Sunday, 10 April 2011

European solutions to Ukraine-Russia gas disputes

Early in 2011, Ukrainian President Viktor Yanukovych publicly attacked Russian gas pipeline policy at the World Economic Forum in Davos, Switzerland.

His speech was the most recent sign of growing tensions between the two countries over the gas politics that many believed would subside after Ukraine’s election of a seemingly pro-Russian president. These tensions between Ukraine and Russia are not new, but their resurgence bodes ill for European energy security.

The latest argument between Europe’s largest gas-supplying country and its key transit state is symptomatic of the wider disagreement between Kyiv and Moscow over gas transit and pricing. This should be a warning flag to Europe that, despite efforts by the International Monetary Fund and numerous countries, the underlying causes of the dispute that left Europe without gas for heating and electricity for nearly two weeks in 2009 remain unresolved and require European intervention.

Following Yanukovych’s 2010 election, Russia agreed to a new gas pricing arrangement that lowered Ukraine’s import prices and was perceived as a return to Russia’s policy of subsidized gas prices for friendly states. In reality, political hype aside, the deal did little more than bring Ukraine’s prices in line with the rates paid by other European consumers as a result of falling market prices.

At the same time, it revived the old practice of mixing political interests with gas pricing by packaging the deal with a Ukrainian extension of Russian basing rights for the Black Sea Fleet. Having pocketed the basing agreement, Russia can continue to play with the terms of the gas pricing deal if it chooses to seek further concessions in the future. Ukraine’s leaders are already voicing buyer’s remorse.

The real culprit in the dispute is the unstable underlying incentive structure in the relationship between the two countries. Gas pricing disagreements between Russia and Ukraine lead to a game of brinksmanship in which each threatens to cut off gas flows to Europe if the other will not back down. For Ukraine, a breakdown in negotiations means losing access to the gas that powers its industry and heats it homes. For Russia, a serious dispute could result in Ukraine cutting access to European customers, making Russia appear an undependable supplier to markets that could look elsewhere for solutions to their energy needs.

Timely action is in Europe’s best interest. It continues to be vulnerable to ongoing gas disputes as Russia supplies more than 40 percent of the European Union’s gas and 80 percent of this arrives via Ukrainian pipelines. This situation will only worsen in the future as dwindling domestic supplies and burgeoning demand are projected to result in a 37 percent increase in gas imports for Europe by 2030. This dependence, however, is not one-sided. Russia’s government relies on European gas exports for 20 percent of its operating budget and needs Ukrainian pipelines to transport the gas to market. Meanwhile, Ukraine remains heavily dependent on Russian gas for a large portion of its domestic energy use. A stable gas pricing and transit arrangement is important for all parties involved.

Looming in the background is Ukraine’s infrastructure problem. Its gas transit system is so old and decrepit that it offers both Ukraine and Russia an overwhelming incentive to make deals and then cheat on them. Both sides abuse the lack of transparency in the system to make claims and accusations during disputes while blaming each other for subsequent gas cutoffs.

This is compounded by the fact that both Russia and Ukraine’s energy industries are state-controlled and their business negotiations are largely conducted by national leaders. As a result, gas contracts are not constrained by market discipline, but rather are subject to political considerations in the context of relations between the two countries.

These dynamics have resulted in a situation that destabilizes Europe’s gas supply and provides Russia with cover to use gas as a political lever against Ukraine and potentially Europe. IMF loans to Ukraine and recent agreements with Russia have created a temporary degree of stability, but long-term solutions are imperative in the near future to provide for both Ukraine’s fiscal future and Europe’s energy security.

Arguably the simplest way to alleviate the supply problem between Russia and Europe is to dilute Ukraine’s centrality by building alternative pipelines – an option which Gazprom is currently pursuing in the North and South Stream lines. But even if both pipelines are built and operate at maximum capacity, they will not keep pace with projected growth in European demand.

Additionally, neither is yet operational and it is not clear that Russia can secure sufficient gas to fill the new pipelines as its Shtokman field remains undeveloped and Turkmenistan is now also selling to China. Economically it makes more sense to upgrade Ukraine’s transit system which will remain an integral piece even if these projects are completed. Politically, however, Russia may be looking for alternate routes to European customers which would allow it to shut off gas selectively to some in the future. This would enable it to further leverage its energy supplier role in individual relationships with European states.

At the recent Davos meeting, Yanukovych argued that the best solution is for Russia to invest into Ukraine’s deteriorating gas infrastructure – a move that would modernize the transit system and increase its capacity by 20 to 60 billion cubic meters of gas.

Yanukovych contends that a $5 billion Russian investment in Ukrainian infrastructure will yield similar or better results than the $25 billion being spent on the South Stream pipeline, which Russia is pursuing instead. However, while Ukraine does not have the money to modernize itself, Russia has historically demonstrated interest only in agreements where it obtains the dominant interest with minority partners who defer to Gazprom.

Late last year, following an agreement between the EU and Ukraine on cooperation in Ukrainian infrastructure modernization, Gazprom announced that it would seek a joint partnership with Naftogaz, bluntly stating that Russian funding of the modernization would accompany a merger between the two companies. This move affirmed beliefs that future Ukrainian negotiations with Gazprom will only come as part of a larger discussion on at least partial Russian ownership of Ukraine’s infrastructure.

Yanukovych and Ukraine are running out of cards to play against the Russians, having already exchanged an extension of Russian basing rights in the Black Sea for a 30 percent “reduction” in gas prices. As Ukraine’s negotiating position weakens, opportunities grow for Gazprom to achieve its ultimate goal – acquisition and control of Ukrainian infrastructure and consolidated control over the gas flow to Europe. Ukrainians cherish pipeline ownership as part of their national sovereignty and a key source of leverage, but they cannot survive on IMF loans forever or even afford to maintain their infrastructure. Without active European involvement and investment Russia will continue to chip away at Ukraine until it acquires a controlling share of its energy infrastructure.

As pro-Russian as Yanukovych originally seemed, he is on a desperate quest for balance, possibly found through European investment in Ukraine. Indeed, the proposal for greater EU investment that emerged from the March 2009 International Investment Conference on the Modernization of Ukraine’s Gas Transit System was a good first step in this direction. Opening Ukraine to foreign investment and partnership with the EU represents a practical step towards resolving the volatility of gas disputes and the problems plaguing Ukrainian energy infrastructure.

If the European Union is willing and able to invest money in a modernization and reform program, its capital would come with strings attached – including demands for market transparency, privatization of Naftogaz, and the raising of domestic prices to market levels. An EU presence would bring modernization to the transit infrastructure, transparency into natural gas transport, and limit the ability of either Ukraine or Russia to use technical issues as a negotiating tactic. It would also temper the possibility that future disputes will turn into energy crises. Given Europe’s dependence on both Ukraine and Russia for natural gas, breaking the bilateral nature of the negotiations carries a host of benefits for Europe and provides a degree of stability and mediator in the event of gas disputes.

Such an arrangement would give Ukraine an invested ally and financial capital, but not at the expense of losing a key pillar of its sovereignty. Russia would also gain from a long-term, stable and dependable energy partner. Moreover, a serious EU investment does not preclude Russian investment, only denies control. While this step would go a long way, the foundation for an energy security framework that ensures stability of supply to Europe will not be found in a single solution. Alternative pipelines, if they materialize, will relieve some of the dependence on Ukraine’s infrastructure and a foreign-capitalized modernization program would significantly improve its reliability while locking the country into long-needed domestic energy reforms.

The dire state of the Ukrainian economy should provide the EU with the necessary impetus to act. Time is a factor as Ukraine’s negotiating position continues to weaken. Ukraine cannot be viewed as a business opportunity alone, but rather as a long-term partner imperative to ensure European energy security. Without greater EU investment, Gazprom will likely force Ukrainian cession of ownership rights over its pipeline network in future negotiations over gas prices and modernization. While partnership with the EU will not fully fix the Ukrainian energy sector, it is certain to reduce the volatility of future pricing disputes and is the only solution that does not leave Europe’s security solely in Russian hands.

Richard B. Andres is a professor of national security strategy at the National War College and senior fellow and chair of the energy & environmental security policy program with the Institute for National Strategic Studies at National Defense University in Washington, D.C.

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