John Lough
Associate Fellow, Russia and Eurasia Programme
Despite the EU’s dependency on Russia for more than 30 per cent of its gas imports, the European Commission has kicked Russia’s pipeline plans into the long grass.
EU Energy Commissioner Guenther Oettinger greets Ukraine's Energy Minister Yuriy Prodan after addressing a press conference following talks on energy security in Berlin, 30 May 2014. Photo by John Macdougall/AFP/Getty Images.EU Energy Commissioner Guenther Oettinger greets Ukraine's Energy Minister Yuriy Prodan after addressing a press conference following talks on energy security in Berlin, 30 May 2014. Photo by John Macdougall/AFP/Getty Images.

This week the governments of Bulgaria and Serbia bowed to the inevitable and accepted the demands of the European Commission to suspend construction on their parts of Gazprom’s South Stream pipeline, which is designed to bypass Ukraine and bring Russian gas to Europe via a new southern corridor.

The Commission has ruled that the intergovernmental agreements underpinning South Stream with all the countries along its route (Bulgaria, Serbia, Hungary and Slovenia) do not comply with EU competition law and require revision before the pipeline can be built. It has also begun to investigate the tender process that led to a consortium headed by the Russian company Stroytransgaz being awarded the €3.5 billion contract for the construction of the Bulgarian section of the pipeline. The owner of Stroytransgaz is Gennady Timchenko, who is on the United States sanctions list.

The decisions by Sofia and Belgrade are a blow to Russia. They will delay Russia’s long-standing effort to separate its relations with Ukraine from its European gas business, as well as to isolate Ukraine and to diminish its importance to Europe. If built, South Stream, with a capacity of 63bn cubic meters per year, will reduce Russia’s gas transit dependency on Ukraine to zero by 2020. It will also deprive Ukraine of a critical source of influence in its relationship with both Russia and Europe. Russia currently exports around 50 per cent of its gas supplies to Europe through Ukraine.

A South Stream bypass would also mean that Russia could use energy as a tool in its relations with Ukraine without hindrance, since Ukraine would no longer be able to hold Russia hostage by potentially redirecting supplies destined for the European market for its own needs. Ukraine also remains an important market in its own right for Russian gas, importing from Russia over 50 per cent of the gas that it consumes.

By challenging the legality of South Stream, the Commission has kicked the project into the long grass and forced Russia to seek a longer-term solution to the vexed issue of gas transit through Ukraine. The Russia-Ukraine gas wars of 2006 and 2009 showed that unresolved price disputes between the two countries carry the risk of gas supply interruptions to Europe, with Russia unable to restrict gas supplies to Ukraine without affecting its European customers.

In a bid to avoid another gas crisis, Russia’s President Vladimir Putin invited European Union leaders to support negotiations between Russia and Ukraine to ensure the delivery and transit of gas. This led to several rounds of talks, mediated by European Energy Commissioner Günther Oettinger, which began in May and have so far led to Ukraine paying off $786m of its gas debt to Russia, that Moscow claims is now $4.4bn.

The key unresolved issue is the price formula for future gas sales. Russia claims that according to the 2009 gas contract, the price should be $485 per 1,000 cubic metres (mcm). Ukraine argues that $268.5 (the price that it previously paid when discounts applied) is a fair price that is profitable for Gazprom. Gazprom’s European customers pay around $370 per mcm.

Russia’s latest offer is a $100 per mcm discount on the 2009 contract price but Ukraine’s government is demanding a new price as part of a new contract. It argues that a discount price on the current contract can be cancelled arbitrarily on political grounds, as was the case after former president Viktor Yanukovych was deposed in February.

Both sides are threatening action against the other: Russia says it will force Ukraine to pay in advance from 16 June for its gas unless it clears its gas debt up to 1 April in full. Ukraine has said that if it cannot agree a new price with Moscow, it will go to arbitration in Stockholm.

There are two key differences from previous gas conflicts between Moscow and Kyiv: first, Ukraine is dependent for economic survival on IMF financing, which is conditional on action to address unaffordable gas subsidies. Second, Russia’s annexation of Crimea and its destabilisation of the southeast of the country has encouraged Ukraine’s leaders to sign quickly the Association Agreement with the EU and significantly increase trade and economic integration with Europe. These twin pressures are impelling the Ukrainian authorities to start genuine reform of the country’s notoriously murky energy sector for the first time.

The EU has called for the installation of gas metering stations at the Russia-Ukraine border to reliably establish how much gas Russia is supplying to Ukraine. Lack of transparency in this area has benefited the business interests of both countries for many years.

The EU is deploying other instruments as well: it has frozen an exemption granting Gazprom full access to the OPAL pipeline running through Germany to the Czech border that feeds off the Nord Stream pipeline. This effectively incentivizes Gazprom to keep supplying gas through Ukraine and to agree a price with Kyiv for gas sold to Ukraine. The Commission is also quietly pursuing its anti-trust probe into possible market abuses by Gazprom that could result in a heavy fine.

Despite its dependency on Russia for more than 30 per cent of the gas it consumes and the heavy reliance of some individual member states on Russian gas deliveries, the EU holds strong cards at present in its gas relationship with Russia and is using them effectively.

Paradoxically, for all its capacity to buy influence and create chaos in Ukraine, Russia has shown that it needs the EU’s involvement in resolving its gas dispute with Kyiv. An interdependent energy relationship between the EU and Russia that has so often seemed weighted in Russia’s favour looks less so at present.

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