EU need not fear new Russian gas pipeline

Gazprom’s Nord Stream 2 pipeline project has fuelled fresh debate about the European Union’s dependence on gas from Russia.

Critics say that although Western Europe would benefit from cheaper gas, the new pipeline would give Moscow more power over Central Europe’s energy supply and damage Ukraine’s economy. But the risks to the EU can be mitigated if the bloc continues to build a better-integrated, better-connected gas market.

The proposed new pipeline would follow the route of Nord Stream 1 in the Baltic Sea between Russia and Germany, doubling its capacity. The backers of the project are Gazprom, the state-owned Russian company, and five energy companies from Germany, France, the UK, and the Netherlands.

Germany, which promises to become a more important energy hub if the project goes ahead, is supportive, as are Austria and the Netherlands. They argue that the new pipeline makes commercial sense and could also increase security of supply, citing the pricing disputes between Russia and Ukraine that disrupted gas flows to Europe in 2006 and 2009. In 2016, 53% of Russian gas exports to the EU went through Ukraine. With Nord Stream 2, Gazprom could reduce gas exports to the EU that go through Ukraine to around a quarter of current volumes.

However, a group led by Poland and the Baltic States want the pipeline cancelled. They argue that it is a political project to boost Moscow’s hand in the region, and note current import pipelines are only running at around 60% capacity. Moscow has previously interrupted gas flows for political reasons. They say the Nord Stream 2 project runs counter to the EU’s efforts to diversify its energy sources – in 2015 Russia was the EU’s largest single supplier and accounted for 37% of the EU’s natural gas imports.

Critics also note that additional revenues for Russia from Nord Stream 2 would soften the impact of EU sanctions against Moscow and deprive Ukraine of much of the €1.8 billion (nearly 2% of GDP) it earns annually in gas transit fees. It’s unclear how the EU can permanently frustrate Gazprom’s effort to circumvent Ukraine, but those losses would undermine European efforts to support the country. The European Investment Bank has lent Ukraine billions of euros to improve its gas infrastructure, while the EU is working with Ukraine’s state-owned energy company to clean up this notoriously corrupt sector.

Some member-states would not benefit from additional deliveries through Germany. Because there is limited capacity for shipping gas from the West to the East, Slovakia would no longer be able to access competitive gas markets in Western Europe as needed. Rather, the West-East pipelines would be filled up with gas bought under long-term contracts, which tends to be more expensive.

Since 2015, Ukraine itself has also chosen to buy Russian gas indirectly from European traders rather than directly from Gazprom. But with Nord Stream 2, other countries like Slovenia and Croatia would also be forced to bid for the gas flowing through Germany, thereby creating a bottleneck which Russia could use to political or commercial advantage.

The European Commission opposes Nord Stream 2 largely for geopolitical reasons, but it has not found any legal grounds to block it. No public funds are involved. So the Commission is using regulation to try and disrupt the project. However, member-states, as well as Europe’s gas companies, have concerns about a Commission proposal to expand EU regulations to cover pipelines coming into the bloc from third countries. The regulations prevent gas producers from controlling the pipelines they use for delivery—Gazprom would find it difficult to comply.

The combination of this new regulatory uncertainty and new discretionary US sanctions on Russian energy export pipelines has also made capital markets wary. As a consequence, Gazprom and its European partners will have to finance much of the project on their own. Denmark could also make trouble. It recently passed a law allowing it to opt out of the Nord Stream 2 project on security grounds, which could force a costly rerouting away from Danish waters. In fact, delaying the pipeline past its ambitious target completion date of late-2019 could temporarily give Ukraine more leverage in its dealings with Russia. The two countries must negotiate a new transit deal to begin in 2020. There will be more twists in this tale.

Even if the Commission has been unable to stop Nord Stream 2, it has not stood idly by. It accused Gazprom of hindering competition, prompting the company to avoid an EU fine by pledging to permit the resale of its gas between member-states. New internal market regulations also aim to ensure that member-states help neighbours in the event of a serious gas shortage.

While Russia is still top dog, Europe has made progress in making alternative gas supplies available. The Commission says that nearly all member-states could now withstand the temporary loss of their biggest supplier. South-Eastern Europe is the region most vulnerable to Russian gas cuts; the EU is making it more resilient by funding new interconnectors. Gas prices are falling as new supplies become available; the medium-term outlook is good.

The EU is also providing funding and political support to ‘projects of common interest’, such as a pipeline in Lithuania for that country’s new LNG terminal, and new gas interconnectors between Slovakia and Poland. This does not mean that Poles or Lithuanians will necessarily stop buying Russian gas: Lithuania leveraged its terminal to negotiate a cheaper contract with Gazprom. One priority of the EU’s energy strategy is “empowering consumers”; and consumers may choose not to pay more in the name of diversification.

And while it’s true that many EU member-states remain highly dependent on Russian gas, it is a double-edged sword. Russia is also dependent on selling hydrocarbons to the EU: in 2015 oil and gas accounted for 62% of Russian exports, and nearly half of Russia’s total exports went to the EU. With oil prices low and plans to sell more gas to China faltering, Gazprom’s financial position is weakening, even with record-high gas sales in Europe.  However, European companies’ long-term contracts with Gazprom mean member-states won’t be able to significantly reduce their dependence on Russian gas before the mid-2020s.

If Nord Stream 2 does go ahead, it should not be allowed to poison Germany’s relations with its neighbours. The pipeline’s opponents and supporters should work together to alleviate its localised negative effects. It is vital that Nord Stream 2’s beneficiaries continue to support infrastructure to improve security of supply for the whole EU. For the next budget cycle, the Commission should also protect, or preferably increase, funding for the Connecting Europe Facility, an infrastructure fund. Member-states’ money would be even better spent on energy efficiency – that way Europe would need less gas and would also make progress towards its climate goals. Europe’s continuing need for Russian gas – for reasons of proximity and price – is a reality, but it need not leave the EU over a barrel.

Noah Gordon is the current Clara Marina O’Donnell fellow at the Centre for European Reform.