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Tensions Threaten Long Standing Natural Gas Partnership between EU and Russia

As the areas of potential conflict are multiplying, the EU and Russia seem to be blundering into an increasingly fractious energy relationship that threatens to hurt both sides. Russia’s policies are even risking the whole future of gas in the European energy market, argues Frank Umbach,  Associate Director at the European Centre for Energy and Resource Security (EUCERS), King’s College, London. Umbach, who also works for the Centre for European Security Strategies (CESS) in Germany and the U.S. Atlantic Council, calls for “mutual preventive diplomacy” to improve relations. Specifically, he says such diplomacy should also address the lack of a legal instrument to guarantee Western investments in the Russian energy sector after Russia withdrew from the Energy Charter Treaty in 2009– before the Yukos case currently before the Permanent Court of Arbitration in The Hague will give rise to yet another conflict.

As a collective community, the EU-27 is still the world’s biggest energy importer. Unlike the USA, which is increasingly becoming self-sufficient in energy in the North American context, when viewed over the medium-term to 2035 the energy import dependency of the EU-27 is set to continue increasing dramatically and threatens to generate ever-increasing costs that will need to be paid to energy producers outside Europe and that will therefore not be available for investment domestically. Seen against the USA and other competitors, this will increasingly call Europe’s economic competitiveness in global markets into question in future.

Since the 1970s, Russia has become an increasingly important energy supplier to Europe. Russia has not only emerged as the EU’s biggest gas supplier, but is also the biggest exporter of crude oil, uranium and even coal to the EU. In addition to this, Russia ranks third for electricity exports to the EU. On the flip side, the EU has emerged as Russia’s biggest and most important trading partner. Recently it broke through the 50% threshold for Russian export trade. Russia also has a reciprocal dependence, in terms of its energy exports, on the European energy market, which accounts for 88% of its oil exports, 70% of its gas exports and 50% of its coal exports.

First conflict area: gas prices

But specifically with regard to the bilateral gas partnership, the direction of travel on both sides points to a realignment, with stronger diversification either of gas imports (EU) or exports (Russia). The increase in European dependency on gas imports from 48.9% in 2000 to 62.4% in 2010 would barely have been possible without increasing reliance on Russia. Yet the two Russian-Ukrainian gas crises in 2006 and 2009 and Moscow’s manipulation of gas dependency (particularly that of the new EU Member States, in making them up to 100% dependent on Russia) have triggered a paradigm shift on the part of the EU-27. Without these gas crises, it is highly unlikely that the EU states would have shown the political will for a common energy policy and a significantly stronger focus on the security of energy supply. The realignment of national and community energy policy within the EU has, since 2007, been based on the one hand on a broader energy mix (expansion of renewables), and on the other hand on increased energy savings and improved energy efficiency, going hand-in-hand with stronger diversification of gas imports (expanding the share of LNG and pushing ahead with direct gas imports using the Southern Gas Corridor from the Caspian region, thereby avoiding Russian territory and Russian pipelines).

In addition to this the shale gas revolution in the US, combined with a global and European weakening of demand for gas from 2009 onwards, has had considerable geo-economic and geo-political effects, with an increasing impact on the European energy market that has been officially denied by Gazprom – as the Russian natural gas export monopolist – right through to today. The unwillingness at Gazprom to move away from its traditional long-term contracts, its problematic “pay-or-take” clauses and the linking of its gas prices to the oil price have cost Gazprom considerable market share in recent years. In terms of EU gas imports, this share fell from nearly 50% in 2000 to 31.8% in 2010 and further, to just 25%, in 2012. By contrast, Norway has responded to the new market conditions far more rapidly and flexibly, and adjusted its contracts to reflect a stronger orientation to the spot market – with the result that in 2012 Norway eased past Russia to become the EU’s biggest gas supplier for the first time. Whereas EU gas imports from Norway rose by 12% in 2012, despite gas demand in the EU falling by a further 4% (and in 2011 by as much as 10%), EU imports from Russia from Gazprom fell by 10%.

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Given high Russian gas prices and cheap coal imports from the US, EU gas companies that rely heavily on Russia have  increasingly come under pressure, since Russian gas has become the most expensive buying option. It has also become increasingly difficult to sell Russian gas on the European gas market, compared to LNG imports based on spot-market prices. It is not just in Germany that gas-fired power stations are becoming less and less economically viable, especially as the shale gas revolution in the USA has led to a massive collapse in the demand for coal there. For 2 years cheap coal has been flooding onto the European energy markets, putting additional pressure on the demand for gas in the EU – a pressure reinforced by the strong reduction in the price of solar panels and the increase in subsidized renewable electricity.

This has resulted in considerable conflicts of interest between Gazprom and its European gas partners, who not infrequently have felt the need to invoke the intervention of neutral arbitrators. From the perspective of Russia’s European gas partners, however, what is needed is not simply a compromise over gas prices, but a fundamental realignment to spot-market and “gas-to-gas” prices. The view amongst European gas experts is that Russia is not only risking further losses in market shares, but is jeopardizing the whole future of gas as the most environmentally-friendly fossil fuel in Europe.

More recently, the level of concern has increased considerably in Russia too. President Putin has repeatedly criticized Gazprom publicly, not only for its lack of efficiency compared to other Russian gas producers such as Novatek and Rosneft, but also for the need to take the American shale gas revolution more seriously from now on and to develop counter-strategies. Part of the reason why this is necessary is that the diversification in the Russian economy promised by President Putin on taking up office in 2000 (with a view to reducing dependence on its energy exports and on international energy prices) has not been achieved -  a point which his predecessor President Medvedev had already conceded. In actual fact, the dependence of the Russian budget on energy revenues from exports has risen from 47% at the start of Putin’s presidency in 2000 to fully 50% today. To that extent, the developments on the European gas market are not just threatening for Gazprom, which has also seen its share price take a significant hit in recent years, but also for the Russian national budget and the future modernization of the Russian economy.

The increasing decoupling of the gas price from the oil price, however, has meant that the share of revenues for gas exports has steadily fallen in recent years. Nowadays, 80% of energy revenues from exports are attributable to Russian oil exports and the higher oil price. For that reason, the Kremlin is also pressing ahead with shale oil exploration and Arctic offshore natural gas extraction with ExxonMobil and other Western partners; yet the same fracking technology is being used for this as for shale gas extraction, which President Putin and Gazprom had criticized to a European audience as not profitable and as being too hazardous for the environment.

Second conflict area: liberalization and competition

A further explosive conflict area in the European-Russian gas partnership are EU moves towards liberalization, aimed at creating a consistently integrated and liberalized gas market via the “Third Energy Package” and its “ownership unbundling” requirements for legally-prescribed disengagement or separation of the energy suppliers’ transmission networks from their generation and sales operations. The intention behind this is to strengthen competition, granting all market participants the same opportunities and thus operating to hold down prices. For Russia and its gas pipelines in the EU, this means that Gazprom can either no longer retain direct control over the pipelines itself (at best, it can do so via subsidiaries), or that it must make up to 50% of pipeline capacities available for other market participants. Under these conditions, any geo-political manipulation of gas pipeline dependencies by the Kremlin is practically no longer possible. It is therefore hardly surprising that Gazprom and the Kremlin protested vehemently against the “expropriation” of their gas infrastructure and rejected the EU unbundling requirements for themselves.

When this approach no longer appeared realistic, Russia demanded exemption arrangements, which in principle are possible for a certain period and which, for instance, have also been granted by the EU on the Nord Stream Pipeline. In addition, Russia attempted to obstruct access by other market participants to its pipeline capacities by hoarding capacity, even it if was not being used at all, in order to ensure greater influence on gas prices as a result. The critical issue remains how to handle the situation if there are no other market participants interested in the pipeline capacities, given fears that Gazprom is capable of scaring off other market participants from acquiring such free pipeline capacities, due to its market position and the dependence of many European energy and gas companies on Russia.

It was against this backdrop of a rapidly-changing European gas market and a push for liberalization and competition that in September 2012 the EU competition authorities raided Gazprom, along with other European gas companies, triggering a 15-month long investigation. Gazprom and the other European gas companies are suspected by the EU Commission of using unfair means in gas price competition, of abusing their power in the market, and of obstructing competition through pricing agreements.

What is more, political relations have cooled off significantly since the new Putin presidency commenced, due to internal political developments in Russia. Reformers and critics of Russian energy foreign policy and gas policy have now called for a complete realignment of Russia’s internal policy – calls not restricted just to the Russian policy towards the challenge of shale gas, but also pressing their own demands for liberalization and for a completely new energy foreign policy, based on building long-term confidence in EU-Russian relations. The underlying aim is to avoid losing further market share on the European energy market and to prevent further political unrest between the two powers.

Related article: Debate Over US Natural Gas Exports Heats Up

At this moment, though, the Kremlin and Gazprom still feel relatively strong, to the point where they are reacting to the challenges with fairly traditional counter-strategies. That said, a decision on the direction of Russian energy foreign policy and on business and price models is inevitable, since the regulatory policy basis of the two energy policy strategies in the European gas market are diametrically opposed: on one side, a push for liberalization and competition to maintain the overall global economic competitiveness of the EU and, on the other, the retention of dominant market power using monopolistic and oligopolistic instruments where transparency, long-term confidence-building and flexible market mechanisms for holding down prices play barely any part, and a policy that also reflects geo-political interests, given the close meshing with Russian energy foreign policy. While the threat of such a fundamental regulatory policy conflict with geo-political consequences persists, both sides are reliant on one another for the foreseeable future, without being able to resolve this fundamental conflict of aims.

Third conflict area: Western investment protection in Russia – the overlooked significance of the Energy Charter Treaty

At the same time, the framework conditions for Western investment protection in Russia have not improved. Where different interests are at play, a legal instrument providing the power to arbitrate to resolve possible conflicts is vital for European investments in Russian energy projects. To that end, the EU originally developed the European Energy Charter Treaty (ECT), which – unlike the European Energy Charter as a policy statement of intent – is a legally binding, multilateral treaty. The ECT was signed in December 1994 and came into force in 1998. By comparison, in the event of such disputes concerning its investments in Russia, the only option open to the USA is diplomatic instruments, since it has not signed the ECT. However, Russia is a signatory, along with 50 other states and the EU. Although Russia did not later ratify the Treaty, unlike other states, it remains legally bound by it under Art. 45(1), given that Russia had not lodged any reservations when signing the Treaty. And although Russia formally withdrew from application of the ECT in October 2009, even in that situation the European investments in Russian energy projects made during the provisional application phase that is binding on Russia remain protected for 20 years, under the provisions for protection of investments in  Art. 45(1) ECT.

As a result, negotiations are currently ongoing before the Permanent Court of Arbitration in The Hague concerning an action by Group Menatep Limited (GML) against the Russian Federation. The case, launched in 2005 on the basis of the ECT, requires arbitration on the breakup of the Yukos Oil company and the expropriation of corporate assets with a compensation value of US$ 50-100 bn.  After Russia initially rejected the court’s competence, at the end of 2009 the competence of the Permanent Court of Arbitration was upheld on the basis of the “provisional applicability” of the ECT (Art. 45I ECT). This decision also implicitly confirms the 20-year investment protection. Experts therefore consider the action against the Russian state as having good prospects of success, given that similar actions (albeit with lower amounts of compensation involved) have already been successful and have led to findings of expropriations of ownership on the part of the Russian state. A decision in the GML case is expected in the near future.

The tribunal is not only pointing the way ahead for the EU and Russia when it comes to the amount of compensation, but also because the decision and the Russian response carry significant relevance for the future protection of European investment in and the associated legal security of Russian energy projects. Given the context of the numerous other potential conflicts in the European-Russian energy partnership, the GML case could become a touchstone for relations. It is precisely for this reason that mutual preventive diplomacy between the EU and Russia is vital in advance of the arbitration judgment, and a proactive diplomatic role by Germany as an “honest broker” in the bilateral conflict between the EU and Russia is called for.

Dr. Frank Umbach is Associate Director at the European Centre for Energy and Resource Security (EUCERS), King’s College, London (www.eucers.eu); Senior Associate and Head of the Programme “International Energy Security” at the Centre for European Security Strategies (CESS GmbH), Munich (www.cess-net.eu) &  Senior Fellow at the U.S. Atlantic Council, Energy and Environment Programme, Washington D.C./USA. (www.acus.org).

By. Frank Umbach for Energy Post

Source: http://www.energypost.eu/index.php/european-russian-gas-partnership-threatens-to-unravel/

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