The relationship of the EU-Russia-Ukraine triangle is contentious by nature and has therefore been closely followed by both policymakers and analysts for more than a decade. Currently the Ukrainian corridor constitutes one of the weakest links in the security of Europe’s gas supply, and the pressure is increasing as the transit contract between Moscow and Kiev expires on 31st December 2019. This paper argues that Ukraine will, in the medium term (3-5 years), remain an important transit country in the EU-Russia gas trade, although its transit volumes will decrease. Following a brief historical overview, this argument is underpinned by both qualitative and quantitative analysis with the former highlighting the importance of the European Commission’s efforts to maintain the Ukrainian transit corridor and the latter assessing the various infrastructural scenarios and financial implications. Preceded by some potential counterfactuals the main findings of the paper are assessed in the conclusion.
Partners with a complicated pedigree
The question of Ukraine’s role in the EU-Russia gas trade has been closely followed by both policymakers and analysts from all concerned parties, for more than a decade. As demonstrated by the 2006 and 2009 crises [Stern (2006); Stern et.al. (2009)] the transit security of the Ukrainian corridor has been among the weakest dimensions of European gas supply security in the 2000s. [Pirani-Yafimava (2016)] Most recently, the Stockholm Chamber of Commerce (SCC) ruling raised concerns as to the status of this triangle as it ordered Gazprom to pay Naftogaz Ukrainy $2.56 billion, ending a 2.5 year-long judicial process between the two companies. [Reuters (2018)] Although both parties claimed that the transits to European countries will be uninterrupted, Gazprom’s decision to launch the process to terminate its gas supply contract with Ukraine, [Deutsche Welle (2018)] as well as the transit contract between Moscow and Kiev expiring in 2019 and governing almost half of Russian exports to Europe, [Henderson-Sharples (2018)] enhance the risk of a possible disruption, and raise questions on the future of the transit of Russian gas through its Eastern neighbor. However, the situation is far more complex than the popular discourse tends to be, with several factors insufficiently mentioned.
The importance of gas transits between the two countries cannot be overemphasized. On the one hand, as underlined by Berschidsky, despite the all-time low political relations, Russia and Ukraine managed to remain business partners, “joined at the hip by Ukraine's gas transit system,” [Bloomberg (2018)] supported by the mediation of the European Commission. Therefore, gas trade remains one among the few areas where agreement, based on the mutual interest of both countries, could be achieved since the annexation of Crimea in 2014 and the eruption of the crisis in Eastern Ukraine. On the other hand, financial aspects play an important role, as the transit fees paid to Naftogaz amount to $3 billion, whereas Gazprom’s revenues from gas export reached $25 billion. [Henderson-Sharples (2018)] Finally, gas imports from Russia constitute a notable share of the EU’s own energy mix.
For this reason, this paper argues that Ukraine will remain an important transit country in the EU-Russia gas trade after 2019 for the medium term, although its transit volumes might decrease. Furthermore, it underlines that the European Union is currently undertaking considerable efforts to ensure this is indeed the case for Kiev. Following a brief historical overview of the Russia-Ukraine gas relationship between 2009 – signing of the current transit contract – and 2018, as well as some basic data on the ratio of gas within the EU’s energy consumption, this paper will analyze the main aspects of Russian exports to Europe. This section concludes that the future of those exports is mainly influenced by external factors, rather than by the Kremlin. Therefore, the paper focuses on the EU’s most recent maneuvers regarding its gas imports from Russia, as well as outlines some scenarios, should new infrastructure be put in place. Finally, it assesses some possible counterarguments to the hypothesis outlined above. The main findings of the paper, as well as some recommendations resulting therefrom, are summarized in the conclusion.
Bumpy start, altering conditions
Most recent history
As indicated above, the two Russia-Ukraine winter gas disputes of 2006 and 2009, leading to a complete cut off of Russian exports for several weeks, severely damaged the image of Russia and Ukraine as credible partners. [Stern et.al. (2009)] They also shed light on the possible consequences of unrest between the two countries for the EU. The transit and supply contracts signed by Prime Ministers Putin and Timoshenko in 2009, attempted to resolve the crisis, reestablished a supporting system of underpinning intergovernmental agreements, and introduced a host of other significant changes. As underlined by Pirani, the 10-year supply contract provided for delivery of an annually contracted quantity (ACQ) of 52bcm of gas, with a take-or-pay requirement of 80% and oil-indexed prices, with an unfavorably calculated netback principle for Ukraine. [Pirani (2014)] In 2010, following a renegotiation, Naftogaz received a 30% discount, however only in exchange for significant political concessions. Nonetheless, the past nine years completely transformed both the European gas markets and the Russia-Ukraine relationship.
On the one hand the adoption of the Third Energy Package (2009) and European Energy Security Strategy (2014), as well as the establishment of the Energy Union (2015) [European Commission (2014)] induced the transition of Gazprom towards a gas-to-gas based hub-pricing system. The growing interconnectedness of European countries, the fluctuations in the European gas demand, the increasing competitiveness of US LNG, as well as DG Comp’s investigation on Gazprom’s business practices in Central and Eastern European countries [DG Comp (2012-17)] necessitated a strategic change from the Russian gas export monopoly. Hence, although one third of its contracts are still oil-linked, one third are now hub-price linked and another third are hybrid contracts which effectively offer the lower of oil or hub-linked prices [Henderson-Sharples (2018)].
On the other hand, as emphasized by Pirani, Gazprom demonstrated reluctance to amend its contracts with Ukraine, and showed preference for short-term concessions in return for favorable political changes. [Pirani (2014)] The situation was complicated by the accumulating debt of Naftogaz, as well as by the eruption of a political crisis in November 2013 leading to the election of a new, pro-EU president and government in Ukraine. The annexation of the Crimea by Russia and the civil war between government and separatist forces backed by the Kremlin in Eastern Ukraine, resulted in EU sanctions against Russia [BBC (2014)] and in a deteriorating political relationship between the two sides. The question of responsibility for the crisis is debatable. [Mearsheimer (2014)] Nonetheless, the present situation has to be addressed. As indicated by Pirani and Yafimava, the political crisis between Kiev and Moscow resulted in a new system, where the existing supply and transit contracts have been underpinned by tripartite agreements between the parties, with active mediation by the European Commission, ensuring the uninterrupted transit of Russian gas in 2014-15 and 2015-16 through ‘winter packages’ consisting of gas purchase commitments from Ukraine and a guarantee for discounted price from Russia. [Pirani-Yafimava (2016)] [EU Observer (2015)] Nonetheless, the most recent ruling of the SCC outlined above, raises questions on the future outline of this fragile triangle.
Forced path cooperation: Russian gas exports
Although the common discourse tends to depict Russia’s gas export as one of the leverage-enhancing political tools of the Kremlin, the Russian gas is in fact “no longer an issue of necessity, but one of convenience” [Luciani (2015)]. The global oversupply, as well as the suitable conditions1 for a competitive diversification, [Franza (2016)] creates a buyer’s market where Moscow needed to make notable concessions and adapt new marketing strategies in order to secure its most important market. The result of this has been two years of record gas export sales to Europe. (167bcm in 2017)2 [Henderson-Sharples (2018)] Nonetheless, as highlighted by Henderson and Sharples, this achievement has been facilitated by favorable external factors, including delays in new LNG start-ups, higher coal prices, declining European production and a recovery in overall European gas demand. [Henderson-Sharples (2018)] Russian gas is competitive both in short-term and long-term vis-á-vis US LNG, and due to its enormous (80-100bcm) spare capacity is able to influence hub prices as well. [Franza (2016)] Nevertheless, a slower tempo of the on-going switch from coal to gas, or unfavorable changes in the aforementioned aspects may impact these results negatively.
Figure 1: Russian pipeline flows to the EU compared to other flows (bcm/month) Source: Timera Energy
Finally, the increasing volume of Russian export can enhance the bargaining power of the EU and Ukraine vis-á-vis Moscow, due to infrastructure limitations. Gazprom’s diversification options are also limited, since the Power of Siberia pipeline (38bcm) requires a green field investment in Eastern Siberia, [Gazprom (2017)] and thus does not guarantee the company an opportunity for arbitrage between the European and Chinese markets. The construction of the Altai pipeline meanwhile, is delayed due to significant problems [Henderson (2014)].
Due to the above outlined aspects, the Ukrainian transit route will continue to be of strategic importance. Although Gazprom’s transit diversification strategy – through the construction of the Yamal, Blue Stream and Nord Stream pipelines – has achieved notable results in the past 15 years, the resistance of the European Commission is growing considerably, as will be demonstrated in the next chapter through the case study of Nordstream-2. To conclude, gas exports were and continue to be an important foreign policy tool of the Kremlin. Nonetheless, its application is far more complicated than it was a decade ago, owing to several external factors.
The importance of natural gas for the EU
Apart from ensuring security in its Eastern neighborhood, the stability of the Russia-Ukraine relationship is important for the European Union to ensure its security of energy supply. With a share of 14% in its primary energy production, [Eurostat (2015)] as well as being the biggest importer in the world, natural gas constitutes a top priority for the EU. As highlighted by Franza, the Union remains to be the world’s sink market, with a central role in balancing global supply and demand. [Franza (2016)] After peaking in 2007-2008 around 550bcm the European gas consumption crashed by 100bcm below 450bcm in 2014, with slow recovery in the past three years driven mainly by extremely low prices. Nevertheless, there is consensus among analysts that the demand is going to increase by 30-35bcm by the end of the next decade. [Henderson-Sharples (2018)] Natural gas can also play a notable role as a transition fuel over the medium term, in fulfilment of the EU’s carbon emission targets of -40% and -80% until 2030 and 2050, respectively.
Figure 2: Real flows of natural gas to the EU (2016; bcm)
Source: CIEP, BP Statistical Review 2017
For this reason, considering a declining internal production – a historical low of 110bcm in 2017 [Eurostat (2017)] – the EU has to increase its imports from external suppliers to meet its energy needs. Although its LNG infrastructure with an aggregate import capacity of 221bcm/year is substantial, its utilization rate remains below 25% [GIIGNL (2017)] due to the surging Asian LNG demand. Furthermore, the European prices are converging towards short-term marginal costs, thus undermining the perspectives of investment in new supply capacities and hindering diversification. [Franza (2016)] Under these conditions, as the most competitive producer, Russia managed to increase its share of the European market from 27 per cent in 2011 to 35 per cent in 2017, and delivered 40 per cent of the overall EU-imports, [Gazprom (2018)] 45 per cens of which came through the Ukrainian transit corridor. As underlined by several studies, by 2022-24 Gazprom’s export volumes to Europe are likely to increase. Therefore the EU needs to carry out intensive energy diplomacy in order to resolve the overlapping challenges of increasing Russian gas volumes, as well as the insurance of its security of supply in a competitive sustainable way.
Why still Ukraine?
Political and legal efforts: The case study of Nord Stream 2
Given the above outlined market tendencies, the European Commission and certain member states, are worried about the expansion of Gazprom’s dominant market position and thus attempt to hinder the construction of new pipeline projects (e.g., South Stream). This tendency is clearly identifiable in the discussion around Nord Stream 2,3 which according to Lang and Westphal, addresses a three-fold consistency and coherence test on the rules for the internal energy market in terms of its foreign policy and security objectives towards Ukraine, and regarding to the internal cohesion of the EU which Nord Stream 2 could erode given the rift between the supporting and the opposing countries. [Lang-Westphal (2017)] Although the project does have a commercial rationale, underpinned by geo-economic factors, it nonetheless tests the EU’s stance towards Ukraine and raises concerns as it overstepps purely economic aspects infringing on broader security concerns of Eastern European member states.
As an indication of the issue’s gravity, the European Commission decided to directly intervene and requested a mandate from the European Council to negotiate an agreement with Russia concerning the operation of Nord Stream 2, [Council (2017)] as well as proposed amendments to the 3rd gas directive. [Henderson-Sharples (2018)] Although the legal service of the Council has concluded that the jurisdiction of the EU cannot be applied on Nord Stream 2, [Vedomosti (2018)] some questions remain regarding the pipeline. On the one hand, the Danish parliament granted the government the right to block the construction of pipelines in the country’s territorial waters on grounds of foreign policy, national security, and defense interests. [Euractiv (2017)] On the other hand, the issue of transport pipelines remains to be discussed. The example of Nord Stream might provide guidance: although the pipeline’s construction was carried out without serious rifts, Gazprom has been able to use first 50 and then 80 per cent (from 2016) of the transporting pipeline’s (OPAL) capacity under an exemption decision achieved after several years of disputes. [Lang-Westphal (2017)] The same process might hinder the construction of Nord Stream 2’s onshore extension. (EUGAL)
To conclude, although the regulatory powers of the European Commission are not absolute, they are strong enough to delay new, primarily onshore infrastructural projects for Russian gas exports, thus buying time for negotiation regarding the transit through Ukraine. As proved through the case of Nord Stream 2 the EC’s strategy is focused on the one area – export pipeline capacity – where a bottleneck can be created and implemented in practice. [Henderson-Sharples (2018)]
A quantitative underpinning
Apart from the diplomatic and political struggles, financial and infrastructural realities underpin Ukraine’s role as a transit country, notwithstanding Gazprom’s announcements on termination of contracts. On the one hand, as underlined by Molnár, in the case of immediate cessation of transits, the Russian company would have to pay Naftogaz Ukrainy the contracted transit fees – amounting to $6.5 billion – by the end of December 2019, in addition to the $2.56 billion resulting from the SCC ruling. [RIAN (2018)] The company’s financial opportunities are limited to a certain degree, as the aggregate cost of all its announced gas-related projects could be as high as $200 billion, almost a fifth of Russia’s nominal GDP in 2016. [Franza (2016)] On the other hand, a detailed calculation on all possible pipeline scenarios carried out by Pirani and Yafimava, concluded that even if both strings of Nord Stream 2, as well as its onshore extensions are built by 2020 and 100% of their capacity is used, Russia would have to continue to serve Turkey and South-Eastern Europe through the Ukrainian network. Hence, according to the authors, the infrastructural limitations in South-Eastern Europe, as well as the growing Russian exports necessitate Gazprom’s continued usage of the Ukrainian corridor, most likely in the range of 40-60bcm. [Pirani-Yafimava (2016)] With the delay of the new infrastructural projects this volume might increase.
Counterarguments to consider
Finally, some aspects which have the ability to negatively influence Ukraine’s transit status, need to be addressed. One of those is the controversial negotiating strategy of Naftogaz, aiming at increasing its transit fees for Russian gas. Although the potentially lost transit revenues might be partially covered by the lower price of reverse-flow-gas, [Goldthau (2016)] the approximately $3 billion received for gas transit in 2017 [Interfax (2017)] is an important asset for Kiev.
Figure 3: Cost stack for Gazprom’s export sales to Europe (US$/MMBtu)
Source: [Henderson-Sharples (2018)]
Therefore, as highlighted by Bros, Naftogaz could make Nord Stream 2 financially less attractive by reducing the price of its own transit, thus making the participation of European partners in the financing of the project less justified. [Bros (2016)] Nonetheless, by proposing an increased tariff now, Ukraine is sending the opposite message to stakeholders, who will be reluctant to invest in the country’s transit network, the capacity of which has decreased to 105-110bcm, and requires at least $4.3 billion over the next 7 years for modernization, while at least $2.8 billion would need to be spent to keep that in operational condition. [Pirani-Yafimava (2016)] Full compliance with the rules set by the Energy Community through the adoption of primary legal acts might be an important step forward. [Energy Community (2017)]
Additionally, the Eastern European countries are making significant progress to reduce their dependence on the Ukrainian transit route. The final investment decision4 (FID) on the construction of the BRUA pipeline, connecting Romanian gas fields with the Baumgarten delivery point in Austria has been published in December 2017. [EBRD (2017)] According to the schedule, by 2020 1.75bcm of natural gas can be transported to this region, gradually increasing to 4.4bcm by 2022. [Ministry of Foreign Affairs and Trade of Hungary (2018)] Furthermore the possible materialization of the Eastring pipeline connecting Turkish and Austrian hubs could also undermine Kiev’s position. [Financial Observer (2017)]
To sum up, the ruling of the SCC and Gazprom’s reaction to it signal the start of a very tense period in the EU-Russia-Ukraine energy triangle, with a possible culmination in 2019 when a number of events ranging from the scheduled completion of Nord Stream 2 and TurkStream, to the renegotiation of the Ukrainian transit contract occur, with a further complication being that elections to the European parliament and elections in Ukraine are also due in 2019. [Henderson-Sharples (2018)] The analysis concluded that volume of Russian gas exports to Europe is mainly influenced by external factors, as a result of which, the Kremlin needs to be in line with EU regulations and accept the Commission’s diplomatic initiatives in this regard. Furthermore despite market tendencies, the EC is opposed to the expansion of the Russian market share, has the ability to delay the construction of new onshore infrastructural projects, and, as proved in the analysis, is attempting to create a bottleneck in terms of Russian export infrastructure. For this reason, as concluded in the paper, the most likely scenario is that Ukraine will remain a transit country in the medium run, albeit at reduced volumes of 40-60bcm/year.
A grand bargain might be achieved if all parties focus on common interests and commit to certain policies. The EU should not sacrifice its unity, as well as its stance vis-á-vis Ukraine for security meant to assuage supply-related fears and should support Kiev’s energy market reforms. On the other hand, Russia is unlikely to risk its most important market and is therefore likely – as demonstrated in the case of other European customers – to accept a compromise and play by the rules. Finally, Ukraine should commit itself to a full completion of its energy market reform, as well as modify its negotiating strategy. If these aspects are fulfilled, a notable diplomatic achievement might be reached by the end of the next year.
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1. Surplus production and delivery capacity; liquidity of the LNG market; Competing external suppliers; Surplus import infrastructure; Open and accessible market [Franza (2016)].
2. On the divergence between Russian and European data regarding natural gas flow see [Henderson-Sharples (2018) p.6].
3. Nord Stream 2 is an offshore pipeline project ensuring a direct export of an annual 55 bcm of natural gas from Russia to Germany. Apart from Gazprom (50%) the financiers of the project are Uniper, BASF/Wintershall, OMV, Shell and Engie. The pipeline is planned to start operating by the end of 2019. [Nord Stream 2 (2018)].
4. As a PCI-project, the BRUA pipeline will be financed by the Connecting Europe Facility, EBRD and Transgaz. (Romanian TSO).