Home » Economy » Why has Europe had difficulty imposing sanctions on Russia?

Why has Europe had difficulty imposing sanctions on Russia?

Annexation of Crimea, Russian military posturing along the border with Ukraine, demonstrations in Eastern Ukrainian cities, Donetsk’s declaration of its independence – all these sweeping revolutionary metamorphoses in Ukraine prompted the West to respond with a series of economic sanctions against Russia. The sanctions banned around 33 Russian and Ukrainian top officials and businessmen from traveling to Europe and the US, froze their foreign bank assets, and disabled processing Bank Rossiya and SMP Bank Visa and MasterCard transactions, and expelled Russia from G-8. Despite such pressure, so far, the Kremlin continues to dismiss the sanctions as inappropriate and shows no sign of giving in under pressure.

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On the contrary, Moscow increased its pressure on the interim Kiev government, which it views as illegitimate. Meanwhile, Russia’s major power – its energy resources and ability to export them – still remains untouched. Targeting this economic sector would seriously, if not fatally, hurt Russia, since 60% of its state revenue comes from oil and gas exports and constitutes more than a half of its federal budget. But would the gas export ban be only fatal for Russia?

Europe remains dependent on Russian energy
Russia is, by far, the largest supplier of energy to Europe. According to the Energy Information Administration (EIA), European countries import 84% of Russia’s oil exports, and about 76% of its natural gas. The degree of energy dependency on Russia varies across European countries. The Baltic States and Finland are 100% dependent on Gazprom, Bulgaria, Slovakia and Hungary– 80%, Slovenia, Austria, Poland, Turkey, the Czech Republic and Greece –50%. Obama suggests replacing Russian gas in Europe with Liquified Natural Gas (LNG) imports from North America, Australia and/or Papua New Guinea. So far, this idea is but an amusing fantasy for at least two reasons: first, neither European countries nor Ukraine are able to use American LNG because they lack essential terminals to regasify LNG. It might take at ten years or more to technically prepare European terminals to fully utilize American gas, including installation of new pumping systems and other expensive facilities to decompress and store gas. Second, the cost of the LNG gas will be markedly higher than traditional gas piped from Russia – accounting for both its transatlantic shipment and associated infrastructure. The project per se is plausible but unrealistic in the near-term. Given the size and scale of these projects, it will to take years before LNG begins moving from the Gulf coast in substantial volumes. Additionally, the United States is not ready to export sufficient amount of gas to Europe yet – largely accounting for its own needs. In 2013, the US used 736 billion cubic meters of gas (98% of its total) on its domestic consumption, whereas Russia domestically consumed only 456 billion cubic meters (68%). The domestic consumption level inevitably impacts the amount of gas slated for export. Over the past year, Russia exported 190 billion cubic meters of gas, while the US only 44 billion.

 

Europe is looking forward to breaking free from Russia’s dependence on fuel supplies and has enthusiastically started to explore its own potential shale gas reserves. Poland is estimated to possess 346-768 billion cubic meters of shale gas, Bulgaria may host 481 billion cubic meters, Germany has technically recoverable shale gas reserves of 481 billion cubic meters. According to U.S. EIA estimates, Europe could have as much as 13 trillion cubic meters of recoverable shale gas. However, due to regulations on fracking and the generally high cost of European Shale, by 2020, the total annual production of shale gas in Europe is only expected to be 4 billion cubic meters, according to energy consultancy IHS. Regardless of how optimistic or pessimistic one views Europe’s potential production in 2020,  2020 is still 6 years away. Where will Europe get gas to keep its houses warm and lit this coming winter? Another impediment with fracking gas in Europe is its possible impact on the local environment. Probe shafts drilled in Poland have suggested that Europe’s ground structure differs from that of America, making it harder to cost-effectively extract natural gas. Also, political pressure from environmental groups in countries like France and Bulgaria has resulted in the imposition of outright bans on fracking. As a result, Europe is unlikely to experience the sort of “shale gas revolution” that is transpiring in North America.

 

Another energy source that will replace some Russian gas is coal. The US has plenty of excessive reserves of coal and its producers are looking for foreign customers. Because of the low demand over the past three years, the prices on coal have fallen – from $130/ton in 2011 to $75/ton today. In 2014, America is expected to send 100 million tonnes of coal abroad, mainly to the EU. By 2015, Eni predicts, Germany will shut its gas stations that cumulatively produce 10 gigawatts and open coal stations with 7 gigawatts power. According to the EIA, to produce 1 gigawatt hour (GWh) of energy needs 225,000 cubic meters of gas or 490 tonnes of coal. By contrast, for 650 terawatts produced from Russian gas, Europe pays Gazprom $60 billion a year. The equivalent amount of coal (around 340 million tonnes) would cost Europe half as much- $30 billion. On the other hand, a coal plant is still a coal plant, producing roughly twice the CO2 emissions of a natural gas plant, regardless of how much is invested in its emissions control system. WWF estimates the new coal plant planned in Greifswald, Germany, will produce 6.9m tonnes of carbon emissions a year, an amount equivalent to the entire emissions of the country of Tanzania. Coal is not the environmentally-friendly energy source of the future.

Europe could step up imports of Middle Eastern energy, however, this is fraught with issues as well. First, Europe has never fully entrusted its energy security to the Middle East and has no plans to start now. Second, although increasing oil tanker shipments is straightforward, importing Middle Eastern and Caspian Zone natural gas would require construction of thousands of miles of additional natural gas infrastructure. Currently, many of the European refineries in Czech Republic, Poland, Slovakia and Germany still get their crude oil via the Soviet-era pipeline network “Drouzhba” running through Ukraine and Belarus to Europe. In the event of an embargo, those refineries wouldn’t be able function until the logistics are adjusted. Third, OPEC could potentially leverage Europe’s situation to gouge it on pricing. Obama is currently trying to manipulate world oil prices. He has paid visits to Saudi Arabia, to speak with its 80-year-old king about the development of Saudi facilities to extract gas and deliver it to Europe in exchange for reduced oil prices. The idea that jawboning Saudi Arabia into reducing prices will have any lasting impact on the world market is a complete farce.

The most draconian policy Europe could impose would be an embargo on imports of Russia’s oil and gas. However, even with such a policy, the embargo is not going to destroy Russia. There could be cuts (say, by 20% or by 50 million tons) in volume of oil imports by European states. In that case, Russia’s loss would be $35-40 billion a year. At the same time, once Europe introduces the embargo, Russia would look for new customers. Fortunately, there are many potential oil-importers out there – notably, Central Asia and China and oil itself is fungible. Russia will refocus both economically and strategically towards Asia, thereby strengthening China – obviously, to no great thrill to the West.

All of these facts indicate that Europe can’t simply ignore its energy relations with Russia and cut itself from Russian supplies. Energy security in Europe is quite a sensitive matter, which requires a delicate approach to its resolution; in an attempt to screw Russia over, Europe could be shooting itself in the foot.

How could Russia and Europe solve the dilemma?

Europe fears the repetition of the gas supply disruptions in 2006 and 2009 when Russia simply switched the gas flow off in response to Ukraine’s fail to pay its gas bills. Who was to blame in that – Russia’s supply or Ukrainian transit? European governments were collectively blaming Russia and its aggressive rulers, whereas German, Italian, and French leading energy firms were in agreement that it was primarily Ukrainian transit crisis. Who to trust? Well, governments do politics and employ much rhetoric to justify their deeds as well as to attract more votes, whereas companies do business. The current situation in Ukraine has put European countries under the threat again, and has repeatedly shown who has been the major hurdle on the road.
When then pro-Russian president of Ukraine Victor Yanukovich chose not to sign the association agreement with the EU, Putin graciously offered him a $15 billion package of loans plus a generous discount on gas supplies. Now, when Yanukovich fled the country and the new interim government (whose legitimacy Russian authorities refuse to recognize) is assertively anti-Russian and explicitly leaning toward the EU, Russia does no longer feel obliged to provide Ukraine with any subsidies. What’s more, Russia claims Ukraine has not settled its previous gas debts. Naftogaz, Ukrainian national gas company, still owes Russia its unpaid gas bills for March, thereby totaling the debt to $2.2 billion. If Russia suspends the gas supply, Ukraine will need to turn to Europe for loans to pay off its debt in order to continue the transit of gas from Russia to Europe. In other words, Europe will have to take care of Ukraine’s debt, which Ukraine herself can’t reimburse. “Russia is not obliged and no longer going to bail out the Ukrainian economy through discounts and gas and forgiving debts, and through the subsidies to pay off Ukraine’s trade deficit with the EU countries,” said Putin in his letter to the 18 European leaders on April 10. “According to the current contract, Gazprom will have to switch to the system of preliminary payments for gas supplies and in the event of violation of the payment obligations, will have the right to fully or partly suspend the supply of gas. In other words, Russia will provide gas as longas Ukraine pays a month ahead.”
Earlier in March, Alexey Miller, head of Russia’s Gazprom, announced that starting from April 1st, the gas price for Ukraine would be $385.50 per 1,000 cubic meters in the second quarter of 2014 as the conditions of payment had been violated. On April 3, Russia announced the raise of the gas price as high as $485 due to the cancellation of the discount that was included in an old agreement concerning the deployment of the Russian fleet in the Black Sea. To compare, the initial price Ukraine used to pay for Russia’s gas was $268.50 for 1,000 cubic meters of gas (as of December 2013). In addition, during an April 3rd meeting with Mr. Miller, prime minister Dmitry Medvedev announced the cancellation of the so called “zero tariff” on gas for Ukraine. The “zero tariff” was adopted after the signature of the 2010 Kharkiv agreements in exchange for the permit to keep Russia’s Black Sea fleet in Sevastopol after 2017. The agreement implied that if the gas market price is $333 and beyond per 1,000 cubic meters Ukraine is granted a discount of $100, if the price is below $333 – Ukraine gets 30% of that level. Russia authorized this discount through the “zero tariff” on the amounts of 40 billion of cubic meters a year in 2011-2019, which the prime minister has cancelled now after the annexation of Crimea and denunciation of the Kharkiv agreements. The Kremlin now is planning to charge Ukraine for the missing incomes from the exploitation of the “zero tariff”.
Whether Ukraine pays its debt off and buys Russia’s gas at the reviewed prices or it doesn’t, Russia is committed to its European relationships and long-term contract obligations to provide Europe with gas. So far, Russia can’t bypass Ukraine in terms of gas delivery to Europe. However, it is under Gazprom’s control to decide who are his clients. Once Ukraine refuses to pay the full price, Gazprom cuts it off from the gas supply. The way out of such a troublesome situation Ukraine sees in reverse gas supplies from Hungary and Poland. The European pipe-line system can potentially be upgraded so that it can stream gas in the opposite direction – from the West to the East. According to the Slovak gas-transmission operator Eustream, the pipeline will allow “the supply of gas to Ukraine in reverse flow mode already in October of this year, with a volume of 3.2 billion m3 a year. Later on, in March 2015, this capacity could be increased to as much as 8-10 billion cubic meters a year.”
To reverse gas flow from Europe to Ukraine the pipeline needs an interconnection that would connect the pipe in Slovakia with the one that Eustream and Ukrtransgaz are planning to set in reverse mode – in Ukraine. Thus, the gas should physically cross the border with Slovakia, otherwise Gazprom may legally appeal because during the pumping of gas in Ukraine Gazprom is still the owner of that gas and any manipulation with it can’t be done without Gazprom’s permission. Eustream suggests that Ukraine build this technical solution because in addition to its functional effectiveness it will also legitimize the reverse supply of gas. The cost of the project is expected to be €20 million. The construction can be finished by the beginning of this winter. However, the Ukrainian authorities criticize this project as overly time consuming and insist on immediate revers supplies, notwithstanding the warnings from the Eustream that such a deal could violate the contract with Gazprom.

Gazprom to renegotiate the prices

It is not only Ukraine and Europe who have found themselves in an uneasy situation with Russia, Gazprom too has to reconsider its policy in response to the changing gas market reality. European market has been in stagnation since the 2008 crisis and the demand for gas has been relatively low. Hans-Peter Floren of the Austria’s OMV AG board of directors is speaking about oversupply of natural gas in Europe for the next couple of years. He expects the demand on gas in Europe to stagnate till 2020, thus, he suggests the provisions of the long-term contracts should be reviewed, the gas-suppliers should cut the price in order to restore the competitiveness of gas in the energy market. Energy Information Agency (EIA) says that the demand in Europe fell by 7.5% in 2010, and by 3.5% more in 2012.
Despite the tensions and hostile political environment between Russia and the West, European companies still view Russia as their business partner, particularly with regard to its energy sector. In the past two months alone, three major energy deals have been negotiated or signed between European and Russian companies. On April 1st, Hungary signed a 10 billion Euro credit agreement with Russia for an upgrade of its nuclear plant in Paks.
Russia’s Lukoil holds talks with France’s Total regarding the exploration of shale gas in Russia. Italy’s Saipem has signed a $2.8 billion contract to build Gazprom’s new South Stream pipeline. In March, Germany’s RWE sold its oil and gas exploration and production unit to Russian oligarchs for $7.1 billion.
Gazprom now is in a position when it can literally save the situation from rolling further downhill and maintain trust and good partnership with the West. For that it needs to become more flexible and willing to renegotiate its long-term contracts with European clients. Gazprom’s long-term contracts’ price formation mechanism is based on oil indexation. According to Sergei Komlev of Gazprom Export, such a mechanism lays down fair trading conditions in which neither supplier nor costumer can manipulate the price. The gas price is determined by the energy market. Another reason Gazprom does not want to abandon its long-term contract system is that it guarantees minimum annual purchase of gas (“take-or-pay” contract) by a client given the falling demand for energy due to the crisis in the Eurozone. However, being known for its legendary sturdiness, Gazprom has actually started reconsidering its policy: the long-term contracts are no longer unchangeable throughout decades, they are reviewed every 2-3 years and as a result have become framework agreements rather than a decade-long contracts. Eventually, Gazprom has brought its gas prices close to spot prices. If we look at a chart drafted by Thierry Bros of Societe Generale, we will see that in early 2013 the Gazprom prices were different from the NBP (gas hub in the UK, with the highest liquidity in Europe) prices by no more than 5-6%.Moving Gazprom towards market-based pricing and contract terms has served to depoliticize, to an extent, Russian-European energy trading.

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Energy-supply routes diversification

Given that this is not the first time when relations between Ukraine and Russia achieve a boiling point, Russia is seeking to avoid Ukrainian transit in its energy supplies to Europe by all means. The most feasible way out of this conundrum for Russia would be to move gas westwards using routes bypassing Ukraine, whereas for Europe it is both to diversify the pipeline routes and its energy sources.
In 2003, then-President Putin signed an agreement with the German government to construct the Nord Stream pipeline. The two pipelines of the project run almost parallel to one another through the Baltic Sea and provide Russian natural gas to Germany – from Russia’s Vyborg to German port at Greifswald. The lines were completed and set online in 2011. While the construction of a pipeline along the seabed is over three times as expensive as the construction of a similar overland pipeline, Russia benefits immensely from its investment, as Nord Stream bypasses Ukraine, Belarus, and Poland, reducing transit costs and consolidating Russian control over the energy supply to Germany and the center of Europe.

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In 2007, the Kremlin and the Italian government signed a memorandum of understanding regarding the construction of a Russian pipeline to supply natural gas to Italy. South Stream, scheduled to begin transport of gas in 2015, will travel from Russia across the Black Sea, Bulgaria, Serbia, Hungary, Slovenia, and finally to Italy. Its capacity is estimated to be 63 billion cubic meters. It is over 930 km long and 2 km deep. The pipeline is in its early phase of construction as Gazprom is laying down pipe in Russia, Bulgaria, and Serbia. The European Parliament is looking to use the South Stream as a tool to put pressure on Russia and freezes talks on its further construction. This is clearly rhetoric, yet who knows how far this rhetoric might go. Once the Nabucco project turned a failure, Europe might also want to make stake on Azerbaijan’s Southern Gas Corridor, which is underway and designed to pump gas via Georgia and Turkey to the Balkans. Once its construction is completed, the 1,250-mile pipeline will supply gas to Bulgaria, Montenegro, Bosnia and Herzegovina, Croatia, and Albania. As a result, it will make this part of Europe far less dependent on Russia.

Bottom line

No matter how desperately Europe would like to punish Russia for its truculent actions in Ukraine, European countries are to varying degrees dependent on Russia’s energy supplies. Thus, sooner or later, Europe will have to get back to the negotiating table. The interdependence between Russia and the European Union means that crippling economic measures against Russia’s key sectors may turn out a double-edged sword – strongly impacting both Russia and Europe.  Even before the outbreak with Ukraine, the Kremlin’s energy policy in Europe was aggressive and ruthless rather than cooperative and respectful of its costumers. Throughout the years Russia has systematically acquired a significant amount of influence over the countries of Eurasia and the European Union, benefiting from their dependence on Russian natural gas. As a result, it has been hard to find economic sanctions that would harm Russia without hurting other states’ economies. For example, Cutting off European imports of natural gas from Russia would leave them scrambling for other resources. Now, however, the Western states’ desperate eagerness to switch to non-Russian sources of energy strongly suggests that Russia’s energy hegemony won’t last much longer. If Russia remains in a political confrontation with Europe, Europeans will diversify their energy supply away from Russian fossil fuels, either by switching fuel sources (e.g. coal) or by country of origin (e.g. U.S. LNG)  rendering Russia’s most potent source of leverage impotent. Taking a long-term perspective, European states will need to reconsider their energy security priorities and develop them into a more coherent and harmonized policy, which will reduce Europe’s vulnerability in the event of a broken relationship with Russia.

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