The continuing turmoil in Ukraine has once again heightened Europe’s concern over its energy security and rehashed memories of the gas disputes of January 2006 and 2009 when supplies to Europe were disrupted. Following these disputes, the 28 Member States (MSs) of the European Union (EU) have been working to develop a more coherent energy security of supply (SoS) strategy. The question of whether Europe is currently in a better position to head off a potential new gas supply crisis continues to be of concern to oil & gas players, utilities, financial institutions and other investors, and government agencies.
This article takes stock of the myriad of existing EU rules dealing with gas SoS issues and potential new approaches as put forward in the European Energy Security Strategy released by the European Commission (Commission) on 28 May 2014. It also considers the impact on the Russian and US gas markets.
For Europe, energy and security are inextricably intertwined. Part of this reflects simple economic reality. The EU is both the world’s second largest consumer of energy and the world’s largest energy (oil and gas) importer. Several countries in Central and Eastern Europe (CEE) are completely gas import-dependent. Moreover, their import-dependence is poorly diversified, with Russian gas predominant – in some cases the only source of supply.1 Today, Europe covers around 65% of its natural gas demand from imports.2 Some 39% of Europe’s gas needs come from Russia via three routes – the Druzhba pipeline through Ukraine; the Yamal pipeline through Poland and Belarus; and the Nord Stream pipeline that crosses the Baltic Sea to Germany.
The Ukraine crisis sparked a newfound sense of urgency among European leaders regarding the need to reduce this high gas dependency and the European Council3 called on the Commission to present a comprehensive study of EU energy security, which it published on 28 May 2014.4 Before considering the study, this article reviews the existing EU regulatory framework for safeguarding energy security and considers why Europe is now in a better (or worse) position compared to the 2006 and 2009 Ukraine gas crises.
II. Europe’s evolving energy landscape
EU internal gas market and its external dimension
The first aspect of Europe’s energy security policies involves its own internal energy market (IEM).
One of the central ideas of the IEM is that through market liberalization and integration rules, all MSs are connected to a Europe-wide gas supply grid. This IEM would not only provide a more robust gas system throughout Europe, but also allow MSs to share and trade gas more flexibly, thereby creating a more liquid market that mitigates the impact of potential supply interruptions. Following a third wave of energy liberalization directives and regulations commonly referred to as the “Third Energy Package”, the IEM is to be completed by 2014 according to a European Council declaration made in 2013.5 However, significant work remains to be done, in particular with the drafting and implementation of the so-called “network codes” (NCs). These codes essentially create common rules on technical and commercial conditions for the access to and use of the gas transmission networks across Europe so that gas can be sent to where it is commercially interesting and/or technically needed in the event of a crisis. For example, the NC on Capacity Allocation Mechanisms6 – which enters into force on 1 November 2015 – provides for rules on the allocation of capacity at the interconnection points of transmission systems between MSs. It requires transmission system operators (TSOs) to apply harmonized auctions, to offer bundled products (so eliminating the risk for a shipper of only securing capacity rights at one side of the border) and to bring unused capacity back to the market through surrendering procedures such as use-it-or-lose-it (UIOLI). Gas trading is increasingly being regulated too in an attempt to create more liquid wholesale markets.7
While the IEM is primarily aimed at the development of an integrated energy market between MSs, the EU is also exporting its internal gas market reforms into neighboring non-EU countries, notably through the Energy Community Treaty.8 The Energy Community Treaty covers not only South Eastern Europe9 but also Moldova and Ukraine, with Armenia, Georgia, Norway and Turkey taking part as Observers.10 While Ukraine acceded to the Energy Community in September 2010, it went further by signing an MOU in February 2014 to accelerate the transposition of the abovementioned Third Energy Package and certain other EU gas regulations into national law and to reform its energy sector, including Ukraine’s oil and gas incumbent Naftogaz and its TSO, Ukrtransgaz.11
The external dimension of the SoS further takes shape thanks to other international/multilateral instruments such as the Energy Charter Treaty (ECT).12 Despite having the improvement of energy security as one of its key objectives, especially in relation to gas transit disputes, and the availability of a fast-track conciliation procedure, the ECT’s leverage to act is low as Russia did not ratify the ECT and ceased its own interim application thereof in October 2009.13 However, the ECT may remain relevant to potential future transit problems, for example in the Southern Gas Corridor under development. While the ECT is the EU’s primary document governing energy investment trade with external parties, various bilateral instruments, as well as soft law and (in)formal cooperation mechanisms exist too, e.g., the Eastern Partnership; Southern Mediterranean Partnership; EU-Russia Dialogue; and EU-US Energy Council.
Apart from the gas reform or liberalization laws that impact SoS, applied both inside and outside the EU, the EU has also enacted several instruments specifically aimed at mitigating gas supply risks.
For example, following the Russian-Ukrainian gas crisis in January 2009, the EU adopted the so-called SoS Regulation.14 The Regulation contains requirements for national energy regulators to produce risk assessment, preventive action and emergency action plans. TSOs in turn need to adapt their networks to enable permanent physical reverse flow at all interconnection points.15 The Regulation further requires that all gas undertakings provide information regarding their long-term gas supply contracts with third (non-EU) countries/suppliers to the relevant national energy regulator(s). Details to be provided relate to contract duration; contracted volumes in total, on an annual basis and the average volume per month; in the event of an alert or emergency, contracted maximum daily volumes; and contracted delivery points.
Another important transparency requirement relates to intergovernmental agreements (IGAs) in the field of energy concluded by MSs and third countries.16 New IGAs must be submitted to the Commission for assessment of their compatibility with EU energy law. It is precisely in this context that the Commission claims that the IGAs concluded between six MSs and Russia in relation to the South Stream pipeline – which would run from the Black Sea to Austria and make the EU’s flagship Nabucco pipeline project irrelevant17 – should be reviewed, as they are allegedly not in line with EU gas law, in particular the rules on unbundling and transmission tarification.
Partly in response to the 2009 gas disruptions, European gas infrastructure system is arguably more robust than it was five years ago, with more supply options: storage,18 LNG terminals and cross-border interconnections.
The Third Energy Package created a more pan-European approach to infrastructure planning through the so-called Ten-Year Network Development Plans, which are drawn up by the TSOs of all MSs. It also provides certain stimuli for infrastructure construction, such as the obligation on national energy regulators to grant appropriate risk-related incentives through regulated transmission use tariffs (anticipatory investments, early recognition of costs incurred, additional return, etc.).
However, significant physical congestion at cross-border points and other concerns remain, and strengthening its infrastructure is therefore a priority for the EU. The Energy Infrastructure Package of 2013 seeks to facilitate investment and to accelerate key cross-border infrastructure to support the IEM.19 Key infrastructure includes bidirectional interconnectors; newly built LNG terminals, increased storage and re-routing pipelines. In gas, the following four trans-European priority corridors and areas have been identified: North-South gas interconnections in Western Europe; North-South gas interconnections in Central Eastern and South Eastern Europe; the Southern Gas Corridor; and the Baltic Energy Market Interconnection Plan in gas.
The European Commission adopted in 2013 a list of 248 key energy infrastructure projects within these priority corridors. This list will be updated every two years. Carrying the label “projects of common interest” (PCI), they will benefit from faster and more efficient permit granting procedures and special regulatory/tarification treatment. They may also have access to EU financial assistance under the so-called Connecting Europe Facility (CEF) program, under which a 5.85 billion euro budget has been allocated to trans-European energy infrastructure for the period 2014-2020.20 Enhanced loans, project bonds and equity instruments will also be available.
The EU is not only looking at trans-European gas infrastructure but also outside. For example, the EU pledged to ensure effective interconnections not only between MSs but also with third countries such as Ukraine, notably through a reverse flow gas pipeline with Slovakia.21 Constructing so-called transit-avoiding pipelines is also under consideration; because 90% of European gas imports are delivered by pipelines, gas is transported across several sovereign territories, raising the possibility of a further layer of risk, and hence heightening security concerns. Pipelines such as Nord Stream and South Stream – filled with Russian gas – bypass traditional transit countries such as Ukraine and Belarus.
Promoting indigenous energy supply: from renewables to shale and nuclear
There is broad European agreement that the EU should also look inward to determine how its dependence can be mitigated by indigenous energy sources.
First of all, renewable energy has significantly diversified the EU’s energy supply mix. The current share of renewables in EU final energy consumption has increased from 8.3% in 2004 to 14.1% in 2013 and is projected to reach 20% in 2020.22 This is partially due to the revision in 2009 of the so-called Renewables Directive, which aims at increasing Europe-wide production and use of alternative and renewable energy sources (RES). In January 2014, the Commission proposed a 27% RES target by 2030.23 However, the revised EU state aid guidelines published on 9 April 2014 may no longer facilitate deployment of renewable energy as rapidly as in the past, since the Commission introduces important changes such as the obligation that power is sold against wholesale price instead of fixed feed-in tariffs.24
Apart from Norway, which is not an EU member, there is very little gas production within Europe (essentially only in the UK, the Netherlands and Denmark) and it is declining. Certain MSs such as the UK and Poland see shale gas as an important way to develop Europe’s indigenous unconventional resources and as a path to energy independence.25 Shale gas reserves are currently anticipated in at least 16 countries across Europe. The EU’s Joint Research Centre puts Europe’s technically recoverable unconventional gas resources at 11,700 bcm, about a quarter of that of the United States.26 The US Energy Information Administration estimates that Poland and France hold the largest reserves of shale gas in Europe (they have estimated reserves large enough to make them self-sufficient for the next three decades).27 Significant estimated reserves are also said to exist in the UK, Germany, Belgium and the Netherlands, certain Scandinavian countries, Romania and Ukraine. Shale gas exploitation in Europe is considerably more complex than the United States for a number of reasons (including ownership of mineral resources, population density and geology). For a while, it seemed that the regulatory framework would have added another layer of risks as the EU was considering imposing specific shale gas regulations. However, the UK and Poland argued that there was no need for additional legislation that would stifle investment. Instead, on 22 January 2014 the Commission published a set of minimum principles that MSs should implement in connection with the regulation of the exploration and production of hydrocarbons using high volume hydraulic fracturing (i.e., “fracking”).28 These guidelines are non-binding, although the Commission has indicated that it may establish binding law in mid 2015 if MSs fail to apply them in an effective manner.
Nuclear power is even more controversial than shale gas in terms of public acceptance. It nonetheless accounts for roughly one-third of Europe’s overall power generation.29 However, governments are polarized in Europe, and while nations such as France and the UK rely heavily on nuclear power, others such as Germany oppose it and have committed to phasing out their nuclear reactors altogether. Pronounced differences in national nuclear energy policies, and the principle that the energy mix is left to each MS to decide,30 have prevented the EU from developing a common nuclear energy policy.
Promoting foreign gas supply
Apart from reducing its reliance on imported gas by developing renewable and nuclear power as well as unconventional hydrocarbons such as shale gas, the EU is also looking at diversifying its sources of imported gas, in particular through the development of the so-called Southern Corridor.31 This would link Europe with gas from Central Asia and the Caspian and Black Sea areas. Supply would mainly come from Azerbaijan and possibly Turkmenistan. The UK also proposed to work with the Middle East and to explore the export of Iraqi gas into the Southern Corridor.32 North Africa and the Eastern Mediterranean are other regions in which the EU is seeking to develop future gas supplies.
Apart from piped gas, the EU already imports significant amounts of Algerian, Qatari and Nigerian LNG and increased LNG reception facilities have been constructed or are being considered in several MSs – which may be welcome in view of possible US LNG (see further).33 LNG also entails fewer supply disruption risks compared to piped gas, as a tanker can be re-routed to another gas-producing country and/or terminal.
Apart from regulatory constraints (e.g., capacity use; third-party access) and opportunities (subsidies for pipeline construction), the gas market is also framed by contracts between commercial partners. Contracts can relate to infrastructure investment and use as well as to gas supply arrangements. Long-term gas supply agreements in particular facilitate infrastructure investment.34 There is a high level of interplay between this legal/regulatory space and the contractual space.
Additionally, contracts are increasingly being challenged either directly by contract parties or by authorities. Contract parties – in particular the buyer – frequently try to renegotiate long-term supply agreements, typically arguing that the price (indexation) or take-or-pay clauses are unfair. This is sometimes resolved amicably, while at other times arbitration proceedings are initiated. The Commission has also intervened in this contractual space by initiating proceedings for alleged anti-competitive behavior.
Commission’s new energy security strategy
In a reaction to the geopolitical events in Ukraine and the EU’s dependence on imported energy, on 28 May 2014 the Commission adopted a new European Energy Security Strategy (Strategy), with the aim of strengthening SoS.35
The Strategy is based on an in-depth study of MSs’ energy dependence and addresses medium- and long-term SoS challenges. Not surprisingly, MSs in the East and South-East of Europe are most vulnerable to supply disruptions. The Strategy not only focuses on gas concerns but also on oil, coal and power.
While it is heralded as a new comprehensive strategy, it does not really propose a whole new set of measures but instead brings together the existing SoS pillars (diversifying external energy supplies, upgrading energy infrastructure, completing the EU’s IEM and focusing on energy efficiency) as described in this note, and seeks to further fine-tune and reinforce them.36
For example, the Strategy emphasizes the need for cross-border gas infrastructure as already developed under the aforementioned Energy Infrastructure Package of 2013 and singles out 27 gas projects that are “critical for EU’s energy security in the short and medium term … and the Commission therefore intends to intensify its support for [these] projects by bringing together the project promoters to … speed up project implementation … and relevant Ministries to ensure strong political support.”37
The “speaking with one voice”-doctrine in external EU energy policy is not new either, although the Strategy includes proposals to make this more concrete for the first time. For example, the Commission will analyze the development of a “single buyer” model or a “voluntary demand aggregation mechanism” that would increase the bargaining power of European buyers vis-à-vis gas suppliers.
The Strategy also calls for more homegrown energy. This includes renewables, exploiting existing gas reserves and shale gas, which “could partially compensate for declining conventional gas production”.
In terms of additional and/or alternative gas suppliers, the Strategy emphasizes a reinforced partnership with Norway as well as with Azerbaijan (Southern Gas Corridor), North Africa (Algeria, Libya) and Arab states (Iraq and Iran if sanctions are lifted). LNG is praised for its flexibility and the EU is therefore looking at (increased) supplies from Qatar, Australia, Nigeria, and possibly from the United States (although the Commission recognizes the competition for cargoes going to Asia).
It comes as no surprise that the Strategy focuses on the EU becoming less reliant on Russian gas. The Commission clearly singled out Russia when it stated that the South Stream project “should be suspended until full compliance with EU legislation is ensured and re-evaluated in light of the EU’s energy security priorities.” The Commission also criticized the fact that there is neither diversification nor back-up of nuclear fuel assemblies for Russian-designed reactors operating in Europe (which account for 40% of the reactors in operation) as these are supplied as an integrated package by TVEL.
Similarly, the EU will consider measures to protect strategic or critical energy infrastructure and particularly those controlled by “non-EU entities, notably state-companies, national banks or sovereign funds from key supplier countries.”
The possibilities for increased indigenous European production, or increased supplies from anywhere but Russia, will involve not only a lot of time but also money.38 The Commission recognizes this and hopes that by making funding available – through the EIB or national investment banks – this will leverage additional private capital investment participation.
The proposals of the Commission, including actions to ensure uninterrupted supplies this winter, were discussed by the European Council on 26–27 June and will be further implemented this year.
III. US perspective on energy security in a transatlantic context
Together, the EU and the United States represent the world’s largest energy market. Over the years, the EU and the United States have been broadening the transatlantic energy dialogue. In November 2009 they established the ‘EU-US Energy Council’ to promote transparent and stable global energy markets.
At the 2014 EU-US Energy Council summit,39 parties confirmed the SoS measures discussed above in terms of supply diversification, increased production of domestic energy resources, etc. Reference was made to the Trans-Atlantic Trade and Investment Partnership (TTIP) currently under negotiation, with the idea being that a trade agreement in energy would form part of the TTIP. This would end US limits on exports of natural gas and possibly open the way for shale gas exports to Europe. The four Visegrad states of Poland, Slovakia, Hungary and the Czech Republic recently petitioned the US Congress to begin such exports.40
Of course, for exports to commence, the US Department of Energy must approve the export terminals (exports of gas from the United States to a country with which the United States has a free-trade agreement (FTA) are fast-tracked). To that end, the US Department of Energy has introduced new streamlined procedures for the approval process, so that a project may “jump the queue” if it hurries to complete its environmental reviews. At this writing, one project has been approved and 14 proposals are being studied by FERC, the United States energy regulatory agency.41
IV. And what about Russia?
Russia owns 45 tcm of gas reserves, which amounts to 23% of the world’s total proven reserves.42
In order to maintain or even increase its current production levels, Russia must invest heavily in its gas production capacities. Gazprom’s major producing fields are already in decline, including the “Big Three” (Yamburg, Urengoy and Medvezh’ye). To compensate for declining output from these fields, Gazprom has to develop new ones. And, perhaps also in the wake of the events in Ukraine, attention is now focused on the massive Charanda and Kexytka fields, which will eventually become the primary source for the gas to be sold by Gazprom to China National Petroleum Corporation (CNPC) in a major (38 bcm/y) deal signed on 21 May 2014. To access these fields in remote eastern Siberia, however, Gazprom must use prepayments (and other financing) to complete the world’s longest pipeline, the 3,200 kilometer “Power of Siberia” pipeline to deliver the gas to East Asia.
Russian gas exports to Western Europe are predicted to increase by only 30bcm/y in the Russian Energy Strategy 2020.43 Since the adoption of the EU’s Third Energy Package, Russia has made it very clear that it was unhappy with certain of the new obligations, notably on unbundling,44 gas transport capacity allocation and third-party grid access.45 Resolution was sought for years informally through the Russia-EU Energy Dialogue and the EU Russia Gas Advisory Council (part of the Russia-EU Energy Dialogue), but with little outcome. On 30 April 2014, the WTO received a request for consultations from the Russian Federation against the EU Third Energy Package and the implementing legislation by MSs in relation to the unbundling and third-party grid access rules, which allegedly are inconsistent with a number of obligations under GATT, GATS and the Agreement on Subsidies and Countervailing Measures and the Agreement on Trade-Related Investment Measures.46
Like the EU, Russia has been keen over the last few years to develop alternative transit routes so as to reduce its dependence on Ukraine as a transit state for gas supply to Europe (e.g., the Nord Stream and South Stream gas pipelines).
With the European gas market becoming more problematic, Russia fears that the Third Energy Package is a wedge issue, and that rather than Russian being a monopoly supplier, Europe threatens to become a monopsony buyer. With that in mind, Russia has shown not only by the inking of the Gazprom-CNPC deal, but also by lifting the monopoly on LNG export projects, that not only the “Power of Siberia”, but also LNG (Rosneft’s Sakhalin-1 project, Novatek’s Yamal project, and, further on, Gazprom’s Vladivostok project) all promise to reduce Russian dependence on Europe in the longer term – at which point Europe may have already significantly reduced its dependence on Russia.
V. Outlook and implications for industry
Security of supply has an important investment component. The establishment of large-scale gas infrastructures is very capital-intensive, with construction costs for pipelines running into billions of euro. As a result, a clear, transparent and predictable framework for energy transactions is very important for investors. While the existing framework already poses challenges to investors (e.g., secure bankability for pipeline projects in view of EU regulatory restraints on third-party access) but also to shippers/suppliers (e.g., secure gas pipeline capacity that matches their long-term contractual supply obligations), it remains to be seen if any new proposals that may follow from the new European Energy Security Strategy will not further muddle this already complex framework.
In addition, the EU seems keen to have a say in the more commercial aspects of gas projects, ranging from enhanced transparency over commercial terms to limiting the (long) duration of supply agreements and to setting up an EU agency acting as a single buyer. It remains to be seen if the EU dares to touch on the commercial legal basis of European gas security (i.e., long-term supply and transport agreements), which it could always do under the pretext of antitrust enforcement. Stronger enforcement of the EU energy regulations governing the entire gas supply chain (exploration of (un)conventional resources; gas import, midstream and downstream transport; wholesale trading) are announced in the new European Energy Security Strategy, certainly when foreign (non-EU) companies or states are part of the business activity concerned.
Finally, new opportunities may arise from piped gas from Central Asian states (for the EU) or to Asia (for Russia) as well as from LNG cargoes. At the same time, significant infrastructure investments are needed throughout the EU (interconnections, LNG, storage), Russia (pipelines) and the United States (LNG terminals).