Europe’s Energy Security in the Context of the Ukraine Crisis

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Joakim Aleksander Mathisen || Creative Commons

The Ukraine conflict made obvious that Russians energy industry, notably Gazprom, became a political instrument in the Kremlin’s foreign policy. The short natural gas supply cut to Ukraine during the 2006 gas crisis and the 2009 dispute, in which Gazprom again decided to halt all gas supplies via Ukraine, not only contributes to a growing perception of the politicisation of EU-Russian gas trade but the reliability of Russia as an energy provider in general.

Energy is the lifeblood of economic development. Empirical research suggests that energy is a limiting factor in economic growth.i Although the total size of the economy tends to grow faster than total energy consumption, the two nonetheless trend together over the long run. Energy consumption is not merely a by-product that can be totally decoupled from GDP growth. Even if a more energy efficient economy can be more productive the opportunity costs of energy restrictions will have negative effects on future growth. A lack of energy security and the resulting price increase can therefore be expected to impede prosperity. Energy supply security not only encompasses the resilience of an economy against short-term supply disruptions but the longer-term adaptation process of both supply and demand patterns. This indicates the importance of functioning energy markets as well proper regulation in securing a stable energy supply.

Beside climate change the biggest energy policy challenge that the European Union faces is security of energy supply. According to the European commission in 2012 the EU imported about 53% of its energy at a cost of around €400 billion, which makes it the world largest energy importer.ii Since 1995 the EU energy import dependency increased about 10 percentage points. By now the EU 28 countries import almost 88% of their crude oil consumption, about 42% of solid fuels and nearly 66% of natural gas. While some member states import only a minor share of their energy most EU countries depend from external sources by more than 50%. With reference to particular energy sources some countries are heavily dependent on imports.

The role of natural gas in Europe’s energy supply

With respect to Russia and the Ukraine conflict the most problematic energy source is natural gas. Natural gas plays an important role in the current and future energy mix of most EU member states. In 2012 its share in total primary energy supply for the EU 28 was 23%.iii It is primary used in power generation, household heating, industry and the service sector. Notwithstanding the decrease of Europe’s gas consumption in recent years, triggered by a general decrease in primary energy consumption and a substitution by cheap imported coal in power generation, natural gas will keep its importance as an energy source for the decades ahead. Europe’s ambitious plans to cut its carbon emissions by 80% by 2050 compared to 1990 levels call for natural gas as a bridge fuel. The reduction of the share of carbon intensive coal in electricity generation and the replacement of ageing nuclear power plants simultaneously to a switch to not always reliable renewable energies is difficult to imagine without gas fuelled power plant capacity.

The state owned natural gas export monopolist Gazprom provides about 30% of EU gas supplies, the share is as high as 100% in some countries of central Eastern Europe. A persisting leg of cross-border interconnections makes Russia a crucial market player. In addition it took substantial investments in trading, distribution, pipeline, and storage activities all across Europe. In many East European countries Gazprom controls large shares of natural gas assets and arranged bilateral, oil indexed Long Term Contracts (LTCs) with several European gas companies. Gazprom is the Russian government’s means to act as major player in the European energy market. While the politicisation of Russia’s natural gas exports presents the EU with a serious challenge, a manipulation of the natural gas market as demonstration power might backfire to Russia.iv

Some EU members completely depend on Russia for their entire gas imports, like Estonia, Finland, Latvia and Lithuania, or consume almost all of their natural gas from Russia, like Czech Republic, Slovakia and Bulgaria. Lithuania’s, Latvia’s and Slovakia’s share of natural gas in total primary energy supply is well above the EU-28 average. That renders their economies not only vulnerable to supply shocks but the government’s susceptible to political pressure. Countries like Germany and Romania with relatively high domestic gas production also have considerable import rates from Russia. Only countries with a significant domestic gas production like the Netherlands and Norway or countries far away from Russia like the UK and Spain are independent from Russian gas. In general Eastern Europe is more dependent on Russian gas supplies while Western Europe has a more diverse access to natural gas.

A broader supply security indicator, calculated by the German Institute for Economic Research, not only taking in account the dependency on Russian natural gas but other important factors like the size of domestic production, concentration of imports and the evaluation of country risks, indicates consistent differences between Central-Western European countries and East European countries. Ukraine currently depends to two thirds upon Russian natural gas, while Belarus and other the East European countries – Finland, Estonia, Latvia, Lithuania are fully dependent. Other countries in the region are also heavily dependent, while Western European countries are able to diversify their supplies. Accordingly the threat potential of a disruption of Russians gas supplies is much bigger in Ukraine, Belarus and Eastern Europe than in central and Western Europe. Nevertheless a disruption would cause higher gas prices and could entail serious consequences for economic growth and employment in all European countries.

Russia’s manipulation of natural gas markets might backfire

Recent gas market developments have put severe pressure on Gazprom, Russia’s prime state owned company and the world’s largest gas producer.v In recent years Gazprom’s production levels fell and export dynamics slowed down. Observers anticipate a loss of profit. European gas companies no longer prefer long term agreements with Gazprom. As recently as in the early 2000’s European gas importing utilities expected a gas supply deficit and rising European gas demand. But by the end of the decade the market started to shift, triggered by soaring LNG inflows and sluggish demand in aftermath of the financial crisis. European utilities took off less gas than agreed in LTC’s because of the declining demand. Hub prices in Europe gradually decoupled from oil and fell well below the oil-indexed price. The result was dispute between Gazprom and European companies over the price formula for long-term Russian imports. Even if the collapse in oil prices reduces the difference between oil indexed and gas hub prices, it will be difficult for Gazprom to attract European companies to long-term agreements marked by rigid price and quantity clauses.

Russia’s Eastern export strategy has shady prospects. New pipeline infrastructure must be built to China and it is doubtful if the investments cash out, given the LNG competition, cheap coal and China’s commitment to nuclear power. Russia still lacks the necessary LNG infrastructure to sell its gas through alternative trade channels. Even Russia’s internal gas market is in motion. The government discusses plans to introduce market pricing and domestic competitors successfully lobbied for repealing Gazprom’s export monopoly in LNG and requested access to Gazprom’s pipelines.

Europeans competition policy in recent years has also upset the Russian gas export strategy. Until lately the EU energy market liberalisation scheme left Gazprom relatively unscathed, because of exemptions to open their transit capacities for competitors. However, the EU’s Third Energy package of 2009 introduced a number of propositions to enhance market practices in pipeline use. Transit flows are no longer exempted from the EU’s liberalisation scheme and it will become difficult for Gazprom to keep rivals out of its transit capacity. A comprehensive package of policy measures in 2011 aimed to enhance the Trans European energy infrastructure. A prioritisation of cross-border interconnectors, LNG projects and gas storage was not only supposed to achieve an enlargement of the overall pipeline system, but a more efficient market by facilitating cross-border flows of natural gas and fostering competition.

Previous Energy Packages in 1998 and 2003 created a common framework for liberalising the EU gas market. A gradual market opening was followed by a mandate for EU member states to establish independent regulators and grant non-discriminatory third-party access through legal unbundling of transport from trading. In addition, the European commission in recent years carried out investigations against Gazprom’s subsidiaries and European business partners for reasons of unfair pricing practices related to oil price indexation and anti-competitive behaviour.

Apparently Russia with its on natural resource extraction focused economy needs European gas revenues every bit as Europe is dependent on Russian gas. Actually Europe would be able to substitute Russian gas, although it requires investments in infrastructure and regulatory changes to further liberalise the market. But Europe might not have to survive without Russian gas, for the crucial importance to Russia for gas exports.

Is the Energy Union package of the EU the solution?

In this light it is necessary to form an opinion about the much debated Energy Union packagevi, particularly propositions exceeding beyond a fully-integrated and liberalised internal energy market. The Energy Union is supposed to bring greater energy security, sustainability and competitiveness by diversifying Europe’s supply of gas and strengthening the resilience to supply disruptions, building the right infrastructure for completing the energy market and integrating renewables, and the further development of the regulatory framework set-up by the 3rd Internal Energy Market Package. Simultaneously the EU wants to speed up decarbonisation and energy efficiency in Europe’s economy, mainly in the energy industry, the real estate sector and the transport sector. The EU’s targets to reach a 27% renewable energies share and energy savings to the same percentage by 2030 complement the Energy Union strategy.

However the public opposition against fracking and nuclear energy in some European countries begs the question about the odds of Europe’s energy diversification strategy. National energy agendas all too often trump common European energy goals. Germany’s “Energiewende” exemplifies the serious adverse effects of a single-handed attempt to revolutionise the energy sector. The rushed phase-out of nuclear energy, the uncoordinated development of renewable energies and the looming de facto moratorium for shale gas exploration not only burdens Germans industry and households with rising energy prices but upsets European neighbours about the dumping of access power in their own networks. The more unsteadily producing renewables strain Europe’s power grids the more flexible power stations, preferably burning natural gas, are necessary. Generally, the technical and economic obstacles of the implementation of rather arbitrary renewable energy targets and inflexible requirements for energy savings give rise to doubts if the five dimensions of the energy union really are mutually reinforcing. The EU runs the risk that conflicting goals of the Energy Union are worsening the prospects of energy security. No doubt, Europe’s capability to set common policy goals and to move their implementation ahead can be a tremendous advantage. But it requires a coolheaded energy policy to put this advantage into practice.

The article is the revised version of a keynote speech delivered at the international conference “Europe’s Dance on the Russian Gas Flame: Challenges and Perspectives for European Energy Security”, Friedrich-Naumann-Foundation for Freedom (July 7, 2015, Berlin).

i See for a discussion of the empirical research: Ross McKitrick, Elmira Aliakabari, Energy Abundance and Economic Growth, Fraser Institute, 2014 (http://www.fraserinstitute.org/content/energy-abundance-economic-growth)

ii EU energy in figures, Statistical Poketbook 2014 (http://ec.europa.eu/energy/sites/ener/files/documents/2014_pocketbook.pdf)

iii Franziska Holz, Hella Engerer, Claudia Kemfert, Philipp M. Richter, Christian von Hirschhausen, European Natural Gas Infrastructure: The Role of Gazprom in European Natural Gas Supplies, diw-kompakt 81, 2014

iv A.V. Belyi, A. Goldthau, Between a rock and a hard place: International market dynamics, domestic politics and Gazprom’s strategy, RSCAS 2015/22; A. Goldthau, Can Europe Survive Without Russia’s Natural Gas? Part I: Maybe, But It Should Not Have To, GMF Policy Brief, Vol. 2, No. 3, 2015

v J. Stern, H. Rogers, The Dynamics of a Liberalised European Gas Market: key determinants of hub prices, and roles and risks of major players, The Oxford Institute for Energy Studies, 2014 (https://www.oxfordenergy.org/2014/12/dynamics-liberalised-european-gas-market-key-determinants-hub-prices-roles-risks-major-players/)

vi Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Investment Bank, A Framework Strategy for a Resilient Energy Union with a Forward-Looking Climate Change Policy, COM/2015/080 final (http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52015DC0080)

Karl-Heinz Paque