Our gas transportation system should function according to the European rules

Dmytro Naumenko, analyst of Ukrainian Centre for European Policy NGO, is doing regular assessments of the reform progress in energy sector as part of  Reform Index. Over the 4 years of the index being around, 58 progressive laws and decrees were passed that are aimed at reforming energy sector in Ukraine. The year 2015 was the most productive: 32 reforms were approved with a view to transform energy sector. The following years saw a drop in activity.

At the end of 2019, ten-year agreement between Ukraine and Russia on Russian gas transit to the EU countries is expiring. Is there any chance that we will come to an agreement with Gazprom on this?

A number of factors influence this process – from geopolitics to the reform of Ukrainian gas market. Right now it looks as if the chances of signing a long-term contract are slim – most probably we will get a short-term option. Nobody knows what the final variant will be – the next round of negotiations will take place in May. February negotiations resulted in nothing: we do not know what the European Commission proposals are, as they have not been made public. Gazprom only wants to extend the contractual model existing at the moment, while the Ukrainian party stems from the fact that the contract will be signed after Naftogaz NJSC unbundling.

Why does Russian gas transit via Ukraine matter so much?

It is our income – we make around 3 billion USD on Russian gas transit annually. On the other hand, the income that Russia receives from the sales of gas transported via Ukraine is also significant and strengthens its financial position.

There is the third party here – the EU, which at least in mid-term perspective will need additional volumes of gas because of the reduced emissions energy policy. On the level of member-states, the battle for who will control supply routes is already underway. Bureaucrats in Brussels, in their turn, want to balance these complicated scales of interests and offer their vision of how these transit routes should be regulated.   

Why is Germany being such an active supporter of Nord Stream 2?

Germany has a long-term vision of energy transition (energiewende) – a transition to the so-called low-carbon society, one of the outcomes of which is complete shutdown of coal generation and power stations. Until Germany switches to 80-95% energy supply in renewables, the loss of these capacities need to be made up for. Natural gas is seen as bridging fuel and the cheapest source of this fuel is Russian natural gas.

There is another aspect here – global competitiveness. The United States have their own source of cheap (shale) gas and, as a result, they already have a competitive advantage.  Germany also wants to have such an advantage among the European countries – if they receive additional supply of Russian gas, it will increase their competitiveness on a global scale and also bring additional income after they’ve become the largest gas hub in the EU.

We do not know what the price for Russian gas transported to Germany is going to be. There is an assumption that the gas will be cheap and, respectively, German companies will be able to squeeze other players from the market. There is a strong commercial component here, which really makes the Germans support Nord Stream 2 despite the foreign economic risks.

What about Denmark banning the Nord Stream 2 pipelines from passing its territorial waters?

Let us say Poland is also not too happy and so is Slovakia – in general Eastern European block is not supporting this project of Russia. By concentrating their supply in one segment of the market, Gazprom can cut the region off other alternative supplies because Russian gas will be cheap.

Denmark has no apparent interest in Russian gas because the country almost does not rely on natural gas today and is planning to refuse fossil fuels in the nearest future. Denmark stems from pan-European interests on this issue. But I think this delay will not stop the project completely – it will just take a slightly different route and additional time will be required for its approval.

In your opinion, what will the decision of Stockholm Arbitration be? Will Naftogaz get money from Gazprom?

On the one hand, the decision of Stockholm Arbitration is one of the preconditions for signing a new contract with Russia. Russia insists that the arbitration issue be handled, where “handling” means cancellation of the request for compensation. On the other hand, Naftogaz is working on a new claim against Gazprom which is based on a very simple idea –  if Gazprom does a complete bypass and will not be using our gas transportation system, the damages must be reimbursed. In fact, it is hard to say what the actual impact is going to be – we should focus on the way we are going to draw up this transit contract and, in particular, figure out whether we will have long-term benefits from the use of gas transportation system.

It is also unclear how Naftogaz is going to collect the payments from Gazprom. Opinions have been voiced that Ukraine may get a share in Nord Stream 2 if the courts arrest some of the Gazprom shares in this project.

Before the new contract is signed, Ukraine needs to divide Naftogaz NJSC, i.e. do the unbundling. Why do we need it?

In my opinion, it is the most important precondition for the negotiations about future transit contract with Russia to be successful. Why? Because we need to take this simple stance to have the requirements of EU Gas Directive completely implemented in Ukraine and to do gas transit in accordance with those requirements. It is also very important for us that the European gas companies (buyers and traders) see us as the same route as other European gas pipelines. All pipelines that are used for gas supply to the EU must be put under the same competitive conditions so that there are no deviations. Transit tariff must be established in a transparent manner, i.e. the pipeline should be managed by a separate company and other market players should have no chance of influencing the operations of gas transportation system. These are the main reasons why we need unbundling.

And who will be checking whether the newly created operator is working transparently? And why does it look like the government and Naftogaz cannot reach an agreement?

There are several approaches, of which 4 are used in European practice with several variations. The strictest model is ownership unbundling. In this case, gas transportation assets are completely eliminated from the structure of vertically integrated company and are transferred to another company which controls ownership issues, operations management and tariff policy.

There are other models which foresee various levels of unbundling but the obligatory requirement in such cases is establishment of tariffs by an independent energy regulator. Tariff issue is always kept strictly outside this process.

We have been tagging on with the unbundling since 2016 and now, when the time has come to start negotiations on the new transit contract, we still do not know what it is going to be. We were at first looking at the ownership unbundling option but the process stuck because of a fierce conflict between different power groups at the Cabinet of Ministers – they were arguing about who would de facto own the future gas transportation company.

Since right now gas transportation system is part of Naftogaz NJSC structure, NJSC can use their influence to establish pricing that fits into their short-term interests.

When the Gazprom conflict reached its boiling point in 2015, Naftogaz NJSC said, “ok, if Gazprom does not want to transport gas after 2020, then we will now set a high transit tariff so that we are able to depreciate the pipeline in 3-4 years”.

Nobody likes such games with tariffs, and the Europeans want for our transit tariff to be set in a transparent manner, i.e. that the pipeline is managed by a separate entity and the other market players have no way of influencing the way gas transportation system functions. Officials in Brussels say, “adopt out regulations, unbundle Naftogaz NJSC, set up a separate gas transportation system operator and then we will negotiate with the new operator.”

In February 2019, the EU states were making a decision on application of EU legislation to gas pipelines of third countries, so-called Third Energy Package. How did that affect the general situation with Nord Stream 2?

Third Energy Package, that the EU Gas Directive is part of, until recently applied only to surface parts of pipelines which run across EU states territories and only now the application was extended to offshore parts of pipelines – thanks to Romanian Presidency at the Council of the EU. But these amendments were made with one interesting stipulation – exceptions to the rules of Third Energy Package shall be approved by the EU state which is the first point of entry on the offshore pipeline. In case of Nord Stream 2, it is Germany that will make such decisions. Still, any decision is subject to approval by the European Commission and if Germany can ensure majority vote or a loyal composition of the European Commission there will be no hindrances. If that does not happen, the European Commission will be putting pressure on Germany and may demand at least partial application of the Gas Directive. But these rules don’t always work.

For instance, Gas Directive did not apply to Nord Stream 1 because back then the directive did not apply to offshore gas pipelines. But the requirements of Gas Directive applied to the cross-piece pipeline, so-called OPAL, which supplies gas from Germany to the Czech border and then to Gas Hub Baumgarten. For some time this pipeline was half loaded, keeping the capacities for other suppliers. Germany cancelled this unilaterally – they allowed the use of pipeline at almost 100% and the European Commission could not do anything. This issue is now being heard by the CJEU but for now OPAL is used to its full capacity for the benefit of Gazprom. Time will tell whether the European Commission has enough political power to fight for the rules in case of Nord Stream 2.

What are the other risks that our gas transportation system will face, besides Nord Stream 2?

Everyone is talking about the Nord Stream 2 but there is also TurkStream which is also a risk for Ukraine…

Russia has a rather clear strategy for diversification of transit routes and they are not trying to hide their intention to bypass Ukraine as a transit country completely. So we cannot exclude the possibility of TurkStream being built for maximum capacity, which is 31 billion cubic meters annually.

The position of Turkey will be decisive. There are two options here – either Turkey is simply a transit country or it becomes a gas hub in the south of Europe and controls all the volumes of gas that will be coming through our territory.

If this stream is built, then after it and Nord Stream 2 are commissioned, we will only be left with technical remaining volumes of gas. These are the volumes the EU needs to cover peak demand jumps in winter and the volumes that will need to be stored in gas reservoirs on our border.  So we will be hostages of natural gas demand in the EU in the long-term perspective. And this is unknown to the unknown – forecasts differ significantly.

That is why it is important that our gas transportation system function in the European field –  because otherwise Gazprom will be controlling it and manipulating the supply routes. What we need is for the European consumer to say – this is the amount of gas we want to receive from Nord Stream 2 and this is how much we want to transit through the territory of Ukraine; and here is the amount we need from Nord Stream. The specific transit volumes will depend on the competitiveness of each of the routes.  

In February you presented Ukraine and the Association Agreement: Implementation Monitoring 2014–2018. What is the progress made in energy sector, is there any progress with the EU Directives implementation?

Energy sector, from the standpoint of Ukraine implementing Association Agreement, is among of the leaders. Reforms are happening in this sector – there is pressure but they are happening.  

If we speak of gas market, we have opened up the wholesale segment for competition but the retail remains monopolized – so we cannot say that our gas market is run under the EU rules completely. The situation is similar with power market, including renewable energy. Regarding energy efficiency, there has been certain progress in the programmes of energy efficiency support, the Warm Loans programme is imperfect but it works. Energy Efficiency Fund is being set up. There has been progress in creation of national system of energy audit and energy certification of buildings. Yet, not much has been done in energy efficiency in industry and state-run sector.