EU-Russian Gas Relations in Perspective: Challenges and Opportunities

While the Arctic region represents a seminal opportunity to move closer to a Euro-Atlantic Security Community, other aspects of the energy equation are more open-ended. Given the elaborate interdependence of European gas and oil consumers and Russian and Caspian gas and oil suppliers, if these issues are addressed constructively, a basis should exist for cooperation here as well. Still, in contrast to the four decades before, over the last ten years, the tension stirred by gas cutoffs and the jousting over pipeline routes demonstrate energy’s potential role to impede efforts to draw the countries of the Euro-Atlantic region together. Hence, in contemplating  a path to the larger goal, a minimum, first-order objective must be to minimize the possibility of energy relations adding obstacles to what inevitably will be a difficult road.

The energy ties among the countries of the Euro-Atlantic region are many and complex, and none more so than between the members of the EU and Russia. Russia supplies 31 percent of EU gas imports, 27 percent of crude oil imports, 24 percent of EU coal imports, 30 percent of total EU uranium imports, and is the EU’s third-largest supplier of electricity. In turn, the EU is not only easily Russia’s largest trading partner, but it is the market for 88 percent of Russia’s oil exports, 70 percent of its gas exports, and 50 percent of its coal exports.

Today, 40 percent of the Russian budget derives from the export of raw materials to the EU.1 Thus, to characterize the EU-Russian energy relationship as already one of dense interdependence is a mild understatement.

Over the decade since Russian president Vladimir Putin, French president Jacques Chirac, and Italian prime minister Romano Prodi proposed the EU-Russia Energy Dialogue, the two sides have done much to develop and address an elaborate agenda dealing with the long-term forecasting of alternative energy futures, factors aiding or hindering the reconciliation of their energy markets, and efforts to collaborate in promoting enhanced energy efficiency. Mechanisms are in place that permit the two sides to explore issues affecting the gas and oil sectors, coal trade, electricity systems, and nuclear power, with each presenting different challenges. And a wide variety of cooperative efforts are under way, ranging from joint clean coal improvements in Russian utility plants to the exploration of steps needed to create synchronous or, before that, asynchronous interconnections that allow electricity trade between Russia and the broader European market; from cooperative nuclear safety projects to “energy bridges” comparing management experiences in Kaliningrad, Lithuania, and Italy. Working groups exist that are focused on infrastructure projects—including pipelines, high-voltage lines, underground gas storage, liquefied natural gas terminals, and liquefaction plants—and on methods, instruments, and models for developing more precise long-term scenarios predicting energy supply and consumption.

Thus, at the core of Euro-Atlantic energy relations, the EU and Russia are fashioning a solid foundation for promoting what the recent Russian proposal for a Convention on Ensuring International Energy Security urges—a commitment “to ensure a predictable and stable joint energy balance by coordinating . . . energy strategies and policies, including projections and planned measures relating to the prospects of supply and demand, the development of energy infrastructure, the legal framework in the energy sector, as well as the transparent, predictable and efficient organization of energy markets.”

Trade in gas, more than any other area of EU-Russian energy cooperation, is suggestive of the distance still to be traveled before energy becomes a buttress for a Euro-Atlantic Security Community rather than a barrier. During the Cold War, when the first pipelines for Soviet gas were laid, the resource played a significant role in alleviating Europe’s dependence on Middle East oil. As an important component in Europe’s energy balance, Soviet gas served as a bridge between two divided blocs and a tangible manifestation of their interdependence. Subsequently, during the energy shortages of the 1990s, Russia remained a reliable energy supplier for the European continent.

Today, as Europe continues to search for a cost-effective response to climate change, Russia’s abundant gas reserves may well provide the best available answer. Financial constraints in the aftermath of the global recession together with limited commercial attractiveness cloud the prospect of a rapid transition to renewable sources of energy. The nuclear disaster at Japan’s Fukushima plant and Germany’s recently announced plan for a nuclear phaseout by 2022, have only magnified the ambiguities surrounding Europe’s future energy balance. Meanwhile, the political upheaval in the Middle East adds to the uncertainty over gas (and oil) supplies as vividly illustrated by disruptions in Libyan gas and oil exports, making Russia still more important as a reliable alternative supplier.

More recently, however, most of the tensions in a highly complex energy relationship have featured gas rather than other fossil fuels, despite the EU’s rapidly increased demand for Russian oil and coal over the last ten years. The likely explanation begins with the lack of efficient markets in the case of gas. Put simply, unlike the case of oil and coal, a truly global market does not exist for trade in natural gas. Instead, regional markets dominate and they come with significant imperfections. They also vary in terms of their maturity, organization, and market structures. In 2010, only 31 percent of the gas produced worldwide was traded across borders, compared with 66 percent of oil.2 This reflects the relative difficulty inherent in moving natural gas from one point to another.

Europe’s own slow progress in building an efficient and integrated gas market constitutes another challenge. Its current infrastructure is far from allowing the optimal distribution of gas across borders. Central and Eastern Europe, in particular, lack anything approaching a competitive market. Their supply sources remain limited and regulatory institutions are underdeveloped. A pan-European regulatory oversight arrangement is still at an early stage of development. It remains to be seen whether the EU’s third energy package will successfully address these remaining obstacles to the creation of a single European gas market.

To a degree, disagreements between Russia and the European Union are an outcome of these market imperfections. Nevertheless, this is only one part of the story. Four additional factors contribute to tensions in Russian-EU gas relations and inhibit progress toward a more efficient gas market across Europe as a whole.

First, on both sides there has been a tendency to politicize the gas relationship. On the one hand, Gazprom has understandably stepped up pressure on its clients in the former Soviet space to pay market prices. Commercial considerations have been a significant part of this decision, but the absence of clear criteria justifying the pace and extent of the price increases has bred a suspicion that Moscow utilizes gas as a political tool. On the other hand, Gazprom has received mixed signals from the Europeans when it seeks to operate in the downstream European market, something it sees as essential in minimizing its long-term risks as Europe’s gas supplier. Europe’s resistance is viewed by the Russian side as a case of a “political phobia” on Europe’s part about Russia. Competing pipeline projects in southern Europe have constituted another source of tension in EU-Russian energy relations.

Second, Russia and the European Union conceive of an efficient continental gas market differently. In the third energy package, the European Commission has insisted that market rules should apply equally to all companies. From Moscow’s perspective, however, this is legislation aimed at limiting Russia’s further penetration into the European gas market. Russian officials argue that exemptions are considered for Nabucco, a competing pipeline project, and have requested a similar treatment for Gazprom-led projects.

Third, with the demise of the European Energy Charter Treaty as a potential mechanism for resolving disputes between the EU and Russia, the continuing lack of an alternative mechanism makes disagreements harder to resolve. European capitals have criticized Moscow (along with others) for failing to ratify the Energy Charter. Russia, meanwhile, has blamed its European partners for ignoring its numerous proposals for an alternative solution. Given the magnitude of the Russian-European energy trade, commercial disagreements are inevitable, but their effects will be more damaging in the absence of a suitable mechanism for resolving them.

Finally, the EU and Russia would probably have had fewer disagreements if the competitive structure and transparency of their respective gas markets were more alike. Gazprom’s monopoly position in transportation and exports remains unchallenged. With limited competition, Russia’s gas sector will continue to be burdened by inefficient contracting practices and high transaction costs. Questions remain about Gazprom’s ability to develop its resources efficiently and in a transparent manner, exacerbating Europe’s energy security concerns. That said, Russia’s gas market is changing: independents account for a growing share of gas output, while domestic prices are being gradually elevated to meet marginal cost. These changes promise to help ease European concerns over the noncompetitive aspects of the Russian gas market, while creating major opportunities for both the Russian gas sector and partners abroad.
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