Market is the Key for Energy Independence

Energy is at the core of the Russia-EU and Russia-Ukraine relationships. Since the 2009 gas dispute, which led to a 13-day interruption of the natural gas exports from Russia to the EU, European politicians have started publicly talking about reducing Europe’s dependence on Russian energy supplies.

A lot more has been said than done on that front, admittedly. Yet, the issue has resurfaced recently, as Russia’s blatant disregard for international law and its aggression against Ukraine brought about fresh fears that the country will once again be leveraging the energy as a “diplomacy tool”.

The good news for both Europe and Ukraine is that a new player – USA – will be entering the European energy scheme. The currently ongoing shale oil and gas boom in that country is turning the United States into an oil exporter, and will likely bring US gas to Europe as soon as the relevant infrastructure is ready. A possibility of increased gas supplies from the Middle East could also change the balance in the European energy sector. It is our belief that:

• The EU and Ukraine need to confront Russia’s energy bullying by uniting their forces;
• In the short run, the EU and Ukraine should appoint a single agent to negotiate with Gazprom, with the European Commission taking a leading role. A preferred solution will be to sell Russian gas at the Russia-Ukraine border;
• In the medium run, Europe needs to actively pursue and encourage shale gas exploration and development. This will require striking a balance with the active environmentalist lobby movement (or culture) on the continent;
• In the long run, the EU and Ukraine should review their gas pipeline network, with the view of creating a structure similar to that present in the United States. The end goal should be redesigning of this infrastructure to facilitate creation of a single European natural gas market. This market will allow for a better substitutability between the energy suppliers, and will diminish the abuse of market power by Gazprom (or any other entity, for that matter);
• Ukraine needs to actively utilize market mechanisms and incentives to encourage development of energy saving technologies throughout the economy.

Ever wondered what allows Russia to use its natural gas supplies as an instrument to blackmail the EU and Ukraine? Of course, the short answer is that the EU is “dependent” on Russian gas – for only about a quarter of its supplies, that is. If we look at the broader issue of Russian energy exports, a puzzling fact surfaces. While energy (gas, oil, and petroleum products) comprises about two thirds of Russia’s export revenue, natural gas is the source of only a quarter of Russia’s energy export proceeds, with oil and petroleum products covering the remaining three quarters. Why then do we not hear about Russia using oil or petrol as its energy weapon?

A short answer to the above question is that there is a well-developed worldwide market for oil and its products, while the same cannot be said about natural gas. We use the notion of “market” here in a somewhat narrow sense to imply both the buyers’ ability to sell to a different customer and the sellers’ ability to buy from a different supplier in case the present relationships fail to work as expected. We are convinced that any long-term solution to the present situation on the European natural gas market must involve creation of a framework (in terms of both infrastructure and institution) that will facilitate substitutability between the natural gas suppliers for all consumers on the continent. Such a framework exists in the USA, and we believe certain lessons can be learned by Europe here. Moreover, a contract signed recently by Ukraine with Statoil suggests that the existing pipeline infrastructure in Europe already allows for such substitutability to some extent. This, however, is a long-term solution that will require substantial infrastructure investment to both bring in new supplies (e.g., LNG from the USA) and restructure the gas pipeline networks to facilitate substitutability for both suppliers and customers.

At the same time, certain steps to counter Russia’s energy bullying can be done now. Part of the Europe’s natural gas problem is that different countries depend on Russian gas supplies to different extents. Overall, Russia’s dependence on the European Union far outweighs the EU’s dependence on Russia. This is also true specifically in the energy sphere (it is, for instance, very difficult for Russia to move its natural gas to different markets should the EU decide to stop buying it). Individually, however, there are a number of countries that depend on Russia more than Russia depends on them. A lack of a single EU position towards Russia in the energy sector means that each European country is left on its own in its negotiations with Gazprom. The Russian gas monopolist has an upper hand in such talks, especially with countries that are more dependent on supplies from Russia. A simple solution to this problem would involve the European Commission taking a more active role in negotiating with Gazprom. This will strengthen Europe’s bargaining position with respect to the Russian monopolist. Further, Ukraine has to strive to also take part in these negotiations on Europe’s side. A preferred solution would be for all the gas that transits Ukrainian territory to be sold to this single entity at the Russia-Ukraine border, further weakening Gazprom’s influence on Ukraine in this sphere.

We are overall optimistic about increased variability of sources of natural gas over the medium and long run. Europe has some shale gas resources, which should and could be tapped into in the medium run. We understand that developing shale gas in densely populated areas will require overcoming resistance from environmental lobbies, and the resulting shale gas volumes will likely not be sufficient to replace gas imports. However, this should not stop Europe from actively working in that direction. USA plans to start its LNG exports to Europe in 2016 – of course, there are a number of uncertainties here, such as the potential for Asian customers outbidding Europe for the US LNG. There are also prospects of increased gas exports from the Middle East – we are understandably cautious here, however, given the current instability in the region. Europe and Ukraine need to work together to ensure that as many countries as possible are able to tap into these new energy sources. For Ukraine this means further developing the means to obtain gas from the EU – the prospect of LNG deliveries to Ukraine are not very bright, as Turkey opposes the idea of using Bosporus for such shipments.

On the domestic front, Ukraine needs to work in two dimensions: ensuring robust domestic energy markets, and implementing energy saving technologies. The former task has to be an integral part of the wider package of the social and economic reforms Ukraine currently requires. To facilitate implementation of energy saving, we advocate the combination of market mechanisms, tax incentives, and potentially assistance from European institutions (e.g., a dedicated EBRD program).

Overall, we need to think about Ukraine’s energy independence as an integral part of the wider European energy policy. Ukraine and Europe will be much more capable of countering Russia’s energy (natural gas, to be more specific) bullying together. The long-term solution we have outlined here – establishing infrastructure for a proper European natural gas market – need not have removing Russia from the energy market as its goal. Rather, the goal for both Ukraine and the EU has to be to make sure that Russia is not able to have market power over any single country. This is only possible if European consumers are able to quickly switch between their suppliers.