Nord Stream 2: Energy Security and Russian Influence Across the Eurozone

Bernd Wuestneck/dpa, via Associated Press

By: Yoran Henzler and Luke Zapolski

Created on the ideological foundation of an “ever closer union,” the European Union (EU) consists of 28 economically wedded nations. Despite the EU’s image as a singular European family with common monetary and agricultural policy, it finds itself on uncertain footing in matters of energy security.

Europe’s energy markets are highly fragmented and characterized by regional pricing disparities. This lack of homogeneity across national energy governance has pushed the EU to extend the notion of European unity to the energy sector, as it seeks to create an “Energy Union.” Yet, while the European Commission attempts to tackle this broad mission of creating a singular and liberalized gas market, it has yet to make clear whether energy security will be governed by policies that promote consumer’s interests or by geopolitical politicking.

The debate surrounding EU energy regulation has been brought to the forefront by Nord Stream 2 (NS2), a gas pipeline running from Russia to Germany that is financed and operated by Kremlin-owned energy behemoth Gazprom. The pipeline has challenged the jurisdiction of EU governance, turning up the heat and igniting a fiercely contested debate as to whether the EU should intervene and stop the project on the basis of foreign policy concerns or allow completion of the pipeline under existing regulatory frameworks.

 On September 5, 2015, Gazprom and five Western European oil companies inked an agreement to build NS2, an offshore natural gas pipeline that runs through the Baltic Sea to connect Russia and Germany. Running 1200 kilometers, the pipeline will operate similarly to its predecessor, Nord Stream, and will carry a combined 110 billion cubic meters (bcm) of Russian natural gas to Germany each year. The pipeline has transcended the boundaries of a commercial project, becoming the focal point of a charged discussion on national security. NS2 has exacerbated European fears regarding Russia’s threat to the region’s security, as many believe the pipeline could become a source of Russian leverage, thereby undermining energy security. Ultimately, the project brings to light the scope of the EU’s policy toolbox of regulation and law and prompts the question: does the EU serve as a neutral market regulator or should the Commission wield its power to secure regional security interests?

 This article weighs the pros and cons of each side of the debate surrounding the EU’s course of action for NS2, with correspondent Yoran Henzler arguing for a political approach that prioritizes security interests and Luke Zapolski arguing for a market-based approach that prioritizes economic efficiency. 

Yoran Henzler: Prioritizing Security Interests

Nord Stream 2 undermines EU energy security rather than safeguarding it, providing Europe a false sense of security while putting it further into the hands of a nefarious actor. Completion of the project gives Russia increased capabilities to disrupt the political climate and leverage its energy position as a foreign policy tool. Rather than providing a secure pipeline for energy supplies, NS2 increasingly disadvantages the EU as Russia will increasingly look to manipulate the asymmetries of its relationship with its largest importer.

The EU serves to be a political union as much as it is an economic union, consisting of both a commission and parliament and having member states committing to a Common Foreign and Security Policy. Although the EU has stressed the importance of being a neutral market regulator that champions competition and liberal markets, its priority above all is to protect and maintain the security interests of member states. When nefarious countries such as Russia hold such market influence that serve to potentially threaten the EU’s security through the use of its “gas weapon”, matters of national security outweigh a market-based approach.

Russia has consistently illustrated its willingness to act heinously in order to achieve its political aims, the latest action being the poisoning of opposition leader Alexei Navalny. Key leaders across Europe have voiced concerns about Russia’s behavior becoming increasingly reckless since construction of the pipeline began, including European Commission President Ursula von der Leyen. While Germany outlines that the project is strictly commercial, it has become progressively more difficult to separate Russian commercial projects from its patterns of political conflict, election meddling, and opposition suppression that has only intensified in recent years. Although the pipeline is 94% completed, the EU must recognize Von der Leyen’s concerns. It needs to begin prioritizing the region’s national security and assess the political impact the pipeline has on countries, rather than solely on economic interests. Even American allies across the pond have cried out that the pipeline stands to become an umbilical cord that further intertwines Europe to the meddling of Russian influence, imposing strict sanctions aimed at stopping completion. Rather than the debate revolve around the commercial interests of the pipeline, the EU instead needs to discuss diversification strategies that wane itself from Russian gas dependence in order to maintain its legitimacy and influence across matters of international geopolitics.

These diversification strategies were explicitly drafted in the Energy Union Strategy in 2015, which aimed to focus on non-Russian energy sources and ensure security and consolidation across EU member states. NS2 directly competes against this directive, as Europe currently imports 40% of its energy supplies from Russia and completion of the pipeline would only increase its dependence. The intent of the Energy Union was to create a common energy strategy across member states so that the EU could utilize its regulatory toolbox in a more strategic and targeted manner. This allows them to promote liberal markets and competition while keeping powerful players, such as Russia, in check and unable to destabilize markets. Russia has consistently proven its unreliability as a gas supplier who has intentions to leverage its position to exert its aggressive foreign policy.

In 2006 and 2009, Russia halted the gas supply to Ukraine in order to demand repayment of outstanding debts due to Gazprom. Russia has also used its gas weapon to undermine democratically-elected governments in both Ukraine and Georgia, siphoning off pipelines and stopping the flow of gas in response to more pro-EU stances taken by democratically elected leaders. These archetypal Russian supply disruptions that destabilize energy security had led experts in Eastern European nations to expect potential disruptions of up to 40% if Russia chooses to shut off NS2. Eight Eastern European leaders have signed a letter that openly rejects NS2 on the premises of it paving the way for “potentially destabilizing geopolitical consequences”.

The European country who stands to lose the most from completion of the pipeline is Ukraine, whose proximity to Russia continues to place it in a precarious position as it looks to move toward more democratic policies while also maintaining relations with the Kremlin. In order to feed Europe its gas supplies, Russia must transport the oil through Ukrainian pipelines that were built when it was under Soviet control. This pipeline network acts as an insurance against Russian meddling, giving Ukraine political leverage over its neighbor while providing critical government revenue through transit fees that Russia must pay, of which Ukraine receives more than $2 billion annually.

Completion of NS2 allows Russia to eliminate the need to cooperate with Ukraine while no longer having to pay expensive transit fees. Rerouting of gas supplies through NS2 rather than Ukraine pipelines further augments the imbalance of power between Russia and Eastern Europe, giving Russia increased leverage to undermine energy security, social cohesion, and democratic advancements of European countries in its periphery. Rather than adding energy security, the pipeline increases Ukranian dependence on Russia while further driving a wedge between EU member countries.

Instead of increasing Russia’s gas supply to the EU energy mix, the EU needs to take advantage of its economic and political weight and take a united front in confronting Russia’s coercive energy tactics. The EU is the biggest energy importer in the world, as well as Russia’s largest gas market, and, therefore, needs to turn the tables on the asymmetries of its interdependence to instead create a more symbiotic relationship with its Eastern neighbor. The EU needs to rebalance supplier and consumer security concerns in order to balance these asymmetries and prevent Russia from using its gas leverage to regulate its political relationships. This can best be done through diversification efforts while still maintaining a cooperative relationship with Russia. The EU should seek to stabilize Ukraine/Russian relationships through directing government investments into outdated Ukrainian pipelines and coming together to the negotiating table to renegotiate pipeline contracts while improving Ukrainian compliance to avoid further fall-out.

Taking on diversification efforts while seeking to improve EU/Russian relations will serve to keep the EU out of its current spiral of security dilemmas, where a EU action creates a Russian reaction, and vice versa. Key diversification developments that need increased focus and investment include the Southern Gas Corridor, an initiative aimed at improving energy infrastructure and supply routes in Southeast Europe. The EU has estimated investment costs of approximately $45 billion in the pipeline, which feeds gas from the Shah Denix gas field in the Caspian Sea through the South Caucasus, Trans-Anatolian and Trans-Adriatic pipelines to member states in the southeast. Other pipeline developments that add to diversification efforts include the Eastmed pipeline, which runs from Israel, crossing through Cyprus, in order to reach Greece. Building relationships with other energy exporters, including Algeria, Libya, and Egypt provide other opportunities for diversification, as well as liquified natural gas (LNG) from the United States. In general though, the complex debate around energy politics should be taken into careful consideration. While it is a lower-emitting energy source in comparison with coal and nuclear, it still contributes massively to carbon emissions worldwide. Progressive and forward-looking legislations such as the Clean Energy for all Europeans Package will carry increasingly more weight. Germany’s well-known ‘Energiewende’, a pact to switch to renewables, could lead by example, ridding itself of the abominable energy dependence on Russia, and embracing the future of energy security at an early stage.

The complexity surrounding energy security requires careful consideration of both political and commercial impacts while seeking to best promote the interests of consumers. While NS2 may be commercially viable, the EU can no longer separate this pipeline project from foreign policy assessment and must instead look for more sound alternatives that do not threaten the security of member states.

Luke Zapolski: Prioritizing A Market Based Approach

Rather than attempting to stop a privately financed commercial project based on an undefined foreign policy assessment, the EU must instead evaluate the prospects of NS2 under the merits of existing competition and regulatory frameworks. Charged political discussions in matters of national energy security have become largely irrelevant, and, instead, undermine the accomplishments of the EU’s directive of forming an Energy Union, while blatantly ignoring the commercial realities of today’s energy market in Europe.

Through the process of connecting scattered gas markets through regulatory and competition law, energy supplies across the European bloc are no longer procured through long-term “take it or leave it” contracts with monopolies that force unfair prices onto consumers. Instead, the proliferation of trading hubs across the EU offers energy contracts at arms-length deals based on “spot prices” that index how much it costs to procure supplies there and then and are highly subjected to regulatory oversight that ensures fair prices. These gas hubs and spot-markets have significantly altered the landscape of gas markets across Europe as increased supplier optionality has largely reduced the potential for monopolistic behavior and unduly high prices. Currently, more than 50% of all energy supplies across the Eurozone are  priced based on spot prices.

Against this backdrop, while memories of Soviet dominance may still linger, these new market developments mean that fears of the pipeline giving Russia leverage to impose assertive foreign policy measures are outdated and based on perceptions that do not align with today’s commercial realities. EU liberalization and regulatory oversight in energy markets have triumphed against Russia’s ability to exert commercial pressure as a dominant supplier, pushing state-owned Gazprom to accept regulatory and competition laws while offering spot-indexed pricing that is competitive with alternative energy sources. Rather than seeking political concessions, Gazprom’s behaviors are defined by a desire to defend its market share across its most prized region, while maximizing revenues and its commercial position. Through increased competition and regulatory practices, the geopolitical threat of Russia using its “gas weapon” has become largely irrelevant as Gazprom is unable to charge higher prices or to reduce deliveries without losing market share to alternative suppliers. Instead of being viewed through the political lens of trying to thwart a threat that is only perceived rather than genuine, NS2 must be assessed on the basis of economic interests.

This market-based approach toward evaluating NS2 must consider how it may potentially further the goals of the Energy Union: creating a competitive and transparent gas market that enhances physical infrastructure, interconnectedness and consumer choice. Although the rise of gas trading hubs have allowed for price divergence to a certain extent, more liquid and integrated markets enjoy more competitive prices than regions who lag behind. Specifically, Western countries such as the UK, Germany, and the Netherlands, which have more established trading hubs that receive an influx of energy supplies from a number of suppliers, offer lower prices.

In contrast, Central European countries are largely home to more regional “transit” hubs that lack the necessary infrastructure, interconnectivity, and liquidity, and, as a result have significant pricing disparities due to an overall lack of competition. Completion of NS2 would accelerate the necessary developments needed to bolster these regional trading hubs, as additional infrastructure will be required to absorb the extra capacity brought on by the pipeline. These developments triggered by NS2 would induce structural reforms including consolidation between regional trading hubs that would increase the interconnectivity and allow for more competitive prices.

As these regional hubs strengthen and become more liquid, they will in turn evolve into full-fledged trading hubs that are competitive with their Western counterparts. Hubs scattered across Central Europe will now be able to exert pricing pressure on Western countries and potentially become “market makers,” where spot-pricing indexation is based on the prices these hubs supply. An unintended consequence of this pricing effect is that it may put even further pressure on Russian prices, essentially making Russian gas compete with Russian gas. Czech traders, for example, may be able to procure Russian gas from a trading hub in Germany for lower costs compared to traditional Russian pipelines.

The region who stands to gain the most from these developments is Southeastern Europe, which significantly lacks the energy infrastructure needed to compete with its northern and western neighbors. Developments in energy markets lag so far behind that the region has found itself in a “two speed Europe,”, where low investment and competition creates energy prices that are considerably higher than their more developed counterparts. The EU has attempted to converge the two pricing systems by launching a number of initiatives to pour investment into the region in order to enhance infrastructure and interconnectivity. The additional gas volumes brought online by NS2 would accelerate these initiatives, creating a vertical corridor that intertwines the north to the south and feeds additional volumes of gas to a growing market. Rather than put into question energy security, NS2 has the opposite effect by increasing competition. The project aligns with the goals set forth by the EU and helps bolster regional trading hubs by supplying them additional volumes and allowing them to reach the scale of their western rivals, thus reducing regional price-differentials and moving the bloc toward a more uniform and competitive pricing system.

It is these structural reforms that best serve to the benefit of Ukraine, rather than the status-quo of its existing transit fee dependency. The current Ukrainian pipeline networks are horrendously aged and require an EU estimate of $3.2 billion of investment to bring the pipelines to full capacity. Russian motives for wanting to reroute already procured energy supplies to Europe are entirely based on commercial interests, as the cost dynamics behind using Ukranian pipelines put Gazprom at a severe disadvantage compared to other pipeline routes. The construction of NS2 brings about a shift of commercial interest to Ukraine: high transit fees and high gas prices for low transit fees and low gas prices. Ukraine will be able to source gas supplies from Western markets that come cheaper than traditional Russian gas, in turn, putting even more pricing pressure on Gazprom. Shifting away from the status-quo of transit fees will additionally force the Ukrainian government to initiate the energy sector reforms that are so desperately needed. Rather than EU energy security being tied to the frail geopolitical relationship between Russia and Ukraine, a country that has notoriously squandered billions of transit fees, NS2 provides further options for transit routes and reduces disruption risk based on Ukrainian geopolitical tensions.

One of the main aims of the liberalization of gas markets in Europe was to ensure market competition that was overseen by regulatory frameworks; yet, the EU has made it increasingly clear that it intends to use its regulatory toolbox to meddle into broader political scheming where it prescribes the normative concepts of good or bad onto commercial projects. Rather than being a neutral market regulator that champions competitive markets and equal application of law to all commercial parties, the EU is increasingly using regulatory provisions to take on selective and targeted action to intervene in free markets with the goal of specific outcomes, in this case: NS2.

The once liberal paradigm is now in the hands of a more mercantilist Commission that risks undermining the EU’s neutrality if it chooses to interfere with NS2. Politically-motivated intervention in the commercial realm has the potential to cause even more geopolitical instability across the region. Instead, it is imperative that NS2 be assessed on its added value to the energy market reforms set forth by the EU.

The views expressed by the authors do not necessarily reflect those of the Glimpse from the Globe staff, editors, or governors.