Lasting Implications for European Market Lessons from the Russian Gas Dispute

Russia and Ukraine have found a compromise to their gas dispute, but the long-term effects of the three-week deep freeze are still unknown.

By Jason Bush

From left: Ukrainian Prime Minister Yulia Tymoshenko, the chief executive officer of Russian energy giant Gazprom, Alexei Miller, and the chief executive of Ukraine's state gas company Naftogaz, Oleg Dubina, speak at Gazprom's central dispatch-control office early on Jan. 20, 2009.

From left: Ukrainian Prime Minister Yulia Tymoshenko, the chief executive officer of Russian energy giant Gazprom, Alexei Miller, and the chief executive of Ukraine's state gas company Naftogaz, Oleg Dubina, speak at Gazprom's central dispatch-control office early on Jan. 20, 2009.

The acrimonious three-week natural gas dispute between Russia and Ukraine, which left millions of customers in Central and Eastern Europe freezing without gas for heating, is now finally over. Under a face-saving compromise finally hammered out on Jan. 20, Russia's Gazprom has achieved its central objective of making Ukraine pay "market prices" for its gas, which will be linked to the European average. But to sweeten the pill, Ukraine has notched a 20 percent discount during 2009. Other terms of the deal include a one-year freeze on transit fees charged by Ukraine and the elimination of RosUkrEnergo, a controversial trading outfit that has acted as intermediary in the Russia-Ukraine gas trade.

Both parties are attempting to frame the outcome as a victory and are already disagreeing over the implications for gas prices. Ukrainian Prime Minister Yulia Tymoshenko has said the rate per 1,000 cubic meters will average $228 for the full year -- well below the $280 predicted by Gazprom (though higher than the $179.50 that Ukraine paid last year). With both sides already disagreeing about the deal's economic implications, the possibility of future disputes arising between the two countries certainly cannot be discounted. "The big question mark is what happens if Ukraine again runs into arrears," notes Chris Weafer, chief strategist at Russia's Uralsib Bank.

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In any case, the long-term impact of the dispute will go far beyond the immediate implications for energy relations between Russia and Ukraine. Despite similarities with the previous bust-up in 2006, Western energy experts emphasize the latest dispute has been far more serious, with lasting implications for the European energy market. "This has been the most serious security event in relation to gas that has ever happened in Europe," says Jonathan Stern, director of gas research at the Oxford Institute for Energy Studies. "It cannot be allowed to happen again."

Exactly what the long-term implications will be are still rather hard to fathom. It doesn't help that many fundamental facts about the dispute remain clouded in controversy -- including the key question of who was ultimately responsible for cutting off Europe's gas. While Russia accuses Ukraine of blocking Russian gas supplies to Europe during the dispute, the Ukrainians say that it was actually the Russians who turned off the taps.

Ukraine Shares the Blame

Getting to the bottom of such matters has more than purely academic significance. For one thing, the threat of legal action by Gazprom's European customers remains real -- potentially exposing the company to huge claims for damages. The debate about responsibility will also rumble on because it matters for the future of European energy policy. "If it's a Ukraine problem, then pipelines bypassing Ukraine are one answer to it. If, however, it's a Russia problem, it doesn't matter where the pipelines (from Russia) go," says Oxford's Stern.

What's already clear is that, in notable contrast to the 2006 spat that was widely blamed on Russia, this time Western observers have also pointed fingers at Ukraine. "This time round, it's clear that Ukrainian politicians have a lot to answer for," says Kash Burkett, energy and utilities analyst at Datamonitor in London. The crisis coincides with intense political turmoil inside Ukraine, including open conflict between President Viktor Yushchenko and Prime Minister Yulia Tymoshenko, which has seriously complicated negotiations with Russia.

The problems in Ukraine mean the dispute is likely to add impetus to energy projects that bypass the country. In particular, Russia backs the Nord Stream pipeline under the Baltic, a project 51percent-owned by Gazprom, in partnership with Germany's BASF and E.ON and Dutch energy firm Gasunie. Yet despite this positive news for Russia's pet project, many Western experts predict that ultimately Russia and Gazprom will turn out to be the biggest losers.

They are mystified why, in response to Ukraine's alleged pilfering of Russia's gas, Gazprom apparently responded by cutting off all gas supplies through Ukraine to Europe. "That's the big question," says Pierre Noël, an energy policy expert at Cambridge University. "Large importers of Russian gas in Western and Eastern Europe have been really scared by what has happened. There will be lasting damage to Gazprom's reputation." He predicts that European governments will now discourage major importers from increasing their exposure to Russian gas.

Alternatives to Russia?

True, the last major gas spat in 2006 also led to much talk about Europe diversifying its sources of energy and weaning itself away from dependence on Russia. But in practice, Europe's alternative options are extremely limited. Countries such as Iran, Algeria, Azerbaijan, and Turkmenistan are frequently promoted as potential alternative suppliers. But when it comes to specific projects, there is widespread skepticism about their viability. "All of this is old, old talk," says Stern. "When we get to the 2020s, things may be somewhat different, but basically Europe has to live with Russian gas."

Nevertheless, the recent gas dispute is sure to energize the search for alternative routes, adding political impetus to projects such as Nabucco, a pipeline through Turkey that would link up with gas fields in the Caspian. And despite the many obstacles, the possibilities for diversification shouldn't be dismissed out of hand. "There has been a lot of diversification over the last 20 years," notes Noël, who points out that Russia's share of the EU's gas imports has fallen from 80percent to 42percent since 1980.

He predicts the trend will now accelerate significantly, driven in particular by imports of liquefied natural gas from the Middle East, which is now experiencing significant overproduction. "The combination of the LNG glut and the economic crisis will create a very difficult situation for Russian gas in Europe and tremendous pressure on the market share of Russian gas," he says.

Unifying the EU's Energy Markets

More speculatively, the dispute may also galvanize the EU into taking bolder steps toward reforming its internal energy market. "The single most effective step the EU could take would be to integrate its energy markets," says Datamonitor's Burkett. "If we had a single market, and a single consumer demanding action from Gazprom, Europe would have far more leverage over both Gazprom and Kiev." At present, Europe's negotiations with Gazprom are handled bilaterally by individual countries and companies, enabling Gazprom to play off one customer against another.

In principle the EU has long been committed to integrating its energy markets, meaning that companies from anywhere in Europe would be able to supply gas to consumers in any other country. As well as increasing competition, such a policy would help to mitigate negative consequences from energy shocks originating in Russia or Ukraine. Countries that are heavily dependent on Russian supplies, typically in Eastern Europe, would be able to source surplus gas from other EU countries, increasing their energy security. And instead of cutting self-serving bilateral deals with Russia, large countries in Western Europe would have to shoulder more of the burden when Russian supplies are disrupted, encouraging a common European approach in energy negotiations with Russia.

Despite these benefits, the future pace of reform remains highly uncertain. To date, such reform has in practice been blocked by opposition from dominant national energy companies, protective of their national markets. But experts warn that without radical new steps to enhance Europe's energy security, the latest crisis to hit Europe's energy supplies is unlikely to be the last.


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