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ECFR: Avoiding the Next Gas Crisis

The following is an article on the aftermath of the Russia-Ukraine gas crisis by Andrew Wilson, Senior Policy Fellow at the European Council on Foreign Relations (ECFR), which was originally published in the Wall Street Journal on Jan. 27.

Avoiding the Next Gas Crisis

After an unprecedented two week gas shut off during a freezing winter, Andrew Wilson looks at what can be done to stop such crises becoming an annual event.

Andrew Wilson, Senior Policy Fellow at the European Council on Foreign Relations

Now that the gas is flowing again, what should be done to stop the same thing from happening next winter? Gas crises like the one this month that saw Russia shut off deliveries to Europe via Ukraine have been an annual event since January 2006. Only in 2007 did Russia provide some variety by arguing with Belarus rather than Ukraine.

The European Union, Ukraine and Russia all need to act.Fortunately it will be easiest for the EU to put its own house in orderfirst. Brussels should set a new standard of “energy security” formember states. Some will need to invest in conservation, others instorage, others in reserve supply. All have different requirements. ButHungary, where the local company E.ON Földgáz has built up at least twomonths of reserves since 2006, shows that a lot can be done if thepolitical will is there, even by next January.

On the other hand, “energy solidarity” should mean sharing theburden between Brussels and national budgets by using structural funds.Bulgaria, for example, is connected only to the Ukrainian gas networkand could not receive supplies from its EU neighbors. So it and otherisolated countries need more so-called interconnectors that would linkthem to more networks, allowing gas to flow as it would in a truemarket next time there is a supply shock. A temporary price spike wouldhelp redistribute supply more quickly next time, including out ofunderground storage and in a reverse flow from west to east.

In the longer term, however, the EU must help break the “Mexicanstandoff” that currently exists between Russia and Ukraine. In everycrisis to date, the two have only made a deal when one side thought itwas losing the PR war. Neither country has enough material leverageover the other to force a deal: Russia controls production and transitfrom Central Asia, while Ukraine controls transit to Europe.

The only way to break the deadlock is to change the balance ofpower. Russia’s proposal to set up a new consortium among Gazprom andGazprom-friendly companies like Germany’s E.ON Ruhrgas or Italy’s ENIwill not do this. The Ukrainians would see themselves outnumbered. Amore feasible alternative is for Ukraine to retain ownership of thepipeline, but for a genuinely tripartite consortium to run it on thebasis of a long-term lease (30 years or more) and an internationaltreaty establishing clear rules of transparency, longer-term pricedeals, supply reliability and dispute settlement.

The gains for European customers from such an arrangement are clear.Ukraine could be brought to the table with promises of a broaderprogram of assistance in energy reform: more link-up to Europe’selectricity grid, the unlocking of domestic production potential, and aserious conservation drive. The EU might also link the creation of aconsortium to the new Association Agreement it promised Ukraine inSeptember.

Here, the EU will need both sticks and carrots. The crisis hasalready weakened Ukraine’s European ambitions by sowing distrust amongthe member states that found themselves without gas for more than aweek earlier this month. But if the negotiations go well, the EU couldhelp compensate for some of Ukraine’s declining NATO prospects andconsequent security weaknesses. An EU mission to Ukraine’s mostvulnerable trouble spot in the Crimea would be a good start. Thepeninsula is the one Ukrainian region with an ethnic Russian majority,and is home to the Russian Black Sea Fleet at Sevastopol on a leasethat is due to run out in 2017. A highly visible EU program should helpdiversify the peninsula’s economy and boost its trading potential.

Russia would gain, too. There would be no more risk of gas theft,its customers downstream could relax, and there would be fewerpolitical obstacles to its alternative pipeline schemes. Russia alsoneeds urgent relief from a quadruple economic crisis. Its stock markethas taken one of the biggest hits in the world over the last 12 months,with the RTS index down more than 70% from its 2008 peak. The slidestarted with Vladimir Putin’s July attack on mining company Mechel forallegedly evading taxes and selling its coal more cheaply abroad, thencontinued with the war in Georgia, before the global economic crisiseven hit.

Second, Russia has structural problems that go far beyond thefalling oil price and the gas price that will soon follow it down. Oneresult of Mr. Putin’s policy of creating state-backed “nationalchampions” is $480 billion of commercial debt, as Western banks lenttoo much money to Russian firms that ostensibly could not fail.

Third, Russia is facing an energy production crisis. Its nationalchampions are champion profiteers, but they do not invest as theyshould. Russia simply cannot get enough gas out of the ground to supplyeverybody. Energy is still incredibly cheap in the inefficient domesticmarket, and the Kremlin will not risk social protest by putting upprices to discourage usage. Then it has to supply the Ukrainianpipeline, alternatives like Nord Stream and South Stream, and otherdistribution routes.

Fourth, when there is a choice between modernization andmobilization, Russia prefers to manufacture crises and enemies ratherthan real solutions. Whoever started the present crisis, Russia hasexploited it to play triple divide-and-rule: widening splits betweenUkraine and Europe, within the EU, and within Ukraine itself. Adepoliticized and strictly commercial pipeline system through Ukrainewill slowly leverage change throughout the Russian system.

Ukraine has plenty of accumulated problems, too. Its property boomhas crashed, and its steel and chemical industries are almost atstandstill. But it mainly needs relief from the political problems thathave accumulated since the Orange Revolution in 2004.

Corruption in the gas industry is the factor most responsible fordriving the revolution off track. The notorious intermediaryRosUkrEnergo made a publically stated profit of $795 million in 2007,but its payment in kind, 20% of gas deliveries to Ukraine, was worthmore like $4.35 billion. That kind of money buys influence and fuelsthe constant gridlock in Ukrainian politics.

Prime Minister Yulia Tymoshenko has long campaigned in publicagainst RosUkrEnergo, but the key agreement with Mr. Putin this monthwas made behind closed doors. The company may diversify into thedomestic market, where it now controls 75% of distribution. Butremoving the cancer of gas corruption is a necessary precondition forcleaning up the political system in Ukraine.

No one has emerged well from the current crisis. But all will benefit if it prompts a serious search for a radical solution.