Can Europe, including the Eastern part, continue to profit from cheap Russian gas without succumbing to Russian energy dominance? According to a new paper from the Oxford Institute for Energy Studies (OIES), the EU should not shy away from “countervailing measures”. But these should preferably take the form of a “grand bargain” with Russia rather than a confrontation.

As Gazprom’s gas exports to Europe keep rising – its market share, now at 33%, could rise to over 40% by 2035 – and relations with Russia seem to keep getting worse, the question of how the EU should deal with its energy dependence on Russia is becoming ever more urgent.

Confrontation is one option. Is it wise – or even effective?

The Atlantic Council – a bipartisan U.S. organisation that promotes U.S.-European relations, and has no love for Russia – has just analysed the effects of the U.S. and E.U. sanctions on Russia’s energy sector. It concludes that they have been negligible.

Here are the takeaways from the Atlantic Council’s report (written incidentally by senior fellow Bud Coote, who “previously spent 43 years with the Central Intelligence Agency where he helped establish and build the CIA’s energy program beginning in the 1970s”):

• “While sanctions have significantly impacted the Russian economy, they missed their mark when it comes to energy. Russia’s oil production and investment is thriving, growing every year since sanctions were imposed with production growth hitting an eleven year high in 2016.

• Even though oil and gas prices have dropped precipitously since 2014, Russia is still comfortably managing its energy sector. In fact, the United States and the European Union may have done Russia a favor, suspending high cost projects, including offshore Arctic development, that would not be economic at current prices.

• Russia’s energy successes, including progress on the Nord Stream 2 and TurkStream pipelines, have renewed political momentum for President Vladimir Putin and Moscowat home and abroad.”

The conclusions of the report are neatly summarized in these infographics:

Ratcheting up the pressure

So what then should be done?

According to the Atlantic Council, the implication is that the sanctions should be intensified. “Changing Russian behavior requires ratcheting up the pressure”, writes Bud Coote. “This would include tightening restrictions on participation in Russian energy projects, including by service companies, addressing foreign investment in current as well as future oil and gas development projects, and imposing stronger antitrust restrictions on Russian gas exports.” 

Clearly this course would make relations with Russia even worse and inaugurate a full-scale Cold Energy War.

Opponents of Nord Stream 2, the planned new pipeline from Russia directly to Germany, argue that it undermines the EU’s “Energy Union” and increases dependence on Russian gas

One of the targets of the Atlantic Council – and others in Washington D.C. as well as in Brussels – is Gazprom’s Nord Stream 2 project. Opponents of Nord Stream 2, the planned new pipeline from Russia directly to Germany, argue that it undermines the EU’s “Energy Union” and increases dependence on Russian gas.

In particular, the position of Ukraine, Poland and Eastern Europe is said to be undermined by the project. One specific criticism of Nord Stream 2 is that, according to critics, it will allow Russia to cut off flows to Eastern Europe altogether – not merely the East-West flows, but also the West-East flows that are likely to increase when the pipeline becomes operational.

As long-time Nord Stream 2 opponent Alan Riley, also a Senior Fellow at the Atlantic Council, points out in a recent opinion piece on The Globalist: “The point often overlooked by German commentators is that Nord Stream 2 will not actually bring much more gas into the German market itself. Instead, the gas will flow onward eastward via NS2’s connecting pipeline EUGAL to the Czech Republic and Poland.”

“What Gazprom seeks to do is lock the CEE states into a gas market dominated by Gazprom with no obvious way out. Western Europe, for its part, will still have a diversified supplied market”

According to Riley, this new route will allow Gazprom to block competing sources of gas that could be delivered from Western Europe to East Europe: “The aim of this eastern flow of Nord Stream gas is to flood the west to east interconnectors with Gazprom gas, effectively blocking access to the Central and Eastern European (CEE) gas market to its competitors”, Riley writes. “In addition, the surge of gas flows from Nord Stream 2 will also undermine commercial incentives to develop alternative pipelines and new sources of supply across the CEE region.”

“In essence, what Gazprom seeks to do is lock the CEE states into a gas market dominated by Gazprom with no obvious way out”, Riley concludes. “Western Europe, for its part, will still have a diversified supplied market. The CEE states will have a gas market largely dominated by Gazprom.”

Market separation

Is Riley right?

As it happens, the German economic research institute EWI has just published an analysis of exactly this claim.

As one of the authors, Harald Hecking, describes the issue: “Various analyses have been published on the impact of the planned Nord Stream 2 pipeline on European gas prices. Some of these claim that the planned pipeline contributes to a division of European markets and could be abused by the owner to play different market strategies in the East and West. The hypothesis of some of these reports is that Europe could be divided by causing congestion of pipeline capacities between East and West Europe by sending Nord Stream 2 gas at low prices to Western Europe, while Eastern Europe, for lack of alternatives, could only source gas from the East, which could then be priced higher.”

In their report, Hecking and his co-authors Martin Hintermayer and Florian Weiser analysed “whether this hypothesis has any merit, using current market data and pipeline capacities”.

Their study, “Central European Gas Market Congestion Analysis“, concludes that there is no reason to fear such an outcome.

“The Nord Stream 2 pipeline cannot be used for market separation, under conditions of existing pipeline capacity and local gas consumption”, they note. “This is due to the fact that in the European internal market, according to the EU’s own market rules, the importers and thus also the consumers are protected against such behaviour. Pipelines in Central Europe cannot be blocked from the use by other market participants and the gas exporter from Russia would risk violating its own contractual obligations in this case.”

“The current design of the European internal market appears robust enough to preclude a market separation strategy”

They add that “even if one ignores the reality of the gas business under laboratory conditions … and additionally assumes increased gas demand, such a hypothetical strategy for splitting the market would be neither successful nor effective. The possible returns from the higher prices in Eastern Europe would be eaten up by the loss from the additional costs of the discounted sale in the West, and in addition, Eastern European gas importers would turn to other sources of supply as soon as possible.”

The main point of the EWI researchers is that “the current design of the European internal market appears robust enough to preclude a market separation strategy. There is and will be plenty of spare capacity that could enable Eastern Europe to import gas from other sources ensuring that Eastern Europe cannot be ‘split off’ from the West.”

In other words, they find that the idea that Gazprom could block West-East flows to Eastern Europe is far-fetched. In the past, when there were still long-term contracts with destination clauses and unbundled pipelines, this could indeed have happened. But these features have been abolished by the EU’s new gas market design.

As they put it: “It is not possible for specific gas suppliers to create congestion along specific pipelines, since gas suppliers can only book entry / exit capacities into specific market areas while physical flows are determined by the unbundled and regulated transmission system operators based on capacity bookings and flow nominations at entry and exit points. This holds especially when taking into account virtual flows. This means that a line separating West and East … is not a viable concept when applied to the EU gas market, which is based on entry exit market zones.”

It should be noted that the EWI study was commissioned by Nord Stream 2, but then again, Alan Riley is a paid advisor to the Ukranian and Polish gas companies Naftogaz and PGNIG.

Countervailing measures

Nevertheless, this does not necessarily mean that there is no reason for Europe to be concerned about Russian dominance in the gas sector. So what should the EU do?

“Gazprom has demonstrated  a level of flexibility in its pricing strategy that has kept its gas very competitive, with the result that its market share in Europe has grown to 35%”

Analysts James Henderson and Jack Sharples of the Oxford Institute for Energy Studies have also just made a contribution to this debate. In an extensive new paper, they in effect accept that Nord Stream 2 will become a reality and that Gazprom’s dominance in the European gas market will grow. They don’t consider this a disaster, but they do argue that the EU would be unwise to simply let this happen without countervailing measures.

Let’s follow their analysis in a bit more detail.

First of all they note that Gazprom has lately certainly been on a winning streak: “Gazprom has confounded many expectations by enjoying two record years of gas sales in Europe in 2016 and 2017”, they write. “External factors have certainly played a role in its success, with overall European demand rebounding, indigenous production continuing to fall and alternative sources of imports failing to deliver at the expected levels (especially LNG). In addition, Gazprom has demonstrated  a level of flexibility in its pricing strategy that has kept its gas very competitive, with the result that its market share in Europe has grown to 35%.”

“The region’s import requirement is likely to rise, with Russian gas and the global LNG market as the only significant sources of potential extra supply”

The authors observe that “the anticipation that this figure could rise towards 40% and above has led EU politicians and policy-makers to become concerned about over-dependence on Russian gas, and many now wish to ensure that Gazprom’s future options are limited by obstructing potential new pipelines. In addition the politics surrounding Ukraine, the imposition of stricter US sanctions, questions surrounding  the DG COMP investigation into Gazprom’s activities and the Stockholm arbitration ruling over contracts with Ukraine add further layers of complexity.”

So what is their proposed solution?

They first set out to explore “whether Gazprom’s two anni mirabiles in 2016 and 2017 can be repeated or whether Russian gas faces a more challenging environment in the rest of the decade.”

They conclude that some of the positive trends for Gazprom “are set to continue. The outlook for European gas demand is reasonably positive, as although renewables will continue to be the main beneficiary of coal plant closures in the power sector, gas should also benefit, if only via the higher utilisation of existing generating capacity. Meanwhile industrial and residential gas demand should remain stable, while indigenous gas production will inevitably fall further as fields in the North Sea continue to decline and the curbs on Groningen output potentially become even stricter. As a result, the region’s import requirement is likely to rise, with Russian gas and the global LNG market as the only significant sources of potential extra supply.”

“Gazprom’s huge resource base and its relatively low development and production costs mean that it is very well placed to increase its share of the European market”

There is some change on the horizon, with a “surge” in new LNG likely to arrive on the markets in 2019. Still, in the longer term, “Gazprom’s huge resource base and its relatively low development and production costs mean that it is very well placed to increase its share of the European market”, the authors note.

So market dominance by Gazprom is a genuine possibility – and something of a threat: “… the company’s stated view that it could have a market share in Europe of 40 per cent or more by the 2030s could be achieved on a more rapid timescale. Irrespective of any political issues, this outcome presents a security of supply question for European policy-makers in pure commercial terms, as having any supplier take such a significant share, especially while indigenous production is in decline, is a risky proposition.”

Grand bargain

According to Henderson and Sharples, there are things that the EU can do in response.

First, “the obvious answer is to create as much optionality as possible, and the European Commission is doing this by incentivising the interconnection of markets and the construction of as much LNG receiving capacity as possible, especially in more remote locations. However, although this provides the potential for diversification, if Russian gas is the cheapest option then its share will rise as customers, with the possible exceptions of Poland and Lithuania, take the opportunity to minimise their energy costs, as seen in 2016 and 2017.”

Nevertheless, “on top of this, the politics clearly cannot be ignored”, the authors point out, “and both the EU and the US have made restraint of Russian gas supply to Europe a geo-political priority.”

“European politicians must decide whether they wish to limit the supply of one of the continent’s cheapest sources of gas or whether they are prepared to compromise by ensuring that as many routes as possible are kept open”

The EU’s strategy is focused in particular on Gazprom’s “export pipeline capacity, where Gazprom is already close to the limit in a number of directions. The majority of current spare capacity is via Ukraine, where the realities of Russia-EU relations collide, with the EU wanting to protect the Ukrainian transit route for political and commercial reasons while Russia insists on trying to maximise its bargaining power by creating alternative routes such as Nord Stream 2 and TurkStream. Meanwhile the US continues to use sanctions to support Ukraine and to promote the virtues of its own gas exports, albeit at a higher price than Russian gas.”

As a result, the authors note, “difficult decisions” are coming up for European politicians, “concerning the use of the OPAL onshore pipeline by Gazprom, the rules governing Nord Stream 2, the pipelines that will sell Russian gas sent via TurkStream into Europe, and the use of Ukrainian transit all need to be made in the next two years, as various construction milestones approach. It is possible, of course, Nord Stream 2 and TurkStream could be physically built before regulation issues are finalised, if Gazprom wishes to take the risk that they cannot be fully utilised.”

Ultimately, the OIES analysts note, EU leaders face a clear choice: “European politicians must decide whether they wish to limit the supply of one of the continent’s cheapest sources of gas or whether they are prepared to compromise by ensuring that as many routes as possible are kept open, including new pipelines through the Baltic and Black Seas. In addition, they need to decide what role, if any, the ongoing DG COMP investigation into Gazprom could play in facilitating or hindering an ultimate deal as, although a resolution appears to be close, political obstacles still remain.”

“Overall, it would appear that a grand bargain is possible”

Henderson and Sharples believe that, in the face of this choice, the best course may be to aim for a “grand bargain”  with Russia.

“Overall, it would appear that a grand bargain is possible”, they write, “which could see a compromise involving guaranteed use of the Ukraine transit system while new pipelines are built, and with Gazprom agreeing to effectively switch to market-based pricing for all its European customers, while also abiding by Third Energy Package rules.”

Next year could be the right time for the EU to aim for such a “grand bargain”: “The confluence of all the parts of the jigsaw appears to be approaching in 2019, when Nord Stream 2 and TurkStream are due to be completed, the European Court of Justice is due to give a final ruling on OPAL and the Ukrainian transit contract needs to be renegotiated, with a further complication being that elections to the European parliament and elections in Ukraine are also due in 2019. In the same year, it would seem that competition between gas suppliers to Europe may also be reaching a peak, meaning that although Gazprom has enjoyed two anni mirabiles in 2016 and 2017, the remainder of the decade may prove more challenging for its business in Europe.”

Editor’s Note

This article was first published, a in slightly different form, on Energy Post Weekly, the premium website of Energy Post, in Karel Beckman’s weekly section Energy Watch. If you don’t want to miss out on Energy Watch – and Sonja van Renssen’s weekly Brussels Insider section on EU energy polices, you can sign up for a subscription here.

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