Une parole franche

 

 

 

 

Sometimes the EU Gets it Right and Sometimes it Doesn't: Modernization of the Ukrainian Gas Transit System

 

by Gilbert Doctorow, Ph.D.

 

Updated on 27 May 2009

 

 

The announcement in Brussels on Monday, 23 March, of an agreement concluded between the EU and Ukraine for investment in the modernization of its gas pipeline network attracted almost no attention in the world press, though it was a significant step forward in the formulation and implementation of geopolitical and economic strategies having pan-European importance. It was so important that the Gazprom delegation to the international conference where the agreement was announced walked out in protest. For his part, Russian Premier Vladimir Putin issued harsh criticism of the deal and a veiled threat that his country would now re-examine its longstanding gas supply policies with respect to the European Union. He called for a re-examination of the very large purchases of European equipment for the Russian gas transmission industry. A day later Russia called off a top-level meeting with the Ukrainian government on cooperation scheduled to take place in the coming weeks.

And on March 27th the Russians reopened talks with Turkey over an addition to the existing Blue Stream gas pipelines to serve the large Turkish domestic market and possibly to open a supply route to Israel, a move without much immediate economic weight but intended to signal its search for alternative vectors of development to gas exports for Europe.

 

The world’s newspapers can be pardoned for their reticence in reporting on the understandings reached March 23^rd or commenting on developments since then. Even the very savvy and hard working Kommersant daily in Moscow took two days to cut through the hot air coming from Brussels and the bluster coming from the Kremlin to begin to understand what is at issue.

 

Conference materials are available from the website of the EU’s External Relations Commission. They are the foundation for the analytical essay which follows, supplemented by details leaked to the press and reported in some detail in Kommersant and The Moscow Times, as well as in Deutsche Welle

 

Looking at the opening speeches of the Conference’s organizers, we find the most useful clues to what is going on in the statements by EU Energy Commissioner Andris Piebalgs. Like fellow presenters Jose Manuel Barroso and Benita Ferrero-Waldner, he noted the strategically important role of Ukraine as the transit country carrying 80% of Russian gas, meaning 20% of all gas imports to EU countries. But he went on to draw some remarkable conclusions:

 

1. “Let’s be clear. It is in Europe’s strategic interest to keep the gas coming through this route. Any other solution is economically less interesting.”

 

2. “Ukraine will consequently stay an important transit route for gas to Europe for the foreseeable future. This is the case regardless of the realisation of alternative routes. Any strategy for the diversification of routes will obviously need to take care of existing routes.”

 

These comments may seem unexceptional but they are very important in setting priorities on a pragmatic basis serving European security, rather than pursuing economic warfare with Russia out of ideological or other reasons by prioritizing the Nabucco project as previously had appeared to be the case.

 

In order to help ensure the reliability of the Ukrainian gas transit infrastructure, investments are needed. These will entail primarily new pipeline, compressor stations, communications systems, metering stations and underground gas storage facilities. Improvement to the compressor stations will lead to increased transit capacity and also to significant savings in the fuel gas required for the transmission process. Installing metering and reporting of transmission within Ukraine will address the issue of transparency that became painfully obvious during the Russia-Ukraine gas dispute of January, when the sides exchanged accusations over possible siphoning off of transit gas for the Ukrainian domestic needs.

 

Finally, Piebalgs set specific requirements to be satisfied for the proposed investments to be made, namely the independence of the Ukrainian gas transmission operator, giving to that operator the revenues from gas transit so that he might operate on a commercial basis and setting tariffs for network access that reflect actual cost and a fair return on investment. None of these conditions is presently satisfied in Ukraine.

 

The Joint Declaration issued at the conclusion of Monday’s gathering of high ranking energy officials from EU member states as well as several other countries is a magnificent tribute to the diplomatic art of opacity. This document bearing the signatures of Yulia Tymoshenko for the Government of Ukraine, the European Commissioners for External Relations and Energy, the President of the European Investment Bank, the European Bank for Reconstruction and Development, and the World Bank is in effect a list of the issues to be agreed over time without any specific content divulged. However, there are many code words and expressions carrying a heavy emotive charge known to insiders and I will comment on these now briefly before moving on to the single element of content that seems to have been leaked to the press, the $2.5 billion loan to Ukraine for modernization of its Gas Transit System (GTS) from the signatory International Financial Institutions.

 

The preamble of the Declaration sets out a vision of future energy relations between the EU and Ukraine that goes well beyond the present relationship of transit country and end user. Ukraine’s interest in joining Europe’s Energy Community is formally acknowledged, meaning that the EU is ready to consider purchasing its gas “in Ukraine or at its Western or Eastern borders.” It is assumed that the Ukrainian Gas Transit System will remain under state ownership.

 

The Signatories express their readiness to support and assist the modernization and development of the Ukraine’s GTS, including projects outlined in a Master Plan which the Ukrainian authorities submitted to the conference (not made public) to improve the technical efficiency and capacity of the system The Ukraine will cooperate with the International Financial Institutions to realize these projects and will implement reforms to its system to isolate the transit operations and ensure transparency in keeping with the guidelines mentioned by Commissioner Piebalgs. The document ends with a list of next steps to be taken by all parties.

 

Unofficial accounts of the March 23^rd meeting indicate that a tentative agreement was reached between the parties on the scope and modality of EU financing for the modernization effort. Kommersant reports that the three signatory International Financial Institutions are prepared to provide a $2.5 billion credit facility for a period of 7 years at the concessionary rate of LIBOR + 1%. The money will go to procure compressors, measuring and other transmission equipment from EU manufacturers, so that the loan is essentially an advantageous export credit.

 

 

Win-win? Or zero sum game?

 

Was there a winner or winners from the agreements reached in Brussels on Monday? And did any side lose?

 

Let us begin with the Russians, who were visibly very upset. Prime Minister Putin is reported by several media to have said the deal was “at a minimum, ill-considered and unprofessional because to discuss such issues without the basic supplier is simply not serious.” The Russians tried to mobilize their friends in the West to support their view and Paolo Scaroni, CEO of ENI, the biggest gas distributor in Western Europe, obliged, telling the press that any plan not involving the gas supplier was “a waste of time and a waste of money.” At first glance, these criticisms might appear to be logical, but in fact they merely confuse issues.

 

The real economic reasons for Russian anger are: 1) that the gas modernization project frustrates its own hopes and ambitions to own or otherwise control the transit pipelines across the Ukraine and possibly the entire Ukrainian gas distribution network, 2) that the emphasis placed on the Ukrainian GTS marginalizes its Nord Stream and South Stream projects of direct delivery to Western Europe just as much as it does the modest possible contribution of Nabucco to Europe’s energy security, 3) that any eventual extension of the EU’s energy community to the eastern border of the Ukraine and plans to take title to gas there run directly counter to Russian hopes to expand their operations downstream and control gas distribution facilities all the way to and inside the consuming countries, thereby maximizing Russia’s share of profits, and 4) that EU countries taking title to Russian gas at the Eastern border of the Ukraine implies that existing Russian contracts with their European customers will have to be revised and it is unclear how the new, presumably higher transit fees in the Ukraine will impact on gas pricing.

 

The real political reason for Russian anger is that by doing a bilateral deal with Ukraine on gas the EU deprives Russia of one of its main levers over Kiev.

 

However, all of the aforementioned ambitions appear to have been unachievable even without the Europeans raising a finger now. The old adage that you catch more flies with honey than with vinegar applies well to the Russians’ efforts to bend the Ukrainians to their will. Whereas the Europeans have many favors to bestow on Ukraine if it is cooperative, the Russians have little more than a stick to beat them with.

 

Given the political instability of Ukraine and precisely its split down the middle between its predominantly Russian speaking Left Bank which favors closer ties with the Russian Federation and the Ukrainian speaking Right Bank which favors closer ties with the EU and NATO, Russian control of or even participation in the Ukrainian gas distribution and transit assets is not a realistic objective. Similarly, Russian political intervention in Ukrainian politics has been and will likely remain counterproductive. Nothing has changed in this sense from the election that brought Viktor Yushchenko to power following crude Russian meddling in favor of its preferred candidate

 

As regards moving downstream, the EU signaled more than two years ago that it will not allow Russian acquisition of gas assets within the Community so long as the Russians do not ratify the Energy Charter which opens its own gas industry to European controlling interests and its pipelines to transit of gas from third countries. This has been a contentious issue holding up negotiation of a new general Cooperation Agreement between the EU and the Russian Federation for more than a year and the stand-off is likely to remain in place for a good long time to come.

 

Though the Russians may not like it, the proposal that Europeans take title to Russian gas at the Ukraine-Russian border is not new. It surfaced during the January gas war as one way to remove transit gas from the dispute between Russia and Ukraine over pricing of gas deliveries to the Ukrainian domestic market.

 

However, before drawing the conclusion that the Russians lost out, the fact remains that the Ukrainian transit serves Russian supply and the end result of improving and making those transit pipelines more reliable promotes Russian commercial interests over the long term.

 

Turning to the Ukrainian parties (both Tymoshenko and Yuschenko factions), do we have a winner?

 

The notion of Ukraine’s joining the EU’s Energy Community has for at least 3 years been promoted by President Yushchenko within his programme to move the country towards EU accession. However, at the same time the EU’s insistence on the independence and transparent business operation of the Ukrainian entity responsible for gas transit goes directly to the heart of the contest between Yuschenko and his political rival within the Orange Revolution camp, Prime Minister Tymoshenko. She had accused the President of defending opaque relations through an intermediary company which his associates partly owned so as to siphon off money to his party faction and to his own re-election campaign. In that perspective, neither politician is a winner at the expense of the other.

 

And what about the Ukrainian national interest? It is served to the extent that the deal helps secure the strategic energy interests of the EU in Ukraine. In these circumstances, the country has a big and prosperous partner who will surely help out as needed to keep the Ukraine stable and capable of paying its bills for energy even in the crisis conditions of today. Meanwhile Ukraine forfeits its possibilities of holding Russia and/or the EU to ransom over its refusal to pay market prices for Russian energy

 

The EU puts its house in order, almost

 

All things considered, it appears that the European Commission is the biggest winner in the latest turn of events over the gas wars. The relatively modest credits being offered to Ukraine for improvement of the technical capabilities of its Gas Transit System have important strings attached. The promise of closer association with the EU within the Neighborhood Policy can over time exert a very positive and stabilizing influence on Ukraine, while sparing Europe the misery and economic cost of gas cut-offs that it experienced in January.

 

Above all, there appears to be a mindset of common sense and pragmatism currently guiding the EU’s energy policy, whereas back in January there was confusion, loss of focus and hotheaded cries for rushing forward with Nabucco and diversifying energy suppliers away from Russia and Ukraine at all costs. Commissioner Piebalgs has correctly prioritized making the gas transit infrastructure that exists work ahead of efforts to lay down new transit pipelines elsewhere.

We may expect the Russians to huff and puff over the latest turn of events, but their possibilities for substantially developing gas exports outside the EU are limited notwithstanding the recent start of LNG deliveries to Japan from the newly opened Sakhalin-2 plant. Much will depend on the speed with which they bring on line the LNG facility planned for the Shtokman field in the far north.

 

Meanwhile the competition between Russia and the EU for the affections and supply commitments from gas-rich Turkmenistan and Central Asia generally continues apace. This grand game over eventual diversification of sources of supply will be played out over a number of years.

 

Another key missing element in the European energy strategy begins to be addressed

 

A Press Release of the European Commission dated 28 January 2009 entitled "Investing today for tomorrow's energy" indicates that the gas war between Kiev and Moscow at the start of that month also prompted action to address another long ignored element in Europe's energy health which can be remedied acting entirely within EU borders. namely the gaps in its internal grid. Indeed the experience of shortages in the latest gas war highlighted the glaring failure of EU Member States to put together an interlinked and comprehensive gas pipeline grid and a system of underground storage facilities adequate to ensure the needs of the entire Community.

Let us consider, for example, what the present absence of linkages means by looking at the paths followed by imported gas coming from the EU's second largest external supplier, Algeria. which accounts for 20% of all European gas imports. Its LNG shipments are received directly in various ports around the Continent, including in Belgium, the south of France and Slovenia. Meanwhile its pipeline deliveries reach across the Mediterranean into Italy and  Spain.  The Spanish line apparently serves only the Iberian Peninsula.  For reasons that remain cloudy, the Algerian gas supply ends somewhere in the southwest of France and the French have not seen fit to tie it into their own national grid.  Do these various cul-de-sacs in domestic EU natural gas distribution have anything to do with the fact that this public utility is in private hands and there have been and still remain objections at the national level against supranational combinations of energy firms?  Would application of a EU-wide 'right of way' be helpful in resolving contradictions of this sort?

Countries like Hungary, which imports 80% of its natural gas from Russia via the Ukrainian pipelines, or Bulgaria, which imports 100% of its gas from the same channels, are often held up as poster boys and girls for an alleged vulnerability of Europe to Russian political and other blackmail through its control of vital energy.  However, the EU as a whole receives only 25% of its gas from Russia.  EU Member States simply have not invested at home to protect themselves against cut-offs or over-dependency on one or another supplying country and route to market.

Instead up to now nearly all talk in EU forums was about pouring billions into construction of pipelines that would compete with Russian sources and simultaneously destabilize an already fragile security environment in Central Asia, the ultimate source of new gas supplies to Europe.

It seems from the EC Press Release dated 28 January that the special appropriation for anti-crisis infrastructure investments has within it an allocation of 1.75 billion Euros for gas interconnections.  However, it is not clear how much of this rather small allocation will go into any one of the handful of pet projects mentioned in the release.  As always, the devil is in the details, and they seem not to be forthcoming. Moreover, there is no mention at all here of increasing underground storage faciliities within the EU, for which the allocations would in any case be totally inadequate. Until Mr. Barroso and his colleagues step up to the plate and explain what they doing to promote energy independence within the boundaries of the EU, it is hard to get enthusiastic about the EU's efforts outside its borders.

 

 

© Gilbert Doctorow 2009