Laszlo Balogh / Reuters An engineer oversees the gas distribution system of Hungary's gas pipeline operator FGSZ in Kiskundorozsma, August 12, 2014.

Europe's Low Energy

The Promise and Perils of the Energy Union

In March this year, the European Commission (EC) announced that it was time to get serious about building a European energy union to complement the European economic union.

Just under a year earlier, Donald Tusk, who was prime minister of Poland and is now chairman of the European Council, had proposed a union as a way to negotiate better energy terms with Russia. After a three-year investigation, the EC had concluded that Gazprom, the Russian gas-exporting monopoly, had abused its position as the sole supplier in Bulgaria, Estonia, Latvia, Lithuania, and Poland by charging inflated prices and prohibiting these countries from reselling gas to others deeper in Europe. By forming a unified gas policy, Tusk argued, Europe could force Russia to play nicer.

A pressure meter is pictured at the gas storage facility of Hungarian state-owned energy group MVM in Zsana, November 3, 2014.

A pressure meter is pictured at the gas storage facility of Hungarian state-owned energy group MVM in Zsana, November 3, 2014.

At the time, some EU officials saw Tusk’s proposal as too radical. Germany in particular opposed the negotiation of even a common European price for Russian gas. As Gazprom’s most important customer, Germany enjoyed (and continues to enjoy) better terms with its Russian supplier. The Germans feared that, by combining forces with the rest of Europe, they would end up paying more. Similarly, Hungarian Prime Minister Viktor Orban opposed Tusk’s plan because his country, too, had negotiated bilateral agreements with the Kremlin that ensured Hungary of a steady supply of gas at favorable prices (in return for Hungary’s support for Russia in other realms, of course).

Such concerns delayed the energy union for a year. By early 2015, however, the EC, understanding that EU energy security was of the highest priority, was ready to move forward. And so, in March, the commission announced a plan to create a European energy union. The new design retains a substantial portion of Tusk’s original proposal, although it omits his idea that all European countries should be required to make joint purchases of gas. Instead, the plan allows EU countries to voluntarily purchase energy supplies as a group. A month later, the EC announced that, for its abuses in Bulgaria, Estonia, Latvia, Lithuania, and Poland—all of which rely on Russia for more than half of their gas supply—Gazprom would face a fine of up to ten percent of sales in the European Union. Meanwhile, several countries have also noted their intention to begin importing gas from Iran.

If the plans are implemented, Europe should see more energy security in the months ahead and Russia’s dominance as an energy supplier in Europe should weaken. If the plans are implemented, Europe should see more energy security in the months ahead and Russia’s dominance as an energy supplier in Europe should weaken. There is reason for skepticism, though.  

STRENGTH IN DIVERSITY

The European Union is the largest energy importer in the world. Last year, imports accounted for 53 percent of the union’s total energy consumption and cost approximately 400 billion euros (almost $450 billion). Many countries, especially those in the eastern part of the European Union, are substantially or entirely dependent on supplies from Russia. Overall, though, imports from Russia account for less than 30 percent of total European gas consumption.

Thirty percent is still a significant chunk, though, particularly when Russia is behaving aggressively. And so, as its first priority, the proposed energy union aims to reduce Europe’s imports from Russia, most of which comes through overland pipelines. “The EU will use all the foreign policy instruments,” the draft energy union document declares, “to develop a strategic energy partnership with the production and transit countries.”

The terms of the union have not been finalized, but at least one of Europe’s major power companies has suggested that Europe can diversify its supplies by bringing gas through Turkey from Azerbaijan and Turkmenistan, which together hold proven gas reserves of 19 trillion cubic meters, and by doubling the capacity of the Trans Adriatic Pipeline. Scheduled to open in 2019, the pipeline will deliver 20 billion cubic meters of gas per year through a 2,000-mile southern corridor from the Azerbaijani coast of the Caspian Sea through Georgia, Turkey, Greece, and Albania to Italy.

Europe cannot truly diversify its supplies until it expands the capacity of its port terminals to accept liquefied natural gas. Another option for diversifying gas supplies would be to restart construction of the Nabucco Pipeline, which would link Europe directly to gas supplies from Central Asia. Originally backed by the United States and several EU members, Nabucco stirred up strong resentment within the Russian government. In response, Gazprom proposed an alternative project that would deliver Russian gas to a terminal in Baumgarten, on the Austrian border with Hungary. Both projects were shelved in 2013, when Azerbaijan initiated work on the Trans Adriatic Pipeline. It might be time to reconsider.

Besides Azerbaijan, Turkey, and Turkmenistan, the energy union draft document also identifies countries in the Middle East and North Africa as cooperative partners.

In practice, though, Europe cannot truly diversify its supplies until it expands the capacity of its port terminals to accept liquefied natural gas. With only one major LNG terminal, Europe’s real capacity to accept gas shipments from overseas is small.

High-tension electrical power lines are seen near the Golfech nuclear plant on the border of the Garonne River between Agen and Toulouse, southwestern France, October 28, 2014.

High-tension electrical power lines are seen near the Golfech nuclear plant on the border of the Garonne River between Agen and Toulouse, southwestern France, October 28, 2014.

Europe also has to improve its internal network of gas pipelines; it has many intra-European pipelines, such as MEGAL, which runs from the German borders with the Czech Republic and Austria to the German border with France, and the Trans Austria Gas Pipeline, which runs from the Austrian border with Slovakia to Italy. But the individual pipelines within Europe are not fully integrated, and the European Union has no dedicated north-south pipeline. The Baltic states are not even connected to the main European grid. Instead, they receive supplies through a single LNG terminal in Klaipeda, Lithuania, and rely on Russia for the rest of their gas. Until these issues are addressed, Europe will have difficulty making efficient use of new energy inputs.

As Europe scrambles to diversify its sources of raw materials, its proposed energy union would also enable the EC to directly influence supply contracts, including contracts with Gazprom. The draft energy union calls for “increased transparency of these agreements and compatibility with EU energy security.” It requires “full compliance with European legislation for all contracts relating to the purchase of gas from external suppliers.” Further, it subjects not only intergovernmental agreements, but also commercial contracts to EC approval.

Presumably, the EC will use its oversight role to demand better terms from Russia, in particular by requesting shorter-term contracts and the elimination of restrictions on the re-exporting of gas among European countries. Indeed, the EC already intervened in an energy deal for the first time in March 2015, when EC Vice President Maroš Šefčovič chaired trilateral talks involving Russia, Ukraine, and the European Union. That month, a previous agreement between Russia and Ukraine, which had been brokered and partially financed by the EU, had expired. Negotiations between Russia and Ukraine on a new contract ran aground until EC officials stepped in to mediate. Despite the ongoing conflict between the two countries, the EC helped to renew gas deliveries to Ukraine from Russia, although the talks also led to a significant reduction in Ukraine’s dependence on Gazprom.

GERMAN POWER

But where does all this leave Germany? Compared to countries of a similar size, economic importance, and technical potential, Germany is rare for lacking a national oil company. Germany’s energy sector depends on private energy firms, especially RWE, E.ON, Wintershall, and EnBW. The absence of a national company puts the German government at a major strategic disadvantage compared to other European nations. Berlin has virtually no influence on natural resource production or supply policies.

As an alternative to a national company, and despite its support for a decentralized market system, Germany would like to create the conditions to allow one strong domestic player to emerge in the gas industry. The logical companies are RWE or E.ON. RWE already buys and stores natural gas for the German market and for some neighboring countries, such as the Czech Republic. Still, whatever firm does emerge as Germany’s national champion in the gas industry, it will surely try to take full advantage of the special German-Russian energy relationship and improve its bargaining position with Gazprom.

Germany’s plans raise questions about European solidarity and have driven other EU countries to pursue their own energy solutions. At the same time, German firms are also pressing forward with plans to expand the Nord Stream Pipeline from Russia to Germany. In June 2015, E.ON, BASF, Shell, and OMV signed a memorandum of understanding with Gazprom to build infrastructure to deliver 55 billion cubic meters of Russian gas to Germany annually, almost doubling Nord Stream’s total capacity.

Germany’s plans raise questions about European solidarity and have driven other EU countries to pursue their own energy solutions. In Italy, for example, the energy company ENI recently concluded a bilateral agreement with Gazprom. This will leave smaller EU states to rely on the strength of the EC to achieve their energy objectives. To improve their negotiating position, the EC continues to urge individual European countries, including Germany, to reconsider their pursuit of a national energy policy in favor of a policy executed on behalf of all EU members.

RUSSIAN DECLINE

Whether Germany gets on board with the energy union or not, Russia is hurting. Gazprom alone accounts for about eight percent of Russian GDP. With recent declines in oil prices, the company has begun to enter losses on its balance sheet. In 2013, for example, Gazprom was able to charge EU customers roughly $341 per thousand cubic meters of gas. Last year, the average price fell to $315. The price declined even further in the first quarter of 2015, to $290. So far this year, the price has mostly stayed in the range of $230 to $240.

Gas pipes bearing the flags of Serbia and Russia (R) lie on the ground near the Serbian village of Sajkas, north of Belgrade, where Serbia ceremonially launched its leg of Russia's South Stream pipeline before the project was cancelled, December 10, 2014.

Gas pipes bearing the flags of Serbia and Russia (R) lie on the ground near the Serbian village of Sajkas, north of Belgrade, where Serbia ceremonially launched its leg of Russia's South Stream pipeline before the project was cancelled, December 10, 2014.

For its part, Gazprom, which controls 18 percent of the world’s gas reserves and accounts for 14 percent of global gas production, is also in decline. The imposition of economic sanctions on Russia by Western nations led to a dramatic fall in the dollar-ruble exchange rate. The drop in oil prices reduced Gazprom’s revenues. Further, the combination of an exceptionally warm winter last year and the introduction of energy-saving programs across Europe led to a dramatic drop in natural gas consumption. In ruble terms, Gazprom recorded higher revenues in the first quarter of 2015 than it did a year earlier. But in dollar terms, revenues have declined significantly, and the company expects a 6.8 percent drop this year in natural gas extraction. It will soon hit the minimum level of extraction at which the company can operate viably. Exports are also expected to decline this year by 5.5 percent.

If the EC does fine Gazprom at up to ten percent and manages to improve the terms of some contracts, the company—and Russia—could be in serious trouble. Apart from their long duration, current contracts prevent suppliers from other countries from using the pipelines constructed to bring Gazprom’s natural gas to Europe. These pipelines have reinforced the Russian strategy of segregating the European market into separate national buyers dependent on Gazprom.

Russia is facing multiple threats. Now is the time to band together to exploit its weaknesses for the sake of Europe’s collective long-term benefit. As these contracts are modified or terminated—and the pipelines to Europe are freed from Russian control and opened up to Western companies—other suppliers may start using Europe’s pipeline network to transport their products within Europe. Many of these suppliers have lower extraction costs and shorter transportation routes than Russia, which uses a cumbersome transportation network to deliberately circumvent Ukraine.

Looming in Russia’s rear view mirror is also Iran, the world’s largest source of natural gas. Now that relations between Iran and the West are improving, Iran could provide Europe with as much energy as Russia. Already, foreign companies have descended on Tehran to negotiate access to the country’s energy wealth. Backed by U.S. and European banks, these companies are putting financing in place for projects that will begin as sanctions are gradually removed. In particular, they have their eyes on one of the largest gas fields in the world, South Pars, which Iran shares with Qatar. Its reserves of roughly 50 trillion cubic meters could theoretically meet European demand for the next 100 years.

ONE FOR ALL

Since the dawn of the European Union, European leaders have puzzled over whether they should manage energy security collectively or individually. Instead of doing one or the other, they have pursued half measures—declaring a union but allowing individual nations to pursue their own sovereign energy strategies. And that is to the detriment of all. Geopolitical realities may have Russia on the run, but if European countries don’t work together, they won’t be able to do enough to diversify their energy sources, reconfigure their pipeline network, or invest more in ports for LNG imports. They won’t be able to denounce onerous long-term contracts for gas imports from Russia or gain a stronger bargaining position.

Russia is facing multiple threats. Now is the time to band together to exploit its weaknesses for the sake of Europe’s collective long-term benefit.

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