Nord Stream 2, the new gas pipeline that Gazprom is planning to build from Russia through the Baltic Sea to Germany, has been criticised for reducing Europe’s diversification of energy sources and energy security. But according to Energy Post’s editor in chief Karel Beckman, the EU should welcome the pipeline, despite deteriorating relations with Russia. According to Beckman, Nord Stream 2 has a sound economic rationale behind it and the EU’s successful creation of a competitive, integrated gas market has made the geopolitical argument largely redundant.

The economic story behind Nord Stream 2 starts with an incontrovertible fact: domestic gas production in Europe is declining. The scale and speed of the decline can be seen in this chart, from a presentation recently given by Klaus-Dieter Borchardt, Director Internal Energy Market at the European Commission:

Source: European Commission, Eurostat

For North West Europe, which Nord Stream 2 is intended to serve, the situation is similar:

How can EU countries respond to this development? They can do to three things: 1) develop their shale gas resources 2) cut back on gas consumption or 3) increase imports.

Shale gas remains a problematic proposition in Europe. Countries like Germany, the Netherlands and France have banned fracking and show little inclination to allow it. The UK is the only country that is actively stimulating fracking, but public opposition is strong. It certainly does not seem realistic to expect massive shale gas production in the UK in future.

Cutting back on consumption seems a more feasible option. EU gas demand actually fell from a peak of some 530 bcm in 2010 to a low of 409 bcm in 2014, mostly as a result of the economic crisis. Last year, demand rebounded to 426 bcm, according to figures from trade association Eurogas.

Nevertheless, even though no one can predict how European gas demand will develop, most analysts believe that natural gas will continue to play a significant role in European energy demand. There are two reason for this: first, reform of the EU’s emission trading system (ETS) will lead to steadily rising CO2-prices, which will drive coal-to-gas switching in the electricity sector. Second, renewable energies will show strong growth, but will still need to be complemented and backed up by gas.

Indeed, for these reasons the European Commission’s own Reference Scenario, which is the main energy modelling tool Brussels relies on in all its energy policies, projects that the share of gas in final energy consumption will stay relatively stable up to 2050:

Final energy consumption by fuel, EU-28 source: EU Reference Scenario  http://ec.europa.eu/energy/en/data-analysis/energy-modelling (June 2016)

The share of gas in electricity generation is also expected to remain stable:

Net electricity generation by fuel type EU-28 source: EU Reference Scenario http://ec.europa.eu/energy/en/data-analysis/energy-modelling (June 2016)

In a recent speech in London, Borchardt’s colleague Mechthild Wörsdörfer, Director for Energy Policy at DG Energy, confirmed that for the EU gas will remain an important source of energy for some time to come: “We expect an important role for gas during the transition to a low carbon energy system, by complementing intermittent renewables and by replacing more polluting fuels such as coal in power generation,” said Wörsdörfer. “Because EU gas imports are likely to stay stable even if demand will diminish, it justifies our continued efforts to diversify sources and suppliers. Our objective is to ensure that, while we make the transition to a low-carbon economy, the gas supplies that we continue to need are secure and competitive.”

She also noted that: “The EU is the biggest importer of natural gas in the world…. Ensuring that all Member States have access to liquid gas markets is a key objective of the Energy Union.”

 This then inevitably leads to the third option: Eurpe will have no choice but to increase its gas imports to make up for its growing “import gap”.

For North West Europe the import gap looks like this:

Source: Gasunie, European Gas Atlas, shows three demand scenarios

It’s this notion that the business case of Nord Stream 2 is built on. North West Europe’s import gap is what Gazprom is eager to fill with its new pipeline.

Heavy reliance on Europe

Currently the share of Russian gas in European consumption is less than 30 percent, with EU domestic production, imports from Norway and other countries accounting for more than three-quarters. Cleary if this figure goes up, European dependence on Russia will increase.

But Gazprom’s “dependence” on Europe is actually greater than vice versa. The Russian company relies on Europe for almost two-thirds of its sales revenue and almost half of its sales volume (figures from the first half of 2016). And although Gazprom is expanding in Asia, Europe is and will remain by far the largest market for the Russians for a long time to come.

Gazprom’s heavy reliance on the West-European market is precisely why the company decided some years ago that it wanted to diversify its routes to Europe. Gazprom has more than once encountered major problems with its gas transit through Ukraine, which until recently was one of the two major routes to the North-West European market. On several occasions, especially in 2006 and 2009, gas transit through Ukraine was halted after payment disputes with Naftogaz, the Ukrainian operator.

To reduce its dependence on its Central European routes, Gazprom – with a number of Western European partners – built the (first) Nord Stream connection, consisting of two pipelines, which became operational in 2011 and 2012, running through the Baltic Sea straight from Russia to Gazprom’s largest market, Germany, avoiding Ukraine.

Major gas pipeline routes in Europe (source Gasunie, European Gas Atlas)

Gazprom at this time also launched a project, South Stream, to build a new connection to South-Eastern Europe (Italy is another major export market), but it cancelled this after the European Commission had indicated it did not fully conform with the requirements of EU energy legislation. The Russians have now agreed with the Turkish government to build a new connection from Russia to Turkey called Turkish Stream which will get a capacity of 31.5 bcm. Turkey is one of the largest consumers of Russian gas, with Germany and Italy, and could also function as transit route to South Eastern Europe.

“Russian gas may end up competing with Russian gas”

At the same time, right after the completion of Nord Stream, in 2011, Gazprom already started exploring the possibility of building another pipeline through the Baltic Sea. This resulted in the announcement, in September 2015, of a shareholders’ agreement between Gazprom and Shell, Eon, OMV, Engie and BASF/Wintershall to construct a second Nord Stream alongside the first.

These prospective shareholders pulled out in August, after objections from the Polish competition authority, leaving Gazprom to build and fund the project on its own, which the company has said it will do. Nord Stream 1’s two pipelines have a combined capacity of 55 billion cubic metres (bcm). Nord Stream 2 will have the same capacity. To put this in perspective: a country like Germany uses roughly 80 bcm per year.

Key point

Many policymakers in the EU – particularly in Eastern Europe, but also in Brussels – regard Nord Stream 2 with hostility. Eastern European leaders have charged that the new pipeline will negatively impact energy security in their region, particularly in those countries that are heavily dependent on Gazprom for their gas supplies.

The European Commission has taken the same position. Maros Šefčovič, Vice-President of the European Commission in charge of the Energy Union, has said that “Nord Stream 2 could alter the landscape of the EU’s gas market while not giving access to a new source of supply or a new supplier, and further increasing excess capacity from Russia to the EU.”

But the energy security argument seems forced. Even if Nord Stream 2 does not bring additional supplies (Gazprom says it will, opponents deny this), all it does is change the route by which Russian gas is transported to Europe. This does not reduce the number of routes or supplies, so how can it reduce competition or energy security?

True, some EU markets, in particular Germany, will see their options to source gas improve, while the existing transit countries will face additional competition if they want to source Russian gas. However, for the EU market as a whole, this should not be a problem. That is to say: if the EU market functions as an integrated whole.

This is a key point in the Nord Stream 2 debate. Most analysts agree that the EU market today is totally different from what it was ten or even five years ago. The European Commission, with the help of far-reaching legislation, especially the Third Energy Package (from 2009), has managed to create an integrated, competitive gas market in the EU. There are rules requiring pipeline operators to allow third-party access. “Destination clauses”, by which Gazprom and other suppliers used to be able to control the market, have been banned. Ownership unbundling of pipelines has become mandatory. In addition, gas trading hubs have been created, new pipeline interconnections have been built and reverse flow capacity has expanded.

As a result, most independent analysts today agree that gas that enters the EU market at any point can be easily transported to almost any other point.

Indeed, this is precisely what seems to have happened with the gas coming from Nord Stream 1, according to Andreas Goldthau, Professor of Public Policy at Central European University. “Particularly in Central Eastern European markets significant shifts happened in the aftermath of Nord Stream coming online”, Goldthau has written. “Gas flows started to reverse. While traditional gas would travel from East (Russia) to West (transiting Ukraine/Belarus and feeding Slovakia/Poland), West-to-East trade picked up.”

Goldthau points out that after Nord Stream 1 became operational, gas prices in Central and Eastern Europe (CEE) “started to align with German prices”. He believes that Nord Stream 2 may be expected to further reinforce this effect on the gas market: “Nord Stream 2 stands the chance of enhancing the liquidity of regional hubs in which the additional volumes will be primarily absorbed….Russian gas may end up competing with Russian gas.”

Completing Europe

Goldthau does caution that this does not yet apply to the whole of Europe. Parts of South-Eastern Europe are still isolated from the overall EU market as a result of insufficient infrastructure.

In a report published in August 2016, “Completing Europe”, the US-based Atlantic Council admonishes the EU to complete the “Action Plan for Central and South Eastern Connectivity” agreed in Dubrovnik in July 2015 to end the isolation of this region. The plan includes the construction of several interconnectors as well as an LNG terminal in Croatia. The Atlantic Council also argues that Europe should build a “robust North-South Interconnector to link the Polish LNG terminal at Swinousjscie with Croatia’s planned LNG terminal at Omisalj in the Adriatic.”

The European Commission in fact is taking action in this regard. For example, it is actively engaged in helping to set up a “Balkan Gas Hub” in Bulgaria, which is to serve as a hub for South Eastern Europe:

Source: European Commission

The Commission is also engaged in promoting the construction of a gas interconnection between Bulgaria and Serbia, a gas interconnector between Romania and Moldova and a gas interconnector with reverse-flow capabilities between Poland and Ukraine.

It’s safe to say that “completing” the internal EU gas market would go a long way to solving the problem of overdependence on Russia that persist in some Eastern European countries. This has the added advantage of creating economic growth in South Eastern Europe. Countries in that region will be able to source gas from North West and Central Europe through the Austrian hub, LNG from world markets, and gas from the Southern Gas Corridor. In future, Israel, Cyprus and Egypt could also become gas suppliers, if the substantial gas reserves in the Eastern Mediterannean are exploited.

Bitter pill

Of course, it is still a bitter pill for existing transit countries, such as Poland, Slovakia and Ukraine, to see their gas transit income reduced. That, however, is how free markets are supposed to work. It hardly makes sense for the EU on the one hand to create a competitive internal market and then to interfere in that market to allow certain countries to keep profiting from gas transit revenues – at the expense of other EU countries, who opt for other routes.

Many critics of Nord Stream 2 have argued that the pipeline does not make economic sense. For Gazprom, however, the Nord Stream route simply makes economic sense. For example, Richard L. Morningstar, Chairman of the Global Energy Center of the Washington-based Atlantic Council, said in an interview recently: “There is a serious question as to whether there is a commercial need for Nord Stream 2. Some of its advocates have said gas production is going to decrease in Europe, while demand is going to increase, so it’s going to be important to have that source. I would argue that there are many sources that could solve any such need.”

But the whole point of a liberalised market is that suppliers and consumers take their own decisions about what they regard as commercially viable. At their own risk of course.

Certainly Nord Stream 2 rejects any suggestions that the project is not economically sound. According to Paul Corcoran, Financial Director of Nord Stream 2 (who held the same job with Nord Stream 1), transit through Nord Stream 1 is already cheaper than through Ukraine.

“The transit cost of Nord Stream 1 is €1.86 per 1,000 cm per 100 km”, he tells Energy Post. “For Ukraine it is €2.26 per 1,000 cm per 100 km. And as Gazprom is half owner of Nord Stream 1, half of the cost comes back to the company in the form of dividends. Not to mention that Ukraine has proposed to more than double their tariffs.”

Corcoran expects that transit costs for Nord Stream 2 will be similar to those of Nord Stream 1. He adds, “It angers me when I read statements that Nord Stream 2 is expensive and uneconomic. It’s not. Looking to the future it’s a very good investment.” He adds that it is “also in the interest of European consumers that gas is delivered via the most cost-efficient route.”

Pipeline politics

What about the geopolitical dimensions of Nord Stream 2? There is no denying that the political situation around Ukraine and the EU’s relations with Russia have deteriorated sharply after the Russian invasion of the Crimea in 2014.

But the question is whether that is an argument for the EU to try to stop Nord Stream 2. There are many economic relations between Russia and Europe going on (think of oil deliveries!) but no one advocates ending them because of geopolitical tensions. The Russian regime is also certainly guilty of many human rights violiations, but so are many other regimes in the world with which the EU is eager to do business. Why would this case be any different?

“The claim that Russia’s pipeline politics constitutes a geopolitical threat for Europe is exaggerated”

Gazprom is routinely accused by critics of “using gas as a political weapon”, but the question is whether that is true. Katja Yafimava, Senior Research Fellow at the Oxford Institute for Energy Studies, asserts in article for the Istituto Affari Internazionali (December 2015, http://www.iai.it/sites/default/files/iaiwp1554.pdf): “There is no evidence at present that Gazprom cut or reduced supplies in the past to those European countries that were paying for their gas imports in full and on time at a price specified in their contracts, which makes the assertion that Russia has used the gas weapon towards European countries problematic.”

Likewise, Marco Siddi, Senior Research Fellow at the Finnish Institute of International Affairs (FIIA) has written that “the claim that Russia’s pipeline politics constitutes a geopolitical threat for Europe is exaggerated.” Tim Boersma, Fellow in Foreign Policy at the US-based Brookings Institution, has described “concerns about Russian gas” as “a relic from the past”, given the changes in the European gas market.

Legal means

In any case, even if some policymakers in Brussels or some EU member states regard Nord Stream 2 as a geopolitical issue, this does not necessarily mean they have the legal means to stop the project. As Severin Fischer, Senior Researcher at the Center for Security Studies at ETH Zurich, has written: “in a community that is based on the rule of law, the rule of law should apply to all actors in the same way. In the end, this means, that economic activities in the range of the legally defined framework should be assessed under the existing regulatory criteria, but not under nor­mative categories of good or bad”.

Paul Corcoran makes the same point. “Political processes should be disconnected from the legal framework”, he says. “The legal framework for Nord Stream 2 is the same as that for Nord Stream 1. It is based on UNCLOS (the United Nations Convention on the Law of the Sea), which gives the right to lay cables and pipelines on the seabed in Continental Shelf areas. Nord Stream 2 will pass through the Continental Shelfs of five countries and the territorial waters of Russia, Germany and a small part of Denmark. If we obtain the required environmental permits, we will get permission from these countries to build the pipeline, just as we did with Nord Stream 1.”

Nord Stream 2 will submit permit applications in early 2017. Corcoran is confident that they will be able to obtain the permits at the end of 2017. At the end of 2019, Nord Stream 2 should be operational, according to plan. “We built Nord Stream 1 on time and within budget. We will do the same with Nord Stream 2”, he says.

It is difficult to see why this would be “a bad deal” for Europe, as US Vice-President Joe Biden has said, echoing Georg Zachmann of the Brussels-based think tank Bruegel. A bad deal for Ukraine – perhaps, although it might not be such a bad thing if that country could wean itself off its corrupt gas sector. For Europe, there seems no reason to be afraid of Nord Stream 2.

Editor’s Note

This article is based on an earlier version which appeared in World Energy Focus 2016, a magazine produced by Energy Post for the World Energy Congress in Istanbul. Full disclosure: this magazine contained an advertisement from Nord Stream 2. Please note that Energy Post has published articles both critical and supportive of Nord Stream 2 and we continue to be open to all reasonable viewpoints.

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