The Russia-EU Gas Relationship: A partnership of necessity

Will Europe reduce its dependence on Russia for natural gas supplies? This question, prompted by the North American unconventional gas 'revolution,' has incited considerable debate. Many speculate that the proliferation of unconventional gas development and the resulting global access to liquefied natural gas (LNG) will give Europe the upper hand in the relationship, allowing them to divorce themselves from dependence on Russia. Others who doubt the success of the unconventional gas revolution see a future of growing European dependence with little chance for diversification.

Inherent in the question, however, is the presumption that a natural gas consumer/supplier relationship between Russia and Europe is fundamentally negative and should be thwarted. Closer analysis would argue for a more balanced view. The relationship between Europe and Russia—energy and otherwise—has deep roots that are unlikely to be severed in the near future. While there will be effects from the unconventional gas development, they may be more gradual and nuanced. Thus, instead of confronting each other, Europe and Russia should engage in a dialogue in order to re-negotiate more flexible pricing and other contractual terms, while developing a coordinated approach to infrastructure development that allows for more versatility and steady supply. Such a sustained contingency will allow for stability for both sides as they gradually adapt to evolving energy markets.

The zenith of the EU-Russia gas relationship occurred in 2000 when the President of the EU Commission at the time, Romano Prodi, declared the goal of doubling EU gas imports from Russia. As oil (and therefore gas) prices steadily rose, however, so did tensions. The EU began publicly calling for security of supply, while Russia complained about the need for security of demand. This tension culminated in 2006 (and again in 2009) when Gazprom cut off its supplies to Ukraine as a result of natural gas pricing disputes. This shut-off compromised European supplies as well, as almost 80% of European natural gas imports from Russia ran through Ukrainian pipelines at the time. Tensions (and mutual skepticism) were exacerbated in 2009 when Russia announced that it would not ratify the Energy Charter Treaty—a document created following the Cold War to support European energy security and one that Russia had supported and signed in 1994. While the failure to ratify the treaty did little in practice, it was a strong political message. Since then, both Europe and Russia have implemented limited measures to diversify supply and markets respectively, while engaging in political posturing.

Russia has proclaimed that it will turn to Asia to lessen its dependence on EU demand, widely publicizing its efforts to build a natural gas pipeline to China. Simultaneously, Russia has been working to strengthen its foothold in Europe through vertical integration, seeking to control pipeline infrastructure, storage facilities, and subsidiaries that sell gas to consumers. Europe has been resisting these latter efforts through legal action, engaging in rigorous anti-trust investigations. These investigations stem from efforts to fully implement the EU Third Energy Package, a measure intended to integrate and liberalize the internal EU energy market. Whereas the Package itself is largely internally focused, some directives therein established, including Directive 2009/73/EC which requires the unbundling of the production, transmission, distribution, and storage of natural gas, directly apply to Gazprom. Progress on realizing the Third Energy Package will perhaps also help with rationalization of the EU’s LNG capacity and thus ability to tap into other suppliers—while Central and Eastern Europe are looking to greatly expand their LNG import capacity, Western Europe has facilities that are underutilized. In fact, skepticism and attempts to diversify supplies generally mirror dependence (with Eastern European countries generally showing a higher dependence on Russia gas supplies), although the eventual integration of the internal EU energy market will lessen this disparity. Meanwhile, Europe’s aggressive renewables development policies not only address climate change, but also counteract European dependence on fossil fuel imports.

While a certain amount of diversification (both in terms of markets and supply) is important, the exaggerated political claims on both sides belie the mutual dependence that will remain at least in the short and medium term. Despite much publicity surrounding the Russia-China natural gas pipeline, the contract (including pricing) has yet to be finalized after many years of negotiations. Even if the pipeline were approved by both sides, Russia would achieve a higher netback (income after taking transportation cost differences into account) from sending gas to Europe. Further to the point, currently about half of Russian natural gas exports go to the EU, while only 7% went to Asia in 2010 (with most of the remainder going to non-EU Europe). This is largely a function of gas’ regional nature—transporting gas by pipeline is currently far simpler and more cost-effective than condensing it to a liquid and shipping it. One pipeline to China will not ease the need for the vast expansion of LNG infrastructure for Russia to access the Asian market more generally and diversify away from overreliance on the European market.

Russia, meanwhile, accounts for 34% of EU natural gas imports, making it the lead supplier of natural gas to the EU. While European demand growth will likely remain weak, import dependence is slated to increase due to the decline in European gas production, meaning that the EU will have to rely ever more heavily on exporters such as Russia. Additionally, the infrastructure needed both to integrate the European energy market and to develop European LNG import capacity is costly and has a long implementation timeline. In this context, the stated aim to achieve such integration by 2014 appears unlikely to be achieved. Even more to the point, the current long-term contracts between Russia and the EU are not set to expire until 2020, meaning supply is locked in for nearly another decade.

Thus, in reality, little is likely to change in the near-term. Europe will continue to be a significant importer for Russia, and Russia will remain a key supplier for Europe. It is important that both acknowledge this to quell the uncertainty that posturing encourages in the evolving natural gas market. In reality, the changes to be expected as a result of the unconventional gas revolution are much more nuanced, but still important. As the pricing structure of natural gas begins to change (moving away from rigid oil-linked pricing triggered by the promise of natural gas exports from the United States), there will be considerable pressure on Russia to follow suit. While Europe’s LNG imports will remain small in the near-term, their presence will force the region to adopt a more global pricing system. Similarly, additional new sources of gas on the market (e.g., from Eastern Mediterranean, East Africa, and Central and Eastern Europe) will help provide more supply diversity for the European market. Flexibility will only increase over time as Europe integrates its internal market and expands its LNG import infrastructure.

It is important that Russia acknowledge Europe's desire for diversification, market integration, and renewables development (instead of either ignoring or criticizing these initiatives at every turn) and modify its Long Term Contracts (including their take-or-pay obligations and oil-indexed pricing clauses), allowing the Europeans increased flexibility. Conversely, Europe must recognize that while new supplies are coming on the market, it will continue to rely heavily (albeit less exclusively) on its big, regional neighbor for the near and medium term. Such mutual recognitions and the accompanying policies would allow for a more measured, gradual evolution in the relationship to match the gradual, but inevitable changes and foster conditions for a stable long-term energy relationship.

Edward Chow is senior fellow with the Energy and National Security Program at the Center for Strategic and International Studies in Washington, D.C. Anne Hudson is program coordinator with the Energy and National Security Program.

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