March 3, 2015

In recent days, Russia has once more threatened the security of Europe’s gas supplies by announcing that it will refuse to pipe gas through Ukraine and will require that a southern alternative be built through Turkey. The European gas supply system has become a vital issue over the past year given Europe’s significant reliance on Russian imports and the conflict arising from Russia’s attacks on Ukraine. Europe depends on gas imports from Russia for approximately 30 percent of its requirements, of which about 40 percent are transported through Ukrainian pipelines.

For years, Europe has allowed Gazprom, the monopolistic Russian state gas supplier, to sell in Europe on terms that are highly anticompetitive and inconsistent with market principles. This has let Russia use gas exports as a weapon of intimidation, especially in Central and Eastern Europe.

Europe’s leaders should crimp Russia’s ability to punish countries politically with its gas supplies by outlawing clauses in Gazprom’s contracts that forbid the swapping of gas supplies among buyers—a requirement that appears already to be part of the European Union’s current set of policies, known as the Third Energy Package. Europe also should press Ukraine to end domestic subsidies of gas prices and to reform its own gas monopoly. These steps would enhance energy security both for Europe and for Ukraine.

Russia's Weaponization of Gas

Russia showed blatant economic aggression in cutting off gas exports to Ukraine last summer.  European leaders again recognized the potential for disruption of European supplies and the need to support Ukraine, with which the European Union had signed an Association Agreement.

Consequently, the EU permitted a “reverse flow” of gas to Ukraine from EU countries including Slovakia, Poland, Romania and Hungary. (These sales are called a “reverse flow” because they include Russian-sourced gas piped westward into Europe, which then is re-exported eastward into Ukraine.) The approval came despite Gazprom contract clauses which were meant to ban the resale of its exported gas. With such reverse flows, and supplies from Norway and other sources, Ukraine was able to withstand the Russian export shut-off and continues to diversify its imports. Russia’s supplies to Europe continued with only minor interruptions and, eventually, Russia backed off and negotiated a resumption of gas exports to Ukraine at somewhat more reasonable terms.

However, reverse flows from EU countries to Ukraine are only a partial solution. They do not help create a fully integrated and competitive gas market as envisioned by the current set of EU policies, known as the Third Energy Package. As Ukraine has acquiesced to this Package, the gas market of the EU should also extend into Ukraine as part of the economic integration envisioned by the Association Agreement.

To Build a Real Market, End Gazprom's Ban on Gas Swaps

The main deficiency currently is that Gazprom contracts continue to prevent gas swap agreements. This anticompetitive provision forces the unnecessary transportation of Russian gas across Ukraine and then a re-importation by reverse flow. Ukraine thus pays a penalty in its cost of gas, one that its fragile financial position can hardly bear and that does not represent a fair market price. (Competitive markets require that pricing be on a net-back basis.)

The introduction of gas swaps are normal to competitive gas markets and would dramatically improve the security of supply for Ukraine and other EU buyers. It would materially inhibit Russia’s ability to punish targeted countries with selective cuts in supply. The removal of swap restrictions from Gazprom contracts would appear to be a requirement of the Third Energy Package, which prohibits anti-competitive practices. (The same result could, in theory, be achieved unilaterally by Ukraine by requiring that transfer of ownership of Russian gas take place at its eastern border.)

Together with the creation of a single European gas market that encompasses Ukraine, the EU should require Ukraine to undertake reforms in line with the Third Energy Package. Most importantly, Ukraine should move immediately to market pricing of gas. Ukraine’s current heavy subsidies for residential and heating use encourage excessive consumption, reduce capital for reinvestment in development, and increase the reliance on imports. The sheer magnitude of these subsidies has heavily drained government budgets, further undermining Ukraine’s financial stability.

Ukrainian Reforms: 'Unbundling' the Gas Monopoly

Another critical reform that would enhance Europe’s energy security is the “unbundling” of Naftogaz, the integrated Ukrainian state monopoly which controls both the bulk of production and the transmission and storage of gas. The separation of these functions is another requirement of the Third Energy Package. It would let independent companies control transmission pipelines and storage facilities on which EU countries depend to import Russian gas. (The Ukrainian government has indicated a willingness to consider joint management of its facilities with experienced international operators.)

This would create transparency, flexibility of contractual arrangements and enhanced efficiency. At the same time, these facilities could then be brought under improved private management with investments that would enhance performance and reliability. Such investments would be at a very low cost relative to politically motivated and uneconomic attempts to bypass Ukraine such as the now abandoned South Stream initiative or the proposed pipeline through Turkey. These are extravagant projects that would create redundant pipeline capacity and require uneconomic investments by EU countries.

A restructuring of Naftogaz also would facilitate privatization of its gas production subsidiaries, which currently account for roughly 85 percent of all gas produced in Ukraine. Given the severe price restrictions on state-produced gas (which is required to sell at about 15 percent of market prices), these subsidiaries have neither the capital nor the incentives to properly develop the existing potential reserves of gas in Ukraine. Privatization would offer investment opportunities for Western oil and gas companies and increase the domestic production of gas in Ukraine. With increased gas supplies and an integrated EU-Ukraine market, dependence on imports would be reduced. Of course, privatization would require the normalization of rental payments or royalties in Ukraine – currently as high as 55 percent of gross revenues--to levels which would make private investment economic.

The benefits of the above changes in EU policy and market reforms in Ukraine can be realized if there is sufficient political will to act. Objections and pressure from Russia are inevitable. However, the proposed policy changes cannot be interpreted as artificial penalties against Russia. They simply would require that Gazprom comport with the Third Energy Package which envisions the creation of a competitive EU gas market with inclusion of Ukraine. The energy security and efficiency of both the EU and Ukraine would be substantially enhanced. Furthermore, the policy does not require massive funding or financial support from the EU. The changes would enhance the financial stability of Ukraine making it into a more reliable and less dependent partner for the EU. The vision is bold and requires decisiveness and rapid implementation to prevent another confrontation and crisis in gas markets. It provides a long ranging and effective solution to a key EU energy question.

Basil Kalymon is a professor emeritus of the Ivey Business School in London, Ontario, and a member of the Ukraine International Economic Observer Group. Adonis Yatchew is an economics professor at the University of Toronto and editor-in-chief of the quarterly Energy Journal, published by the International Association for Energy Economics.

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