Most-Read Article for October 2015

NORD STREAM 2: WRONG DEAL, WRONG TIME?

*first published 20 October 2015*

Nordstream 2 could play a major role in European supply - but it can only work as part of a bigger deal.

Whoever came up with the latest Nordstream 2 proposal should be sent to the deepest darkest cell in the Lubyanka. At first sight Nordstream 2 appears to be a political masterstroke. It divides Western Europeans, from Eastern Europeans, it separates the Americans from the Europeans and puts enormous pressure on the sanctions regime. Unfortunately in reality it is far from being a masterstroke.

It is true that initially there is some division between the Europeans over Nordstream 2. However, as the difficulties, legal, financial and political sink in the Europeans are going to coalesce against the proposal isolating the energy companies who initially agreed to participate and their German supporters.

These difficulties are not small. The world is not the way it was in 2008. The first is the financing issue. Gazprom can no longer generate the cash to build its share of the pipeline from its own internal funds, nor in a $50 a barrel world can its partners. Gazprom and its partners are going to have to seek external financing. Leaving aside concerns on sanctions for a moment, who is going to finance a pipeline into a European gas market which has been declining in market size for several years in a row? Perhaps ultimately external finance can be obtained but only on very stiff terms and/or with some form of public support.

Second, the regulatory environment is much tougher. The third energy package is now in force in national law in all Member States. The third party access, unbundling and capacity reservations rules will apply in full. This means that Gazprom faces being unable to only 50% of the pipeline infrastructure to carry its gas to market significantly undermining the role of Nordstream 2 and its profitability. Exemption under Article 36 of the Gas Directive is difficult to achieve because like Southstream, and unlike the original conception of Nordstream 1, this is a purely diversionary pipeline. No additional gas is being provided that will add to supply or competition.

Third, the political context is much changed from 2008. A second major cut off in 2009, invasion, occupation and annexation of part of Ukraine in 2014 have undermined trust in Russian intentions far beyond the usual suspects in Tallinn and Warsaw. Many governments across the EU have backed the Commission’s plans for interconnection projects across the European gas market to enhance supply security and diversity. Nordstream 2 looks like a project intended to undermine those plans and the billions of euro of investment they represent. Equally, there has been a huge political investment by EU governments and the US and Canada in supporting Ukraine. Nordstream 2 undermines Ukraine’s supply security and strips it of valuable transit revenue streams at a time of acute economic distress. Why should Western states therefore give any support to Nordstream 2?

The fourth problem is the sanctions regime. How easy is it going to be persuade Western finance houses to finance the project for fear that sanctions will be applied? Even if generously we take the view that neither US nor EU sanctions impact on the Nordstream vehicle New European Pipeline AG what investors will be concerned that sanctions may be ratcheted up stranding their investment.

Fifthly, given the ongoing antitrust case in Brussels against Gazprom surely launching Nordstream 2 just as Gazprom was filing its commitment offer to the Commission was unwise? The danger here is that Nordstream 2 advertises the fact that Gazprom intends to increase its export capacity prima facie increasing its market power. Inevitably the Commission will now have to take this potential increase in market power into account in its assessment of the value of the commitments. Also when the commitments offered go out for assessment to the complainants in the case, included Lithuania, the complainants may well take the view that tougher commitments are required.

Given these financial, legal, political, sanctions and antitrust pressures, Nordstream 2 is likely to be at least delayed and the Western allies of Nordstream 2 isolated. In effect what Gazprom has done has provided a threat which provides a rallying point for the West. This will not help Gazprom or its allies. 

The tragedy here is that Nordstream 2 could play a major role in a bigger deal to settle all outstanding disputes between the West and Russia. A deal providing a settlement on Ukraine and lifting sanctions could be underpinned by a major economic deal on the gas. Under such a deal Gazprom would adopt a high volume, low price model, seek western investment and a degree of liberalisation of its gas market. The Ukrainian transit would be repaired and used securing revenues to Ukraine. Nordstream 2 would be put in place to add additional capacity.

Meanwhile the EU would reform its energy markets to provide for a progressive switch from coal to gas cutting C02 emissions and providing in the longer run for gas to be a back up fuel for an enlarged renewable base.

The danger now is that this premature launch of Nordstream 2 will undermine the prospects for its future. The sense in Central and Eastern Europe that Nordstream 2 poses a threat to their security will make a deal on Ukraine and a broader economic deal much more difficult to achieve. Rather than lowering the political temperature Nordstream 2 is raising the political temperature. How is this reality supposed to help Gazprom, its commercial interests or that of its allies?

Professor Alan Riley is a Non-Resident Fellow at the Atlantic Council.