Select Committee on European Union Written Evidence

Memorandum by Dr Frank Umbach, German Council on Foreign Relations (DGAP)


Personal Analysis for the Sub-Committee on Foreign Affairs, Defence and Development Policy, House of Lords, Great Britain

  1.  Strategic Energy Partnership: In October 2000, the European Union (EU) and Russia have initiated an "energy partnership" to discuss all questions of common interest relating to their energy sectors and mutual energy cooperation. Both sides have declared themselves as "natural partners" in the energy sector. Until 2006, for the EU, Russia had been a reliable energy partner for many years, even during the Cold War and periods of internal difficulties. The overall objective of the energy partnership aims to:

    —  enhance the European energy security by binding Russia and the EU into a closer economic-political relationship due to long-term nature of investments in energy production and transport;

    —  open and integrate energy markets on both sides, reflecting the "strong mutual dependency and common interest in the energy sector"; and

    —  "to improve the investment opportunities in Russia's energy sector in order to upgrade and expand the energy production and transportation infrastructure as well as improve their environmental impact, to encourage the ongoing opening up of energy markets, to facilitate the market penetration of more environmentally friendly technologies and energy resources, and to promote energy efficiency and energy savings".

  2.  In many ways, Russia seems to be the natural energy partner for the EU: It holds the world's largest natural gas reserves (48 trillion cubic meter), the second largest coal reserves, the eighth largest oil reserves, and being already the world's largest exporter of natural gas, the second largest oil exporter (only behind Saudi Arabia) and the third largest energy consumer. At present, Gazprom alone supplies almost 25% of the EU's natural gas needs, and the EU buy's 70% of Russia's oil and gas exports. For modernising and expanding its energy sector, Russia needs more than $900 billion by the year 2020. In this respect, the EU appears as the perfect modernisation partner of Russia. The supposed mutual interdependence on energy, trade and investments has been seen as the major strategic factor of the EU relations with Russia. This strong mutual interest and interdependence suggest that energy is an ideal sector in which relations can be progressed significantly—a kind of test case—for the further development of an EU-Russia strategic partnership. Success in the energy sector could then serve as a model for other areas of common interest.

  3.  Given the political instabilities in the Middle East, the natural solution for Germany and the rest of the EU seems to be to expand imports of oil and particularly natural gas from Russia for satisfying its rapidly growing gas (import) demand. At first glance, there are indeed a number of persuasive reasons (not least the argument of improved political stability) for a drastic escalation of energy imports from Russia, being the EU's fifth largest trading partner (after the US, Switzerland, China and Japan). However, the results of the "Thematic Groups of the Energy Dialogue" and the newly created "EU-Russia Permanent Partnership Council (PPC)" on Energy in December 2006 to address energy strategies, forecasts and scenarios and other cooperation issues have been limited and rather disappointing due to different strategic interests on both sides and Russia's renationalization policies of its energy sector. Furthermore, Russian energy export policies, in particular pipeline routes (which are often determined by geopolitical considerations rather than just an economic calculus), are still seen in the Kreml not just as an tool of its economic/energy policies but also as one of its very few effective foreign policy instruments to preserve and maintain its "strategic interests" in neighbouring countries which are either highly dependent on Russian energy sources or function as important transit states. In this light, the EU has been unsuccessful in persuading Russia to pursue a market-oriented energy policy or in aligning the "EU-Russian energy partnership" with market principles.

  4.  Russian-Ukrainian Gas Conflict of January 2006: The energy conflict between Moscow and Kiev, importing a third of its energy from Russia, has shown that the Russian government and President Vladimir Putin are prepared not only to use its energy to force customers to pay much higher prices almost over night, but also as a foreign policy tool to pressure customers to concede to Moscow's geopolitical interests. Ukraine's "Orange Revolution" in December 2004 and the demise of the Kuchma government not only tore it out of Moscow's sphere of influence, but was also a personal setback for Russia's President Vladimir Putin, who had backed in an unprecedent way the losing presidential candidate, Viktor Yanukovich. However, it provoked a national-democratic backlash in Ukraine that ended up strengthening Viktor Yushchenko and increasing international criticism at Putin's foreign policy toward Ukraine. Shortly before the outbreak of the conflict, Gazprom took steps in order to ensure its leverage by blocking all other regional producers from providing Ukraine with alternative sources by buying up all of their production itself such as those of Turkmenistan. The intended gas conflict was also a new attempt by Putin to influence the forthcoming parliamentary elections in Ukraine in March 2006. As the Russian reformer and head of the liberal Yabloko party, Grigorii Yavlinskii criticised: "Right now, instead of helping Ukraine move along [toward Europe] and moving along with it, Russia is uselessly trying to prevent Ukraine from doing so, and is itself trying to pursue some sort of `third way'. In reality, there is no `third way'—there is only the Third World".

  5.  Furthermore, Moscow was not so much interested at world market prices than to acquire the Ukrainian pipeline system—especially after Moscow took over the ownership of the Yamal-gas pipeline on the territory of Belarus in December 2005. Already before, Gazprom has tried to buy into the gas-distribution networks in Hungary and Poland to regenerate itself as a great power in Europe and beyond. It has also put immense pressure on the Georgian government to cede control over the gas pipelines that ship gas from Russia to Georgia and beyond to Armenia. However, Georgia and Ukraine have opposed any Russian ambitions to take over their pipeline system which would have severe consequences for their pro-Western foreign and security policies.

  6.  Renationalization of Russia's Energy and Resource Sectors: Because economic circumstances have changed, the Russian government is now undermining production agreements (Sakhalin 1-2, Kovykta) that were signed in a period of low energy prices in the early 1990's, but its flaunting of contractual agreements will permanently scare off investors in the future. Thus Western investors are not permitted to hold more than 49% of Russian companies. This limitation is unlikely to dispel reservations or create an investment-friendly climate in Russia. In practice, western shareholders of Russian energy companies must content generally themselves with much smaller stakes.

  7.  Implications for the EU: The bilateral ties between European gas companies and Gazprom resemble very much like "cartel-like relations", which tend not to be very transparent, and very protective of the market position of European importers of Russian energy resources. Until very recently, the EU and its member states have granted Gazprom access to the European downstream assets without opening the consumer markets in Europe as well as the production sector in Russia. But for the EU's future energy security and liberalizing its energy (and particularly gas markets) it is highly important to guarantee fair competition rules and the reciprocal opening of the Russian energy markets in order to minimize the risk of downstream monopolization by Gazprom and other producers. On 19 July 2006, Putin has signed the new law "On Natural Gas Exports", which has legalized the Russian gas export monopoly de jure. It has wide-ranging consequences for the EU because any effective downstream competition with a total legal monopoly on the supply end is hardly realistic.

  8.  Emerging Russian Gas Crisis: Russia's reputation as a reliable EU energy partner is also undermined by the imminent threat of a dramatic gas shortfall-one that, until mid-2006, both Moscow and Gazprom's European energy partners completely denied. Although Putin finally acknowledged this supply gap in domestic discussions in September 2006, he did not reveal its full scope or bring transparency to the issue, which is all-important for the European Union.

  9.  With over 47 billion cubic meters of natural gas reserves (26% of global reserves) but covering 50% of its own domestic energy demand, there are two main reasons for the Russian gas crisis: 1) the decline in output from the vast natural gas fields in the region of Nadym Pur Taz (NPT), and 2) an unwillingness on the part of the state energy giant Gazprom to make timely investments in developing new fields in Russia itself. Although Gazprom has adequate capital, it has failed to develop any major new fields apart from the gas deposits in Zapolyarnoye, which can mitigate the effects of the NPT decline only for a short time.

  10.  The Research Institute for the Economics of the Gas Industry (NIIGazekonomika), a Gazprom subsidiary, has recommended a dramatic change of strategy: Russia should decrease exports of natural gas to European markets and concentrate instead on developing new gas fields to keep up with domestic demand. The latter will rise up to 654 bcm per year instead of Russia's Energy Strategy's estimate of 436 bcm until 2020. Therewith, it has confirmed Western experts who have criticized the lack of investment into new gas fields and pipeline construction and maintenance as a growing threat to the EU's gas consumption.

  11.  Gazprom's and the Kremlin's priorities are not the modernization of its gas sector or even customer satisfaction, but rather rent-seeking and the expansion of its monopoly power. During the last four years (2003-06), Gazprom has spent nearly 18 billion Euros on the acquisition of shares in companies outside the gas sector backed by the Kremlin's strong support. This is more than had been invested in the development of upstream gas production in a decade. As the result of failing investment in the exploration of new gas fields, confirmed by the IEA, a deficit of gas supplies is expected to Russia and Europe of 100 bcm per year in 2010 compared to actual demand. Already today, Russia is increasingly dependent on gas imports from Central Asia and the Caspian region (80 bcm) in order to satisfy domestic gas consumption and maintaining high-price exports to Europe.

  12.  Meanwhile, also Russian officials have confirmed the gas deficit. On 19 June 2007, the Deputy CEO of Gazprom, Alexander Ananenkov, indicated that the gas agreement with China of 2006 (delivering 80 bcm to China annually) could be given up because Russia needs the gas for its domestic markets as well as for maintaining its gas exports to Europe. On 2 August 2007, the Russian government demanded from the Sachalin-2 consortium to sell all gas to Gazprom and not directly to China, Japan and other Asian markets because of its increasing domestic gas consumption. In November 2007, the Russian Ministry for Economic Development and Trade warned that a gas deficit is emerging in 2010 which could constrain the domestic gas market.

  13.  Implications for the EU: Russia's gas production is expected to rise from an estimated 608 bcm in 2003 to 655 bcm in 2010 and 898 bcm in 2030 (IEA in 2004). Net exports of gas are hoped to increase from 169 bcm in 2002 to 182 bcm in 2010 and 274 bcm in 2030. Even in the case that Russia may export as much as gas as originally expected in its Energy Strategy of 2003 (274 bcm in 2030) and would not diversify its gas exports to the Asian and US markets (LNG), it is totally insufficient in regard to the EU's gas imports in 2030 (488 bcm), which can only been covered by gas imports from other countries and regions such as Norway, the Middle East, Central Asia/Caspian region and Africa. With other words: The EU is forced to diversify its gas imports. In this respect, the EU is in a very favoured position: Unlike any other region of the world, the EU is geographically surrounded by many gas-exporting countries within a range of 3,000-3,500 km, which can be connected by pipelines. However, most of them are considered as politically unstable.

  14.  Hope on Russia's "independent" gas suppliers? Theoretically, these independent Russian gas producers could partially close the supply gap if the Russian domestic market were made more attractive by raising prices. Russia's 2003 national energy strategy foresees independent companies covering roughly 20% of natural gas demand by 2020 (compared with 13% now). Based on its own projections, the IEA hopes that independent suppliers will account for 40% of the market in 2015-meaning deliveries of 260 to 290 bcm of natural gas. Even so, Novatek and TNK/BP are probably the only companies capable of making a substantial contribution. Reserve levels and available capital are already placing limits on gas-producing oil companies like Rosneft, which are also being lured by the prospect of greater profits in the oil business. This means that the more conservative approach in the 2003 national energy strategy, which envisions a contribution of 120 to 135 bcm, or perhaps even 150 bcm in 2015, seems probably more realistic. Moreover, the amount of gas contributed by independent players will depend on their capital resources and on formal guarantees by Gazprom that they will be able to utilize its network. At the moment, both are highly questionable since they undermine the vision of a vertically integrated energy behemoth controlled by the Kremlin. In the future, independent companies are likely to face even greater restrictions in accessing Gazprom's network. The more quickly Gazprom depletes its own reserves, the more companies it will need to purchase to make up for its gas shortfall. In such a scenario, it is extremely doubtful that the weakened, once-independent companies taken over by Gazprom will be able to maintain their high production levels.

  15.  Furthermore, a full independence of these gas producers is also a political chimera because they always include other state-controlled companies such as Gazprom (in the case of Novatek) or Rosneft and they must sell their gas to Gazprom for exports since Gazprom has an exports monopoly. And they have to act in respect of the Kremlin's declared strategic and geopolitical interests inside Russia and beyond. Ownership of the companies does not equal with real independence.

  16.  Rising EU-Competition with Russia towards Central Asia and the Caspian Region (CACR): Russia's recent policies of a bilateralism with Hungary, Austria, Italy, Greece and Bulgaria are part of a larger strategy to undermine a common European policy toward Central Asia and in particular the Nabucco-pipeline project, which is of crucial importance for the EU's energy security and the diversification of energy supply. Russian politicians and advisors to the Kremlin are very frank about their objections towards a direct pipeline between Central Asia and Central Europe. By circumventing Russian pipelines, the Nabucco project would result in a "loss of money and strategic influence" for Russia. From Moscow's perspective this could potentially trigger "a geopolitical" and "energy crisis". In that context, German and EU policy-makers are overlooking two important facts:

    —  Independent gas pipelines from the Caspian region to Central Europe would force Russia to invest in the exploration of new gas deposits in their own territory. This, in turn, would secure long-term Russian as well as European gas supply.

    —  The Russian focus on gas imports from Central Asia has geopolitical reasons and contributes to the "gas crisis" in Russia. Moscow has thus become a less reliable energy supplier for Europe.

  17.  The aftermath of the EU Spring summit of March 2007 has seen European energy companies, with the backing of their respective governments, intensify their relations with Moscow. In light of such bilateral energy deals, the European Council conclusions run the risk of becoming political lip service. The construction of the Nabucco-Pipeline needs to be supported more decisively by Germany and the EU. The United States' policy to secure the Baku-Ceyhan and Baku-Erzurum pipelines should be seen as a model in this regard. Otherwise, Russia will be able to successfully undermine the EU's options to diversify its gas imports even before the first steps of a common external energy policy can be implemented. From a strategic viewpoint this situation is unacceptable for the EU. But short-sighted national special interests are threatening a unified approach to the EU's external energy policy.

  18.  Mutual and Symmetric Interdependency between EU and Russia: the argument that pipelines make suppliers and buyers fundamentally dependent on one another is overlooking the following facts at least at the short-term perspective:

    —  It is only true as long as both sides do not have and do not seek access to alternative markets.

    —  Both sides must recognise the economic-political interdependence and guide accordingly their strategies and policies. However, that interdependence is not fully been accepted on the Russian side. They deliberately ignore Russia's corresponding dependency on Europe as a market for Russian gas. In political reality, the EU-Russian relationship can be rather characterised as an "asymmetric interdependency".

    —  Russian foreign and security experts have speculated—to some extent rightly—that EU politicians and industrial decision-makers tend to a policy of anticipatory kowtows towards Moscow ("silence for gas"). As the Representative of the EU's Common Foreign and Security Policies (CFSP), Mr Javier Solana, has warned on 20 November 2006: "We may have to deal increasingly with governments whose interests are different from our own and who do not necessarily share our values. Sitting on huge reserves of oil and gas gives some difficult regimes a trump card. They can use energy revenues for purposes which we may find problematic. And it shields them from external pressure. Thus, our energy needs may well limit our ability to push wider foreign policy objectives, not least in the area of conflict resolution, human rights and good governance".

    —  There is a major difference to the situation of the Cold War when Russia proved to be a reliable energy partner: During that days, Russian gas exports to Western Europe were seen in Moscow primarily as an economic tool to earn much-needed hard currency for the USSR as a declining economic and military super power. Today, Putin and his followers are seeing Russian oil and particularly gas exports to the EU-27 not just as a very important economic tool but also as a foreign policy instrument that demands respect for Russian geopolitical interests and ambitions—particularly in Europe and Eurasia.

  19.  Conclusions and Perspectives: Given the EU's rising oil and in particular gas (import) demand and its geographical vicinity to Russia, there is no real alternative to a long-term engagement policy towards Russia. The lack of congruence in the EU energy foreign policies towards Russia, however, made it easy for Moscow to "divide and rule" the Union and to enforce the "bilateralisation" of its energy political cooperation with the individual EU member states and their national energy champions.

  20.  For the EU-member states, a conflict of goals has occurred: The EU's energy foreign policy will either further complicate EU-Russia's relations, or given the EU's consideration of Russia's energy and security interests, put into question the Central Asia and diversification strategy of oil and gas imports from CACR. However, the EU cannot forego diversifying its imports of natural gas from CACR because (1) the Kremlin is exploiting energy dependencies as means of foreign policy, and (2) Russia solely cannot meet the forecasted EU's natural gas demand until 2030, if their need does not mitigate. Furthermore, in the light of the EU's foreign and security interests, it has no alternative than to extend and to deepen its relations with CACR.

  21.  Putin's energy foreign policy is in bold contradiction to both the EU-policy of liberalizing the European gas- and energy markets, its neighborhood policy and CFSP. A more long-term energy cooperation with Russia implies a more concrete definition of EU's own strategic interests in its energy foreign policies, which, however, should not be exhausted in a "Russia first"-policy. Hence, the EU's strategy should both aim at an energy partnership with Moscow being equally entitled, and be dedicated to a distinct reciprocity in the opening of energy markets on each side.

20 December 2007

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