Lowering the Price of Russian Gas: A Challenge for European Energy Security

Europe's energy discourse has been unjustifiably preoccupied with concerns about potential physical disruptions of Russian gas. The real challenge for European-Russian energy relations, and in fact, for European energy security, lies in settling on a price that leaves both sides content. While Europe will come under increasing pressure to acquire affordable energy resources to enhance its competitiveness, Gazprom may find it increasingly difficult to deliver gas at lower prices in the coming years.

Gazprom's failure to diversify its pipeline exports to Asia has solidified its dependence on sales to Europe (c) Russia Beyond the Headlines

Narratives about energy security in Europe often focus on worries about Russia using its energy as a weapon. Such analyses are misleading, however, as they misread current European gas market realities.

On balance, for more than four decades, Moscow has been a fairly reliable gas partner in Europe. Gas relations with Western Europe started to flourish already during the Cold War - despite strong initial opposition from the United States. During the 1980s, the USSR's drive for developing West Siberia's gas coincided with a rapidly expanding market share for Soviet gas in Europe, generating vital foreign currency revenues for Moscow.

Gazprom and Russia carry a fair share of the blame for the misguided fixation on cuts of gas flows to Europe. The disruptions in relation to Ukraine in the winters of 2006 and 2009 had a dramatic impact on several countries in Central and Eastern Europe, severely damaging European perceptions about Russian gas supplies. This is true even if these disruptions need to be viewed in the context of a complex pricing and payment dispute between Moscow and Kiev, as it would be unfair to define Gazprom as the party with the sole responsibility for the predicament created in Central and Eastern Europe in the immediate aftermath of these crises.

What is more, for many years Gazprom itself played on Europe's sense of insecurity by repeatedly emphasizing, and often overstressing the potential threat of physical disruption of its gas sales to Europe -in this case due to troubled transit countries Ukraine and Belarus. It readily endorsed Europe's energy security narrative that puts the emphasis on the risks of a physical disruption, though with different culprits in mind: the transit states. This helped to justify its two grand pipeline projects, and in fact, to secure significant support among European capitals to implement them.

An additional problem with the narrative fixated on the risks of a physical disruption is that it overestimates the benefits allegedly accruing to the supplier, while underestimating the potential harm that suppliers

For many years Gazprom itself played on Europe's sense of insecurity by repeatedly emphasizing, and often overstressing the potential threat of physical disruption of its gas sales to Europe
would typically like to avoid. The act of deliberately interrupting the supply of gas is very much prone to backfire even with a "reasonable" justification and eventually hurt the supplier. It is an incident that cannot escape the public eye. In fact, even the mere threat to cut off gas supplies can hardly remain hidden, as the importing country can immediately secure international support by exposing the supplier's "plot" and impair its hard-earned credibility. The disruptions in the last decade helped galvanize a more common stance on European energy security that could eventually erode Russia's market position even in Central and Eastern Europe: hardly an outcome Moscow wanted. Not then, not in the future.

Neither Gazprom nor the Russian state appear willing to further risk Russia's credibility as a reliable supplier. Not only is the Russian state heavily dependent on gas export revenues, but Gazprom also remains largely locked-in into the European market. To date, the gas behemoth's failure to diversify its pipeline exports to Asia and its late entry into the international LNG market have solidified its dependence on sales to Europe.

Additionally, Europe is headed towards improved capability to deal with the challenge of short-term disruptions in gas supply. Significant efforts are under way for constructing new cross-border connections and storage facilities. In the near future, countries in Central and Eastern Europe are likely to overcome a gas crisis of the magnitude of the one witnessed in 2009 with substantially less damage. Gazprom's two grand pipeline projects, Nord Stream and South Stream, could also minimize the risk of disruption caused by a third party (transit country), enhancing Europe's sense of energy security.

The price of gas - a key element for energy security

It has become more common today to adopt a broader definition of energy security that goes beyond the traditional emphasis on the physical reliability of supply. The ability to acquire energy at reasonable prices is increasingly recognized as an important aspect of energy security.

The importance of the price of energy is yet to be fully acknowledged in Europe's gas relations with Russia. Why is it so important? First, in an increasingly competitive global economy, the price of energy can be a

With Europe bearing the extra cost of staying ahead of the pack in promoting greener forms of energy, the last thing Europeans need is overpaying for gas to its single most important supplier - Russia
significant part of economic competitiveness for a country and even a whole region. With Europe bearing the extra cost of staying ahead of the pack in promoting greener forms of energy, the last thing Europeans need is overpaying for gas to its single most important supplier - Russia. The problem has the potential to be particularly acute for the new members of the European Union in Central and Eastern Europe (see below).

Second, it is in negotiations over the price of gas where Russia holds substantial leverage which could have potential implications for broader policy choices in European countries. Russia’s options to either placate or punish its European partners remain wide. It is these levers that in reality could matter more than any theoretical possibilities of Moscow abruptly cutting its gas shipments to Europe.

Moscow has an array of options to approach negotiations with European clients: providing ad hoc price cuts; consenting to revise an existing price formula for a few years or for the duration of the contract; agreeing to exempt gas sales from export taxes (which could mean an immediate 30 percent more revenues for Gazprom and more room for maneuvering); flexibility over the portion of gas indexed to spot market prices; flexibility on “take or pay” obligations etc. Each of these options accord Gazprom a substantial clout in Europe.

Notably, in contrast to physical disruptions of Russian gas, negotiations over the price of gas are neither very rare nor are they generally exposed to public view. There are nearly constant negotiations over gas contracts between Moscow and European capitals, and their terms mostly remain proprietary. Due to the nature of these negotiations, it is difficult to find evidence that price negotiations provide a channel for Russia to impact foreign policy and economic choices made in European countries. But such a possibility cannot be ruled out, depending on the size of the stick or carrot Russia could put on the table.

Central and Eastern Europe's vulnerability to higher prices

Reportedly, countries in Eastern Europe, including the Baltics and Ukraine, generally pay substantially higher prices for Russian gas compared to Gazprom’s clients further West. The Bulgarian government, for instance, has repeatedly complained that it is paying more than Greece for Gazprom's gas, even though the gas for the Greek market has to cross its own territory. Notoriously, Ukraine, geographically closer to Russia, has continued to pay more than many other Gazprom clients in Europe. A recent report by Russia's Izvestia highlights the substantial differences in the price of gas across Europe (see Table 1 (source: Izvestia)).

In a comprehensive study about Gazprom's pricing in Europe, a Russian investment bank, Troika Dialog (now integrated with Sberbank), has put Gazprom's European clients roughly into two categories: the "price

Troika Dialog has put Gazprom's European clients roughly into two categories: the "price takers" (nearly all former communist countries in Eastern Europe) and the "price breakers" (Germany, Italy, France and Turkey)
takers" (nearly all former communist countries in Eastern Europe) and the "price breakers" (Germany, Italy, France and Turkey). Eastern Europe has had to pay not only relatively higher prices to Gazprom, but has also faced a greater difficulty in renegotiating the terms of their contracts. For instance, Poland was able to secure a modest reduction in the price of Russian gas in November 2012, but unlike several German and Italian companies, it failed to get Gazprom's consent to index part of the sales to spot market prices.

The presence of such a dichotomy should not be a surprise. Access to alternative sources of gas, LNG or piped gas from a non-Russian source, remains the principal path for European companies to negotiate on better terms with Gazprom. As Table 2 illustrates (source: BP), Gazprom's key clients in Western Europe (including Turkey), continued to diversify their sources of supply during the past decade. All six countries listed managed to reduce the share of Russian gas in their imports. By contrast, in Eastern Europe, with the partial exception of the Czech Republic which invested in access to Norwegian gas, the level of dependence on Russian gas imports has remained nearly the same since 2000. And in fact, not much has changed for them since their days as members of the communist bloc.

It is notable that in the past few years, the share of Russian gas has been declining in countries with access to alternative sources of gas (generally cheaper gas indexed to spot prices). Gazprom's loss of market share to Statoil in Germany has been especially troubling for the Russian major, prompting it to accept several revisions in its contracts. By contrast, Gazprom has retained its market share nearly intact in most Central and Eastern European countries, despite some drop in total sales due mainly to the economic crisis.

In the meantime, it is worth recognizing that Gazprom's selective pricing policy is not always an outcome of its ability to exercise its market power. Evidence suggests that Moscow’s foreign policy considerations also have an impact on Gazprom's pricing. For instance, in 2012, Armenia continued to pay less than half of what Ukraine paid per cubic meter of gas.

 

The second part of this story discusses the uphill battle for Russia and will follow Thursday 14 March 2013.