houses

Upgrading of heating systems
for private houses

USD bn

Apart-

ment

houses

51%

10%

39%

Ukrainian households
are

times behind Polish

households in terms
of energy efficiency

Ukraine has spent
USD

billion on direct

and cross subsidies
for households
over the last 10 years

Naftogaz paid
USD

billion

to Russian gas suppliers
in 2006-2015

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2018

OPERATIONS

ANNUAL REPORT 2018

ARBITRATION PROCEEDINGS:

GAZPROM, CRIMEA, UKRNAFTA

The Gas Sales Arbitration was initiated

by both Naftogaz and Gazprom on

16 June 2014 under the auspices

of the Arbitration Institute of the

Stockholm Chamber of Commerce (

“SCC

Arbitration Institute”). In its Request

for Arbitration, Gazprom claimed

payment of unpaid invoices for gas

delivered under the Gas Sales Contract

from November 2013 to May 2014,

while Naftogaz claimed a retroactive

revision of the price under the Gas

Sales Contract, and compensation for

previous overpayments under the prices

applied before the revision. Gazprom

has later added a claim for payment of

gas which Gazprom did not deliver, but

which Naftogaz allegedly nevertheless

was obliged to pay for under the

Contract (the so-called

“take or pay”

claim). On 13 October 2014, Naftogaz

initiated another arbitration under the

Gas Transit Contract claiming a revision

of the transit tariff with retroactive

effect, compensation for underpayments

as a result of tariff revision,

compensation of under delivery of

volumes for transit and revision of

certain provisions of the Gas Transit

Contract.

2014 Gas Sales and Gas Transit Arbitrations

On 31 May 2017, the arbitral tribunal

decided on the case of Naftogaz against

Gazprom relating to

the Gas Sales

Contract by rendering the separate

arbitral award. The tribunal decided that:

On 22 December 2017, the arbitral

tribunal issued the final award on the

case of Naftogaz against Gazprom

relating to

the Gas Sales Contract. The

tribunal:

revised the price formula of the Gas Sales Contract and fully linked the price for gas to

European (German) hub prices, starting from 27 April 2014;

reduced the annual contract volume obligations of Naftogaz from 52 billion cubic

metres to 5 billion cubic metres in 2018 and 2019;

fully rejected Gazprom’s take-or-pay claims to Naftogaz (amounting to USD56 billion

for 2009-2017);

found that Naftogaz is not responsible for gas supplies by Gazprom to any third parties

in the uncontrolled territories in Donetsk and Luhansk regions; and

obliged Naftogaz to pay USD2 billion in favour of Gazprom for the volume of gas

received but not paid for by Naftogaz in certain months of 2013 and 2014.

the clauses of the Gas Sales Contract concerning the minimum contract amounts

and “take-or-pay” provision are invalid starting from 19 January 2009 and until the

date of the final award and must be amended starting from the date of the final

award taking into account the real import demand from Naftogaz;

the price formula provided in the Gas Sales Contract shall be revised starting from

27 April 2014 so as to bring the price to the market level;

Naftogaz is entitled to repayment of amounts paid in cases of a factual payments

price excess over the price as provided by the revised formula of the Gas Sales

Contract; and

the clause of the Gas Sales Contract on the prohibition to Naftogaz to sell gas

purchased under the Gas Sales Contract outside Ukraine is invalid starting from 19

January 2009.

The tribunal has obliged the parties to

determine the elements of gas price

formula to be used for gas supplies

starting from 27 April 2014 through

negotiations. Such negotiations took

place during June-August 2017, but the

parties failed to reach agreement on

remaining issues and thus the Tribunal

had to decide on these issues.

31 May 2017

22 December 2017

4.63

USD billion

On 28 February 2018, the arbitral

tribunal issued the final award on the

case of Naftogaz against Gazprom

relating to

the Gas Transit Contract. The

tribunal:

found that Gazprom had defaulted on its obligations regarding volumes to be transit-

ed and awarded damages in the amount of USD 4.63 billion in favour of Naftogaz;

confirmed obligations of Gazprom in respect of supplies of minimum transit

amounts of 110 bcm of gas under the Gas Transit Contract, which is effective until

the end of 2019;

rejected Naftogaz’s claim for tariff revision due to procedural reasons, as Naftogaz

in its request for transit tariff revision in 2009 did not follow the procedural re-

quirements established by the Gas Transit Contract;

rejected Naftogaz’s claim in respect of the prospective assignment of its rights and

obligations under the Contract to Ukrtransgaz or any other entity designated as

transmission system operator;

rejected Naftogaz’s claim in respect of adjustments of the Gas Transit Contract

according to the EU and Ukrainian competition and energy law, stating that the

EU law does not apply to the dispute and that it is not the role of the Tribunal to

implement reforms in Ukraine, which should be decided by the Ukrainian govern-

ment; and

made the set-off of amounts owing between Naftogaz and Gazprom

pursuant to the Gas Sales Arbitration and the Gas Transit Arbitration

with the effect of net amount of USD 2.56 billion to be paid by Gazprom

to Naftogaz.

28 February 2018

The compansation to be paid by

Gazprom to Naftogaz for breaching

contractual conditions.

Gazprom’s challenges to the awards

After both arbitration awards were

rendered, Gazprom launched the

challenge proceedings against the awards

in the Swedish courts, though challenging

the final award does not suspend its

enforcement by default.

Gazprom filed the challenges with the

Svea Court of Appeals (Sweden) against

the separate and final awards in the

Gas Sales Arbitration on 8 November

2017 and 21 March 2018 respectively.

On 29 March 2018 Gazprom filed a

challenge (as supplemented on 28 May

2018) with the Svea Court of Appeal

against the final award in the dispute

with Naftogaz over the Gas Transit

Contract, alleging inter alia that the

administrative Secretary of the tribunal

wrote a large part of the reasons of the

award.

In March 2018, Gazprom officially

declared its refusal to resume deliveries

of natural gas to Ukraine. Additionally,

Gazprom refused to settle outstanding

amount as decided by the tribunal in the

Transit Arbitration.

Naftogaz’s efforts

to enforce the Transit Award

Based on the final awards and in view of

the Gazprom’s failure to comply with the

awards Naftogaz has moved to pursue

enforcement and attach Gazprom’s assets

in several jurisdictions, including the

Netherlands, Switzerland and England.

In late May 2018, Naftogaz received

permission from a Dutch judge to

attach Gazprom’s shares in its seven

Dutch subsidiaries and the debts those

subsidiaries owe to Gazprom. Six of them

refused to cooperate with enforcement

authorities.

In June 2018, the Commercial Court in

London issued an order to enforce the

Transit Award. In addition to freezing

assets, it requires Gazprom to provide

Naftogaz with a list of all assets with a

value greater than USD 50.000 located in

England or Wales.

According to the ruling of the London

Commercial Court of 15 March 2019,

the enforcement of the award should be

adjourned until the decision of the Svea

Court of Appeal if Gazprom undertakes

certain obligations, in particular,

withholding from hiding or reducing its

assets in England and the Netherlands.

Besides that, Gazprom deposited cash

security for fulfilling the court’s order.

In July 2018, the Zug Superior Court,

Switzerland re-instated attachment of

Gazprom's shares in Nord Stream AG and

Nord Stream 2 AG. These attachments

will stay in place until the Zug Superior

Court decides on Naftogaz’ appeal

against the local debt enforcement

office's earlier decision to lift the share

attachments.

2018 Gazprom-Naftogaz Arbitrations

In furtherance of the refusal both to

settle the debt under the final award

in the Gas Transit Arbitration and to

resume gas supplies to Ukraine in

compliance with the final award in the

Gas Sales Arbitration, Gazprom initiated

a new SCC arbitration on 20 April 2018

(the “Reversal Claim”) essentially

attempting to reverse the outcome of

the awards of 2014 Arbitrations. The

preliminary relief sought by Gazprom in

In 2017, Naftogaz

won the case

against Gazprom.

For more details

watch #Stockholm

documentary.

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2018

OPERATIONS

ANNUAL REPORT 2018

I I I

I I

CRIMEA

On 15 September 2017, Naftogaz and

six subsidiaries — Chornomornaftogaz,

Ukrtransgaz, Ukrgasvydobuvann-

ya, Ukrtransnafta, Likvo, and Gas of

Ukraine – submitted a statement of claim

to the tribunal claiming compensation for

damages caused by the Russian Federa-

tion's illegal expropriation of the Group’s

assets in Crimea.

On 26 April 2018, the London Court of

International Arbitration rendered an

award in the case initiated by Ukrnafta

minority shareholders against Naftogaz.

The Tribunal concluded that the key clauses

of the shareholders agreement between

Naftogaz and the companies controlled by

Ihor Kolomoyskyi on corporate governance

at Ukrnafta are unenforceable, being

in contradiction with the mandatory

provisions of Ukrainian corporate law.

Parts of article 9 of the shareholders

agreement — stipulating that six

members of the Ukrnafta supervisory

board are elected from among

candidates suggested by Naftogaz while

the other five members and CEO from

among those suggested by Ukrnafta

minority shareholders, i.e. the companies

controlled by Ihor Kolomoyskyi — are

unenforceable. Article 9 also provides that

members of the Ukrnafta executive board

are approved by the Ukrnafta supervisory

board upon submission by the CEO.

The Tribunal, however, declared that

the shareholders agreement was valid

in whole, though its key clauses on

corporate governance at Ukrnafta were

unenforceable.

the Request for Arbitration was stated

in the general terms and concerns

adjustment of the specific provisions

of both the Gas Sales Contract and

the Gas Transit Contract based on the

Article 36 of the Swedish Contracts

Act or, alternatively, setting aside both

contracts in their entirety as well as

ordering Naftogaz to pay Gazprom all

amounts due from Naftogaz arising out

of the adjustment sought or setting

aside both contracts. In turn, Naftogaz

filed a number of counterclaims in view

of Gazprom’s breaches of the Gas Sales

and Gas Transit Contracts, the amount

of which is to be quantified at a later

stage of the proceedings.

Apart from the above, on 6 July 2018

Naftogaz filed to the SCC a Request for

Arbitration seeking transit tariff revision

under the Gas Transit Contract based

on the regular application of the transit

tariff revision clause of the contract,

with effect from 13 March 2018 (the

“Tariff Revision Claim”). The Gas Transit

Contract allows the parties to request a

revision of the tariff in case of significant

changes in the European gas market

and if the tariff does not correspond

to the level of tariffs in Europe. In the

final award in the Transit Arbitration,

Naftogaz’s claim for tariff revision was

rejected for procedural reasons, and

Naftogaz’s substantive right to a revision

of the tariff was therefore not decided in

that award. Naftogaz submitted a request

for revision of the tariff to Gazprom in

March 2018, triggering negotiations

pursuant to the Gas Transit Contract. The

reasons for the request are significant

changes in the European gas market,

in particular the rules for setting transit

tariffs, after the Gas Transit Contract was

concluded in January 2009, and the fact

that the tariff level does not correspond

to the European level. Gazprom has not

been constructive in the negotiations,

compelling Naftogaz to refer the matter

to arbitration as provided for in the

contract. The preliminary estimate of

the value of the claim, assuming the

application of the revised tariffs sought

by Naftogaz, is USD 11.58 billion.

Upon request from Gazprom, on 06

September 2018 the SCC Board made a

decision to consolidate both the Reversal

Claim and the Tariff Revision Claim into

the one joint proceeding.

15 September 2017

26 April 2018

14 - 17 May 2018

From 14 to 17 May 2018, oral hearings

were held at the Peace Palace in The

Hague.

Quantum was bifurcated and will

be heard and considered during the

second phase of the proceedings, after

the first arbitral award (on jurisdiction

and the merits) is rendered. On

22 February 2019 the tribunal rendered

its first award and found that the

Russian Federation violated the Russia-

Ukraine bilateral investment treaty

by seizing assets owned by Naftogaz

and its subsidiaries in Crimea. The

tribunal has launched a second phase

of the proceedings to determine the

amount of compensation Russia owes

to Naftogaz. Naftogaz experts have

estimated the value of Naftogaz’s over

5 billion pecuniary claims.

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Chair of the

supervisory board

Spottiswoode Clare

Mary Joan

Deputy chair of the

supervisory board

Demchyshyn

Volodymyr

Vasylyovych

Independent

director

Lescoeur Bruno,

Jean, Gaston

Independent

director

Hochstein

Amos

Board member

Popyk Sergii

Dmytrovych

Board member

Kudrytskyi

Volodymyr

Dmytrovych

Structure of the board and its committees

Appointments within the supervisory board

Proceedings of the board and its committees

The new composition of the supervisory

board had been formed by Ordinance of

the Cabinet of Ministers of Ukraine dated

13 December 2017 # 892-p “On certain

matters of the Supervisory board of Public

Joint Stock Company ’National Joint-Stock

Company ’Naftogaz of Ukraine’” which

came into force on 15 December 2017.

Spottiswoode Clare Mary Joan, Lescoeur

Bruno, Jean, Gaston, Hochstein Amos

and Haysom Steven John were elected as

independent directors. They were joined

by Popyk Sergii Dmytrovych, Kudrytskyi

Volodymyr Dmytrovych and Demchyshyn

Volodymyr Vasylyovych as government

appointees.

During 2018, Haysom Steven John did

not discharge his duties as supervisory

board member and, in particular, did not

participate in meetings of the Supervisory

board and its committees. He did not

enter into a service agreement with ’Na-

tional Joint-Stock Company ’Naftogaz of

Ukraine’. He was not remunerated and did

not make statement of his independence

in line with the Rules of Procedure of the

supervisory board. The decision on early

termination of his authorities was adopted

by Ordinance of the Cabinet of Ministers

of Ukraine dated 20 March 2019 # 160-р.

During 2018, all of the supervisory board

members who concluded the agreements

with the company were compliant with

the necessary criteria including regarding

competences and dedication of time to

the work of the board.

During January and February 2018, the

company concluded service agreements

with the all board members, except

for Haysom Steven John, pursuant to

Ordinance of the Cabinet of Ministers of

Ukraine dated 17 January 2018 # 21-p

“Certain matters pertaining to conclusion

of service agreements with members of

the Supervisory board of Public Joint Stock

Company ’National Joint-Stock Company

’Naftogaz of Ukraine’”.

According to the provisions of the

concluded service agreements with

members of the supervisory board, re-

muneration for the performance of board

duties is established at the level of gross

UAH 6 328 000 annually for independent

directors and 75% of that amount for

government appointees. Supervisory

board members are also entitled to ad-

ditional remuneration amounting to 20%

of total remuneration for performance of

the function of the chair of the supervi-

sory board and 10% of the remuneration

for participation as the member of a

committee of the supervisory board, as

well as to compensation of their expens-

es incurred during performance of board

member functions.

In total, during 2018 the company in-

curred approx. UAH 53 million in expenses

for the operations of the supervisory

board. This amount includes UAH 46 mil-

lion in service fees accrued and UAH 7 mil-

lion in compensation of expenses incurred

by board members during performance

of their duties, as well as D&O insurance

which covers liability of these officers after

their appointment.

Following the formation of the new

supervisory board, at the first meeting

which was held on 22 December 2017,

Spottiswoode Clare Mary Joan was

elected as the chair of the supervisory

board. All members of the supervisory

board supported the motion that

Demchyshyn Volodymyr Vasylyovych

should continue to hold the position

of the deputy chair of the supervisory

board.

The new composition of the supervisory

board’s committees was elected at the

meeting held in January 2018, and in July

2018, Lescoeur Bruno, Jean, Gaston was

elected as the chair of the committee

on health, safety, environment and

reserves. The current composition of the

committees is as follows:

•

audit and risks committee: Lescoeur

Bruno, Jean, Gaston – chair of the

committee, Spottiswoode Clare

Mary Joan and Kudrytskyi Volodymyr

Dmytrovych – members of the

committee;

•

ethics and unbundling committee:

Spottiswoode Clare Mary Joan – chair

of the committee, Hochstein Amos,

Kudrytskyi Volodymyr Dmytrovych and

Demchyshyn Volodymyr Vasylyovych –

members of the committee;

•

nomination and remuneration

committee: Hochstein Amos – chair of

the committee, Lescoeur Bruno, Jean,

Gaston and Popyk Sergii Dmytrovych –

members of the committee;

•

committee on health, safety,

environment and reserves: Lescoeur

Bruno, Jean, Gaston – chair of

the committee, Hochstein Amos,

Demchyshyn Volodymyr Vasylyovych

and Popyk Sergii Dmytrovych –

members of the committee.

The majority of the supervisory board

members devoted twice as much time to

the discharge of their duties compared to

time commitment required by the

Rules of Procedure of the supervisory

board.

In 2018, the company’s supervisory board

held 17 meetings during which it passed

resolutions on more than 130 items

of agenda and considered numerous

matters submitted for discussion. The

most frequent matters submitted by

the executive board for consideration at

meetings of the supervisory board and

its committees were those pertaining to

endorsement of financial plans of the

company and key business companies

of Naftogaz group, increase in natural

gas production, personnel-related

matters, internal transformation of

Naftogaz group, approval of entering into

transactions exceeding the thresholds

set out in clause 27 of the company’s

Charter, the matters of unbundling of the

natural gas transmission business and

liquidity of the company and Naftogaz

group as a whole. The supervisory board

focused substantially on ensuring the

proper operation of the internal audit

department and risk management office,

and in 2018, approved a series of key

documents, policies and procedures

in the areas of internal audit and risk

management in Naftogaz group. In

preparation for the annual general

shareholder’s meeting for 2017,

the supervisory board endorsed for

approval by the shareholder the restated

version of the company’s Charter that

was proposed for aligning provisions

of the company’s Charter with the

effective laws and the requirements

for implementation of the system of

internal control of the company and

Naftogaz group. The supervisory board

also proposed for approval at the annual

general shareholder’s meeting the Key

directions of Public Joint Stock Company

“National Joint-Stock Company “Naftogaz

of Ukraine” for 2018. Charters of key

business companies of Naftogaz groups

incorporated as joint stock companies

were restated so that they comply with

the laws and approved by the supervisory

board and the executive board of the

company at the beginning of Q2 2018.

Furthermore, during the reporting year,

members of the supervisory board

participated in a number of events

related to the preparation of Naftogaz

group for unbundling of the natural

gas transmission business, including

meetings with the shareholder, external

stakeholders, EU representatives and

other stakeholders.

Also, as part of the competencies

development program members of

the supervisory board undertook the

training on best corporate governance

practices in operation of two-tier boards,

which was delivered in April 2018 by the

professionals from Deloitte Corporate

Governance Academy.

Attendance of the supervisory

board meetings in 2018 (regular,

extraordinary and by absentee

voting)

Supervisory board

Audit and risks

committee

Ethics and unbundling

committee

Nomination

and

remuneration

committee

Committee on health,

safety, environment

and reserves

Spottiswoode Clare Mary Joan

17/17

13/13

6/6

11/11

1/3

Demchyshyn Volodymyr Vasylyovych

17/17

13/13

6/6

10/11

3/3

Lescoeur Bruno, Jean, Gaston

17/17

13/13

6/6

11/11

3/3

Hochstein Amos

13/17

4/13

2/6

8/11

1/3

Haysom Steven John

0/17

0/13

0/6

0/11

0/3

Popyk Sergii Dmytrovych

15/17

(with partial presence during

meetings on 16-18 April 2018 and

21-22 May 2018)

9/13

3/6

10/11

1/3

Kudrytskyi Volodymyr Dmytrovych

16/17

13/13

6/6

11/11

2/3

Officially remained a supervisory board member In 2018. His powers were terminated only in March 2019

Total number of meetings includes one meeting of the Committee on Health, Safety, Environment and Reserves as of 20 December 2018 which was not valid due to absence of quorum

2018

CORPORATE GOVERNANCE AND CSR

ANNUAL REPORT 2018

REPORT OF NAFTOGAZ

SUPERVISORY BOARD

-------------------------------------------------------------------------------------------------------------------------------------------------------------

Conflict of interest

During a number of supervisory board

meetings, Kudrytskyi Volodymyr

Dmytrovych notified of a potential

conflict of interest in relation to agenda

items on the performance assessment

and resolving other matters reserved

to the supervisory board as regards

Havrylenko Mykola Mykolayovych,

members of the executive board of

the company and director general of

JSC Ukrtransnafta, because he had been

direct subordinate of Havrylenko Mykola

Mykolayovych in one of his previous

positions.

Board priorities

The priorities of the supervisory board

in 2018 were to continue working on

the implementation of the system of

internal control of the company and to

collaborate with the executive board

and key subsidiaries of the group in

ensuring the increase in natural gas

production and preparation of Naftogaz

group for unbundling of the natural gas

transmission business by 1 January 2020.

Other issues intensively reviewed by the

Supervisory board included liquidity of

the companies across Naftogaz Group,

as well as approval and monitoring of

implementation of the internal audit plan

for 2018.

Shareholder and external communication

Audit and risks committee

In 2018, the supervisory board

maintained regular liaison with the

government by holding joint meetings

with the Prime Minister of Ukraine and

other representatives of the

shareholder.

Additionally, the board regularly

met and held public events engaging

international consortium partners and

and other key stakeholders who engaged

in unbundling matters. Members of the

Supervisory board also took part in the

round table discussion “Cooperation in

the Parliament-Government_Naftogaz

Triangle” which was held at the Verkhovna

Rada Committees in February 2018

engaging dialogue of the members of the

parliament, government and the company

on important topics of unbundling and

role of the supervisory boards in SOEs.

Key functions of the committee

The new version of the Regulations

on the Audit and Risks Committee of

the supervisory board was approved

by resolution of the supervisory board

in February 2018. In particular, these

Regulations define the following key tasks

and functions of the committee:

1. Assisting the supervisory board

in protection of the company’s

interests by preparing drafts and

providing recommendations and

proposals regarding:

1) the completeness, accuracy and

timeliness of the preparation of the

company’s financial statements;

2) the effectiveness of the internal

accounting and financial controls of

the company;

3) the effectiveness of the company’s

risk management activities;

4) the selection, appointment,

performance and ongoing work of

the external (independent) auditor;

5) the selection, appointment,

reappointment and dismissal of the

chief audit executive, performance

and ongoing work of the internal

audit;

6) the treasury arrangements in place

for the company.

2. In accordance with the above tasks,

the committee shall perform the

following functions:

2.1. To organize and perform preliminary

review of the matters included into

the agendas of the committee and

the supervisory board meetings, and

related to finance, audit and risk

management.

2.2. To organize and elaborate

drafting of conclusions, proposals,

recommendations, other

documents, draft policies, strategies,

rules of procedure, procedures,

decisions related to finance, audit

and risk management, and submit

them for supervisory board’s review.

2.3. To organize and perform the

following functions related to

financial statements:

1) to monitor and review the

integrity, completeness, accuracy

and timeliness of the preparation

of financial information of the

company;

2) to review with the management

of the company and the external

auditor the summary financial

statements, as well as justification

and acceptability of applied

principles of financial statements,

and any material correction of the

statements;

3) to review the compliance and

consistency of and any changes

to accounting methods and the

accounting policy along with how

these changes affect the content

of the statements, across the

company and its subsidiaries;

4) to consider any significant

differences between the external

auditor and management

regarding the company’s financial

statements.

2.4. To organize and perform the

following functions related

to internal controls and risk

management:

1) to review at least annually the

overall state and efficiency of the

company’s internal control and risk

management systems, including

review of reports of the external and

internal auditors;

2) to review the effectiveness of

corrective actions taken by the

management with respect to

improvement of the system

of internal control and risk

management;

3) to meet regularly with the

executive board of the company to

review significant risks and issues

of control and planning.

2.5. To organize and perform the

following functions related to

external audit of the company:

1) to make recommendations

to the supervisory board and

where appropriate to the general

shareholders’ meeting on the

appointment, reappointment or

removal of the external auditor,

the audit fee and the terms of

engagement of the external

auditor, to study issues that may

COMPETENCE AND PROCEEDINGS OF SUPERVISORY BOARD COMMITTEES

be deemed as the reason for

dismissal of the external auditor

and to answer any questions of

resignation or dismissal relating to

the external auditor;

2) to control compliance with

the Law of Ukraine "On Public

Procurement" as of 25 December

2015 #922-VIII and other

applicable legislation in the

selection of the external auditor;

3) to control independence and

objectivity of the external auditor

in line with the Handbook of

International Quality Control,

Auditing, Review, Other Assurance,

and Related Services;

4) to establish and apply an official

definition of a policy, types of ser-

vices that are not subject to audit,

and which are excluded or permit-

ted after the committee’s review or

permissible without the recommen-

dation of the committee;

5) to develop and implement

policy on the engagement of

the external auditor to supply

non-audit services, taking

into account relevant ethical

guidance regarding the provision

of non-audit services by the

external audit firm;

6) to review efficiency of processes

of the external audit, the nature

and scope of the audit, to monitor

the audit and review any problems

or reservations arising from

the audit, the responsiveness

of the management to written

recommendations and to review

the findings of the audit with the

external auditor, including but not

limited to the discussion of any

major issues which arose during

the audit, including:

- any accounting and audit

judgments;

- levels of errors identified during

the audit.

2.6. To organize and perform the

following functions related to

internal audit of the company:

1) to submit for approval by the

supervisory board the regulations

on the internal audit;

2) to make recommendations to

the supervisory board on the

appointment, reappointment

or removal of the chief audit

executive;

3) to make recommendations to the

supervisory board on the terms of

labor agreements which are being

concluded with the internal audit

staff (including with the chief audit

executive);

4) to prepare the draft budget of

the supervisory board, including

the budget of the internal audit,

and submit it for approval by the

supervisory board;

5) to submit the annual plan of

risk-oriented internal audits for

approval by the supervisory board;

6) to review reports on the activities

of the internal audit;

7) to review at least annually the

performance and effectiveness of

the internal audit;

8) to consider issues that prevent

the internal audit from effective

performance of set tasks, and help

eliminate such restrictions;

9) to ensure sufficient and adequate

resources for the effective

performance of the internal audit.

2.7. To organize and perform the

following functions related to

treasury arrangements of the

company to review and report to

the supervisory board on the overall

management of treasury activities in

the company, including:

- banking arrangements and

relationships;

- liquidity management and

forecasting;

- debt management;

- interest rate risk management;

- treasury internal control.

2.8. To organize and perform other

responsibilities in the company,

including:

1) to initiate and conduct special

investigations as needed, including

involving independent consultants

(experts);

2) to consider cases of fraud and

assess the adequacy of measures

taken by the management to

prevent fraud;

3) to consider the need for

amendments to these Regulations;

4) providing recommendations

on the selection, appointment,

reappointment and dismissal of

the head of the budgeting unit;

5) to provide the supervisory board

with the report on the committee’s

activity at least once every six

months, as also, upon supervisory

board’s demand, regular reports or

information on certain matters of

the committee’s activity;

6) to submit for review by the

supervisory board of draft new

versions of these Regulations

or necessary amendments

and additions hereto with the

respective substantiation;

7) to perform other duties related

to the committee’s competence

when requested by the

supervisory board.

The Regulations governing the

committee’s activity provide for reporting

to the supervisory board not less than

once per six months.

Key results in 2018

In 2018, the audit and risks committee

held 13 meetings during which it passed

more than 45 resolutions. In January

2018, the supervisory board resolved

on renaming this committee to audit

and risks committee by extending the

competence of this committee to risk

management matters, as reflected in the

restated version of the Regulations on the

Audit and Risks Committee which came

into force in February 2018. In 2018, this

committee focused on consideration

and endorsement of financial and

investment plans of the company and key

business companies of Naftogaz group,

review of the results of internal audits

and revisions of operations conducted

in the company and across Naftogaz

group, matters of forensic audits and

ensuring appropriate action based on

recommendations of the internal and

external audit of the company and

Naftogaz group companies. During 2018,

the committee worked closely with

the external auditor of the company

on the results of audit of consolidated

financial statements of the company for

2017 and planning of external audit for

2018, including meetings without the

company’s management.

PrJSC “Deloitte and TOUCHE USC” was

elected as the external auditor of the

company for the reporting period. The

external auditor of the company was

elected through an open bidding for the

procurement of services on financial

audit and revision of financial and

business operations of National Joint

Stock Company “Naftogaz of Ukraine”

conducted in line with the Law of Ukraine

“On Public Procurement”. In addition,

the company verified independence of

the auditor, namely its compliance with

the specific requirements of the Law

of Ukraine “On Audit Activity” effective

as of the date of such verification,

and performed internal compliance

procedures. In its letter dated 12 April

2019 PrJSC “Deloitte and TOUCHE USC”

informed the company and the audit

and risks committee that the key audit

partner and auditors engaged in

auditing were independent from the

company.

2018

CORPORATE GOVERNANCE AND CSR

ANNUAL REPORT 2018

-------------------------------------------------------------------------------------------------------------------------------------------------------------

Key functions of the committee

The restated version of the Regulations

on the Nomination and Remuneration

Committee of the supervisory board was

approved by resolution of the superviso-

ry board in February 2018. In particular,

these Regulations define the following

key tasks and functions of the committee:

1. Assist the supervisory board in

preparing draft:

1) succession strategy of the company’s

supervisory board, executive board

and other officials (if applicable)

that includes in particular search of

potential nominees for the position

of the chief executive officer in case

of termination of authorities of the

current chief executive officer, in order

to ensure continuous work of the

executive board;

2) policies and standards of the company

on selection of nominees for the

positions of the chief executive

officer and members of the executive

board, other officers of the company

nominated and dismissed by

Key functions of the committee

The restated version of the Regulations

on the Ethics and Unbundling Committee

of the supervisory board was approved

by resolution of the supervisory board in

February 2018. In particular, in line with

these Regulations, the key task of the

committee is to assist the supervisory

board in protection of the company’s

interests by evaluating and providing

recommendations and proposals

regarding:

1) application of the Code of corporate

ethics;

2) conflict of interest at the level of

the officers and employees of the

company;

3) amendments to the Code of corporate

ethics as mandated by the company’s

mission and strategy in the changing

operative environment;

4) effective implementation of the Code

of corporate ethics in the company,

monitoring and elimination of one-off

and recurring violations of the Code

of corporate ethics by the company’s

officers and employees;

5) specific rules and procedures for

handling of third-party complaints

related to ethics breaches committed

by the company’s officers and

employees;

6) appropriate means to mitigate

negative consequences caused by

ethics breaches committed by the

company’s officers and employees;

7) processes pertaining to or associated

with unbundling of the gas transmission

system operator, which are taking place

both inside and outside of Naftogaz

group as to ensure their compliance

with the Law of Ukraine "On Natural

Gas Market", the Third Energy Package,

and taking into account legitimate

interests of Naftogaz group.

The ethics and unbundling committee

shall organize and perform the functions

related to:

1) review of the matters included into

the agendas of the committee and

the supervisory board meeting, and

related to corporate ethics, including

conflict of interest and unbundling;

2) review of allegations of ethics-related

breaches by officers and employees

of the company, and submission of

relevant recommendations to the

supervisory board;

3) permanent review and monitoring

of the conflict of interest between

officers, executives and employees of

the company;

4) upon requests of officers, executives

and employees of the company

conducting, on a confidentiality

basis, of preliminary evaluation of

compliance of particular instances

of conduct with ethics rules of the

company;

5) analysis and review of the company’s

rules, procedures and practice on

ethics-related issues with a view

to identify possible breaches and

assess their effectiveness to meet the

company’s interests and needs;

6) monitoring of the operating

environment and best international

practices (general and sector-specific)

in terms of corporate ethics and

unbundling, engagement with various

stakeholders to assess the adequacy

of current company’s policies in these

areas;

7) ensuring the appropriate level of

accountability and transparency of

the company where this can eliminate

or mitigate ethical risks for the

company with due account of the data

protection requirements;

8) ensuring awareness of ethics-related

issues with the company’s officers

and employees, and the efficiency of

available means to raise and handle

their complaints;

9) promotion of effective communication

between the company’s management

and its staff with a view to reinforce

understanding of the company’s

ethical values and encourage their

implementation, as well as to deter

unacceptable practices;

10) advice to the executive board on

corporate ethics issues upon request

of the latter;

11) reporting to the supervisory board

on the tasks and functions of the

committee performed within the

framework of preparing the annual

report;

12) issuing recommendations to the

supervisory board regarding the

matters of the gas transmission

system operator unbundling.

The Regulations governing the

committee’s activity provide for reporting

to the supervisory board not less than

once a year.

Key results in 2018

In 2018, the ethics and unbundling

committee held six meetings during

which it passed two resolutions and

discussed more than 15 matters

submitted for consideration of

this committee. In January 2018,

the supervisory board resolved on

renaming this committee to ethics and

unbundling committee by extending

the competence of this committee to

unbundling matters, as reflected in the

restated version of the Regulations on

the ethics and unbundling committee

which came into force in February

2018. In 2018, this committee focused

on the matters of unbundling and

cooperation with key external and

internal stakeholders, and members

of the committee gave prominent

attention to holding regular meetings

with representatives of key stakeholders

in order to raise awareness of processes

and work undertaken in Naftogaz group

with the aim to prepare for completion

of the unbundling by 1 January 2020.

The committee reviewed, among other

things, conflicts of interests and leakage

of information.

Ethics and unbundling committee

Nomination and remuneration committee

the supervisory board, aimed at

engagement of qualified specialists for

the management of the company;

3) principles for defining of

remuneration for the chief executive

officer and members of the executive

board in order to create necessary

incentives for the efficient work in

implementation of the company’s

development strategy;

4) terms of employment agreements

(contracts) to be concluded with the

chief executive officer and members

of the executive board, other

officers of the company nominated

and dismissed by the supervisory

board.

2. Submission to the general meeting or

the supervisory board (as established

by the Charter) of recommendations

and proposals on:

1) candidates for the positions of the

chief executive officer and members

of the executive board, other

officers of the company nominated

and dismissed by the supervisory

board;

2) termination of authorities of the

chief executive officer and members

of the executive board;

3) engagement of independent

external adviser for assessment of

the supervisory board members’

work;

4) candidates for the positions of the

supervisory board members.

3. In accordance with the tasks, the

committee shall perform the following

functions:

1) development and periodic review

of the company’s policy (internal

regulation) on nomination and

remuneration;

2) preliminary review of the matters

related to the nomination and

remuneration of the chief executive

officer and members of the executive

board, as well as other officials (if

applicable);

3) organization of drafting and

processing of draft policies, strategies,

rules of procedure, resolutions and