Nord Stream 2: How does Ukraine respond?

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV.COM Ltd.

Can't keep a monopoly down: Gazprom facility, Moscow. [Greg Westfall/Flickr]

The expensive new Nord Stream 2 gas pipeline would not be necessary if Ukraine took certain measures to ensure gas-supply security, argues Alan Riley.

Professor Alan Riley is a non-resident senior fellow at the Atlantic Council.

Nord Stream 2 is clearly seen as a threat to EU supply security and threatens to destabilise Ukraine. On 26 November, ten EU member states (Estonia, Latvia, Lithuania, Poland, Hungary, the Czech Republic, Slovakia, Romania, Bulgaria and Greece) forwarded a letter to the European Commission objecting to the proposed Nordstream 2. It requested that the Commission undertake a close examination of the compatibility of Nordstream 2 with EU law.

Clearly, Nord Stream 2 is also a threat to Ukraine: to Ukrainian revenues (the current transit arrangements net Ukraine more than $2 billion each year); to Ukrainian financial capacity to rebuild its pipeline network. If Nord Stream 2 is built it will be much more difficult to obtain investment for network upgrades. Thirdly, the current transit arrangement provides the one element of geostrategic leverage that Ukraine has both with the EU and Russia. Remove the transit of gas from the territory of Ukraine, then Kyiv has very little leverage with Moscow and is of far less relevance to Brussels, Berlin, Paris and Warsaw.

One of the major arguments deployed by the proponents of Nord Stream 2 in favour of the project is that the new pipelines are justified because of the supply security risk of running natural gas through the Ukrainian transit system. They cite in particular the 2006 and 2009 Ukrainian-Russian gas disputes. This is somewhat disingenuous as the Russian Federation bears a substantial amount of responsibility for both cut-offs. Furthermore, as the current Ukrainian government has demonstrated, despite the impact of military conflict and gas disputes with Russia over the last two years, that it can keep the gas flowing westwards in even the most difficult of circumstances.

In addition, Russia has much more recently (in 2014 and 2015) been the one cutting gas flows to EU member states in order to stop reverse flows of Russian gas back into Ukraine (i.e. this is Russian gas sold under contract to EU states that is then resold to Naftogaz, the Ukrainian state owned operator, and then reverse flowed back into Ukraine).

Ukraine can strengthen its case further against Nord Stream by making any possibility of any Russian-Ukrainian gas dispute extremely remote. It has to be remembered that the prospect of supply disruption to EU states is often confused with the disputes between Russia and Ukraine over the pricing of Ukraine’s own gas. A good example occurred over the last few days, when Ukraine came to the conclusion that because of the cheap and plentiful supply of gas from the EU, obtainable via reverse flow, it did not need to purchase any more Russian gas for the time being. This decision was spun in Moscow as the Ukrainians refusing to pay for Russian gas, with dark hints that Europe’s supplies via the Ukrainian transit network were at risk. In fact, EU supplies in transit were not an issue, and there was no dispute in respect of Russian gas to Ukraine for Ukrainian consumption. Ukraine had just decided it did not need to take any more Russian-supplied gas for the time being.

One confidence-building measure that Ukraine can take to remove Western fears is to move rapidly to fully reform its gas market. This means pushing on with the full implementation of Third Energy Package, including full unbundling of Naftogaz, privatising the Naftogaz businesses and establishing an independent regulator. Ukraine has already taken a number of significant steps towards reform, including the removal of price controls, which have seen consumer and public sector prices tripled. This reform has had two major features. First, increasing prices to market levels will see Naftogaz’s debt fall from 7% of Ukrainian GDP to zero by 2017. Second, and even more crucially, terminating differential pricing levels will remove a major source of corruption in the gas sector (consumer and public sector gas could easily be diverted to industrial purposes). Pushing ahead quickly with all the third energy package reforms will give EU states greater confidence in the operation of the Ukrainian gas market and Ukraine’s commitment to ensuring supply security.

A second confidence building measure would be to consider upgrading the powers of the Energy Community on the territory of Ukraine. Under the Energy Community Treaty, Ukraine has agreed to comply with the EU energy acquis. Ukraine could increase the confidence of the EU member states in Ukraine’s adherence to EU rules by granting the Energy Community EU level powers of surveillance and enforcement on the territory of Ukraine. This would mean that the Energy Secretariat, which currently supervises the application of the Energy Community rules, would gain European Commission surveillance and enforcement powers, and an energy court, potentially based in Kyiv but modelled on the EU’s European Court of Justice, would supervise the Energy Secretariat and enforcement of Energy Community law. This ‘upgrade’ of the Energy Community could be achieved by Ukraine agreeing to a protocol to the Energy Community Treaty. Such a level of international supervision of the country’s national energy sector would make it very difficult to sustain any arguments regarding reliability in ensuring the supply of gas across Ukrainian territory.

The third measure would be to make Ukraine as far as possible independent of Russian gas supplies. If Ukraine uses little or no Russian directly-supplied gas, then there is no basis for a dispute and therefore no threat to continued transit of gas bound for the EU via Ukraine. This prospect is increasingly possible due to reverse gas flows from Hungary, Poland and Slovakia. This is indeed why Ukraine currently is not taking any Russian directly supplied gas. Ukraine should seek support for additional reverse flow supply routes from the EU and enhanced reverse flow capacities from states such as Slovakia who could potentially increase its flows to Ukraine. In addition, Ukraine should also look at alternative sources of supply. Given the decline in Russian-Turkish relations there may well be an opportunity to revive the prospect for an LNG floating regasification station off Odessa harbour, which could provide an additional supply source. Equally, if the government can effectively reform the royalties on gas production that have been a source of dispute with industry over the last year, both conventional and unconventional production could be increased, providing additional supplies of non-Russian gas.

By taking these measures, Ukraine can head off the argument about supply security made to support Nord Stream 2. In fact, Ukraine has done remarkably well over the last two years to keep the gas flowing to Europe through revolution, war and economic collapse. Given the track record of the last two years where transit was maintained in even extreme political circumstances and the commitment to liberalise the Ukrainian gas market, there is no real threat to European supply security which would justify the building of Nord Stream 2. It is far cheaper and provides far greater supply security for the EU to support Ukrainian transit, than pay (as EU consumers ultimately will) for a new €10 billion pipeline under the Baltic Sea.

This editorial was previously published by Natural Gas Europe.

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