September 21, 2012

Baltic Energy Security: Today’s Historic Opportunity

For the first time in modern history, the Baltic states can rely on their own actions to attain energy security. By implementing the European Union’s reforms aimed at creating a unified European energy market, the political leaders of Lithuania, Estonia and Latvia are enabling their countries to secure supplies of oil, natural gas, and electricity at prices determined by market forces rather than by monopolists with divergent commercial and geopolitical interests.

For the first time in modern history, the Baltic states can rely on their own actions to attain energy security. By implementing the European Union’s reforms aimed at creating a unified European energy market, the political leaders of Lithuania, Estonia and Latvia are enabling their countries to secure supplies of oil, natural gas, and electricity at prices determined by market forces rather than by monopolists with divergent commercial and geopolitical interests.

All three Baltic states enjoy reliable supplies of oil, though this was not always the case. Immediately after the fall of the USSR, Latvia became one of the world’s leading oil exporting countries from which significant volumes of Russian and Kazakhstani crude were exported to European markets. Significant volumes of oil exports continue to flow via Latvia’s port of Ventspils and via Estonia’s port of Muuga in Tallinn. Lithuania, however, faced greater difficulty. It relied on the Mazeikiai Refinery, the Baltic region’s only refinery and largest industrial concern, for oil products critical to its economy and for export (via the sea terminal at Butinge). The refinery depended entirely on Russian crude oil supplied by the Druzhba Pipeline.
In July 2006, the Russian Government shut down the Druzhba Pipeline near Mazeikiai for unspecified repairs, crippling the refinery’s operations. The cutoff occurred in the midst of a fierce battle over the refinery’s privatization, as the Russian Government sought to acquire the assets of a private company, Yukos, including the Mazeikiai Refinery. The timing and non-transparency of the shutdown seemed to be aimed at lowering the refinery’s purchase price and persuading Vilnius it could face serious economic and geopolitical consequences for selling Mazeikiai to non-Russian investors. Russian Duma Speaker Konstantin Kosachev heightened such suspicions when he noted just hours after a fire at the refinery on October 12, 2006, “instability will continue to plague the refinery until the Lithuanians finally realize which partners one should choose.”   Rather than succumbing to such pressure, Lithuania worked with private investors to reverse Mazeikiai’s export pipeline to allow non-Russian crude to supply the refinery from the Butinge sea terminal. This bold tactic enabled Mazeikiai to continue operating, leading to its purchase by Polish oil company PKN Orlen on December 15, 2006.
Lithuania’s experience at Mazeikiai underscores two key points: energy monopolists’ pressure tactics have both commercial and geopolitical impacts; and market forces provide the most effective tools for countering such pressure. This reliance on market forces to secure Europe’s commercial and geopolitical interests lies at the heart of the European Union’s landmark Third Energy Package. Passed in 2009, this collection of regulations aims to create a unified European energy market by mandating that EU member states:
• to unbundle natural gas transit and distribution networks to reduce the monopoly power of energy companies (whether Russian or European);
• to diversify sources of gas supply and to connect European gas grids;
• to expand gas trading hubs and to integrate gas storage facilities into gas trading hubs; and
• to connect Baltic electricity networks with those of Nordic countries, Poland, and the entire EU.
The EU’s focus on markets for natural gas and electricity makes sense. Notwithstanding Lithuania’s troubles at Mazeikiai, it is difficult for monopolists to restrict oil flows to European consumers, given that oil can be loaded onto tankers in liquid form and shipped to any market in the world. Natural gas, on the other hand, must be transported either in its gaseous form via lengthy pipelines or via tanker after being liquefied in an expensive process. Natural gas pipelines and liquefaction plants both require billions of dollars in investment. To secure the requisite high levels of financing for such projects, natural gas producers insist on locking in high prices for their European consumers via long-term supply contracts pegged to the price of oil. European consumers have usually acquiesced to these demands, which restricted development of competition among gas suppliers. As a result, Europe does not enjoy a genuine market for natural gas, and European consumers pay considerably more than they would if natural gas prices were determined by market-based competition. Indeed, in the United States, where prices are determined by the free market at trading hubs, natural gas costs four times less than in Europe.
In sharp contrast to the U.S.’s liquid market, a single company, Russia’s Gazprom, supplies 100 percent of the natural gas consumed in Estonia, Latvia, Lithuania, and Finland. In addition, Gazprom controls the gas storage facility in Latvia that is crucial to sustaining reliable flows of natural gas during peak demand in winter, along with pipelines linking that storage facility to all three Baltic markets. These countries are thus isolated into an “energy island” with regard to natural gas supplies.
The Baltic states are similarly isolated from their EU allies with regard to electricity. As a Soviet-era legacy, Baltic electricity networks remain synchronized with Russia’s Northwest Grid rather than integrated into the EU’s system. Besides the commercial consequences of reduced competition, this situation has the geopolitical consequence of preventing Baltic economies from integrating with those of their EU allies, thereby undercutting one of the Euro-Atlantic Community’s core objectives: the reemergence of a Europe that is whole and free. 
The key to eliminating these Baltic “energy islands” is to expand energy trading hubs, where prices are set according to market forces of competition, supply, and demand – and without political interference. The market efficiency of a hub depends on its liquidity, i.e. the degree to which a single gas trade can occur without affecting the price of subsequent trades. Liquidity at a hub requires several factors: access to diversified gas supplies through the convergence of pipelines and/or LNG terminals nearby; gas storage facilities to manage peak demand in winter; and pipelines to consumers that operate under market-friendly regulations.
During the past two and a half decades, several natural gas trading hubs have emerged around Europe’s North Sea Basin. The first was the UK’s National Balancing Point (NBP), which was created when the British Government privatized British Gas in December 1986 and mandated that the company release gas volumes to independent suppliers. Other nearby hubs now include the Title Transfer Facility (TTF) in the Netherlands, Zeebrugge in Belgium, PEG Nord in France, and NetConnect Germany (NCG) and Gaspool in Germany. All are competing to surpass NBP in liquidity and become Europe’s primary point for trading gas produced in the UK, the Netherlands, Denmark, Norway, and Russia. They face additional competition from the Central European Gas Hub (CEGH) at the strategic junction of Gazprom’s major pipelines at Baumgarten on Austria’s border with Slovakia.
The liquidity of gas trading at these hubs has increased with the arrival of additional competing suppliers. Increased liquidity has allowed spot markets to emerge at each hub, where prices are set by supply and demand rather than the price of oil. Since 2008, spot prices at these hubs have converged into a single price – and thus, a single market – for the entire North Sea Basin. This is a dramatic development: it means millions of consumers in northwestern Europe can now purchase natural gas at prices determined by the free market rather than monopolists.  Consequently, both natural gas prices and monopolists’ leverage have decreased.
Market pressure is now building to expand spot-market trading of energy eastward, toward the Baltic Sea. In February 2010, competition among multiple gas suppliers at North Sea gas hubs allowed the TTF to extract Gazprom’s concession to allow spot-market pricing to determine 15% of Gazprom’s sales price at the TTF. Germany’s E.ON AG quickly followed with its own demand for Gazprom to index its sales price fully to spot prices for gas. Later that month, Poland’s PGNiG and Lithuania’s gas utility asked Gazprom to allow some degree of market-based pricing in their own long-term contracts. Gazprom refused all of these demands, and has instead fought to stem the spread of spot-market pricing eastward in defense of its preferred pricing model, pegging natural gas to the price of oil. The Polish and Lithuanian entities replied by threatening to take Gazprom to arbitration. Gazprom Deputy CEO Aleksander Medvedev’s response was chilling: “If it does come to arbitration proceedings, we are pretty confident”¦.God help them if someone takes a risk to go to arbitration.”  
Market forces have nevertheless forced Gazprom to retreat from its rigid demands for long-term contracts with a non-market pricing model. Feeling the pressure from spot-market trading in the North Sea and the potential flood of cheap LNG from the United States, Gazprom agreed in early July 2012 to renegotiate its contract with E.ON: Gazprom offered a price discount in return for E.ON continuing to accept the principle of a link between the prices of natural gas and oil. According to Reuters, Sergei Komlev, head of contract structuring and price formation for Gazprom Export, stated that Gazprom was willing to make this unusual concession to protect the link between gas and oil in its pricing model. “The overall discount remained within Gazprom’s set range of no more than 7–10 percent (and) the oil-linkage in this long-term contract was preserved intact,” Komlev boasted.  Notwithstanding Komlev’s optimism, this precedent provides further momentum for spot-market pricing to extend eastward, with Poland’s PGNiG now expected to renew its demand to renegotiate its contract with Gazprom, and Lithuania recently winning price concessions from Gazprom, as well. 
Indeed, such monopolistic bluster is looking increasingly empty thanks to determined political leaders with a strategic vision of bolstering free-market forces. In the Baltic region, Lithuania is leading the charge. In 2011, Lithuania adopted the EU’s Third Energy Package before any other EU member state, and chose the most aggressive version. Vilnius immediately announced plans to diversify its sources of natural gas supply by contracting for a floating liquid natural gas (LNG) terminal at Klaipeda, scheduled to begin operating in 2014. Vilnius also announced it would end Gazprom’s control of Lithuania’s entire natural gas transit network by separating the country’s internal gas distribution pipelines from its gas transmission pipelines, which import exclusively Russian gas. Gazprom retaliated in early 2011 by charging Lithuania 15% more for natural gas than Estonia and Latvia, and then suing Lithuania at the UN’s international trade arbitration tribunal. According to Moskovskie Novosti, Gazprom’s Deputy Chairman Valery Golubov explained, “Vilnius’s inadequate behavior while restructuring the gas sector, and trying to separate the gas transmission pipelines from SC Lietuvos Dujos” justified the price increase.  Ultimately, however, Gazprom acquiesced to the Lithuanian Government’s relentless commitment to bolster free-market forces in solidarity with the EU. In May 2012, Gazprom accepted the Lithuanian Government’s pipeline unbundling plan at the Lietuvos Dujos shareholders’ general assembly.
Lithuania is proceeding with its aggressive implementation of the Third Energy Package, ahead of all other EU member states. On July 3, 2012, the Lithuanian Government announced a tender for a new pipeline to link the Klaipeda LNG terminal with the country’s natural gas transmission system. Parliament is also debating legislation requiring Lithuania to purchase at least 25% of its natural gas as LNG at the Klaipeda terminal; this aims to prevent Gazprom from destroying the economic advantages of the Klaipeda terminal by dumping cheap gas on the Lithuanian market. Lithuania and Poland are also planning a cross-border gas pipeline of 3 to 5 BCM to facilitate free-market trading of natural gas between the two countries’ national gas grids, with diversified sources of supply from LNG arriving at both Klaipeda and Poland’s planned LNG terminal at Świnoujście. Taken together, these measures will provide the physical infrastructure required to develop a full-fledged gas trading hub. The regulatory and legal framework of such a hub was put in place with the establishment of the Baltpool natural gas exchange, formed under Lithuania’s Law on Natural Gas that was passed on August 1, 2011. 
Outside Lithuania, progress toward spot-trading and gas hubs is also moving, though more slowly. In Latvia, the national government is considering the construction of a large LNG terminal (for which Riga seeks EU financial support) that is intended to serve all three Baltic markets. Latvia is also planning pipelines to link its gas grid with the networks of Lithuania and Estonia, and provide all three states access to Latvia’s crucial gas storage facility at Ināukalns. However, the Latvian Government has yet to commit to implement the EU’s Third Energy Package.  Consequently, Latvia’s entire natural gas pipeline system and the gas storage facility at Ināukalns remain unavailable for free-market trading. 
In Estonia, the country’s top leaders worry that as long as the Ināukalns gas storage facility remains under Gazprom’s control, a regional LNG terminal in Latvia would not enhance Estonia’s security of gas supply during crucial winter months. Estonian Minister of Economic Development Juhan Parts outlined this reasoning in a letter leaked to the press during summer 2011, in which he noted expressed concern about the lack of transparency in conditions for use of the Ināukalns facility.  The Estonian Government consequently directed Elering, Estonia’s state-owned electricity transmission company, to develop plans for Estonia’s own LNG terminal. In May 2012, Elering and the Port of Tallinn announced a joint feasibility study for an LNG terminal at Muuga harbor in Tallinn. Elering, which co-owns the Estlink electricity transmission cable between Estonia and Finland, is also exploring a sub-sea pipeline linking Estonia with Finland’s natural gas grid. This connection, coupled with a new LNG terminal in Tallinn, would provide Estonia and Finland their first diversified supplies of natural gas, thereby laying the foundation for another potential gas hub in the Baltic region. Momentum toward such a hub accelerated on June 6, 2012, when the Estonian Parliament approved the implementation of the EU’s Third Energy Package.
The Presidents of Estonia and Lithuania appear to agree on the need to take their own steps to secure diversified natural gas supplies rather than rely on a regional LNG terminal in Latvia.  Following her meeting last summer with Estonian President Toomas Hendrik Ilves, Lithuanian President Dalia Grybauskaite announced: “We agreed with the [Estonian] president that the existence of just one terminal [in Latvia] could be risky, [as] influence could be exerted on this terminal, and it could be re-sold.”  Overcoming such doubt about Latvia’s reliability requires Riga to confront energy monopolists whose interests are entrenched in Latvian politics and to decide to implement the EU’s Third Energy Package. Absent this politically difficult step, each country’s smaller LNG terminals risk being undercut by monopolists’ ability to dump cheap gas on Baltic markets, while the three countries will never develop the integrated pipeline and gas storage infrastructure required for gas trading hubs to emerge.
In the Baltic states, the evolution of spot markets for electricity may be more advanced than for natural gas. In keeping with the Third Energy Package’s mandate to connect Baltic electricity networks with those of the Nordic states, Poland, and the rest of the EU, Estonia and Finland laid a 350 MW Estlink cable in 2007, which they plan to expand via a second cable (659 MW) in 2014. Sweden and Lithuania plan to connect their electricity networks in 2016 with a 650 MW NordBalt cable. Moreover, Poland and Lithuania have been planning an electricity link for several years, which will facilitate free-market trading between the Baltic states and the rest of the EU. Finally, Lithuania is planning to build a large nuclear power plant at Visaginas, in a joint investment with Estonia, Latvia, and the Japanese industrial giant Hitachi, which will provide a new source of electricity that can be traded among all three Baltic states, their Nordic neighbors, Poland, and the rest of the EU.
Estonia and Lithuania have demonstrated their intention to foster free-market trading of electricity through their participation in Nordpool, the world’s largest electricity exchange, which began in Norway and is centered on the Nordic states. Estonia and Lithuania also favor disconnecting the Baltic electricity grid from Russia’s and synchronizing with the EU system. Latvia, however, prefers to avoid significant new capital expenditures by remaining integrated into the Russia’s Northwest Grid.
It is natural that foreign monopolists and their allies within Baltic political systems would resist reforms aimed at undercutting their commercial and geopolitical leverage. Conversely, it is equally understandable that the Baltic states would fight hard to eliminate such leverage by taking steps in conjunction with their EU allies to bolster market forces in trade for their most strategically significant commodities. As Baltic leaders continue moving forward to establish trading hubs for natural gas and electricity, monopolists’ ability to manipulate Baltic energy markets will evaporate; eventually, the debate over whether Russia uses energy supplies for geopolitical purposes will lose all relevance, as the Baltic states will have achieved energy security for the first time in history. Reaching this goal, however, still requires bold decisions, especially in Riga.
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1 “Gazprom Says It Would Win Arbitration on Long-term Contracts,” Bloomberg, February 15, 2011.
2 “Gazprom Says It Would Win Arbitration on Long-term Contracts,” Bloomberg, February 15, 2011.
3 Henning Gloystein, “Analysis: Russia Takes Long View to Defend Europe Gas Supply,” Reuters , July 5, 2012, available at www.reuters.com/article/2012/07/05/us-energy-gas-e….
4 Алексей Грибач [Aleksei Gribach], “Зампред правления “Газпрома” Валерий Голубев: “Цена газа для Литвы не зависит от состава правления Lietuvos Dujos” [Gazprom’s Deputy Chairman Valery Golubev: “The price of gas for Lithuania does not depend on the composition of the board of Lietuvos Dujos”], Московские Новости [Moskovskie Novosti], February 11, 2012, available at www.mn.ru/business/20110211/300430801.html.
5 Andres Reimer, “Parts: Läti gaasiterminal ohustaks Eesti sõltumatust” [“Parts: The gas terminal in Latvia would jeopardize the independence of Estonia”], Eesti Päevaleht, July 28, 2011, available at www.epl.ee/news/majandus/parts-lati-gaasiterminal-….
6 Anita Brauna, “Lack of Trust Disrupts Gas Project,” Baltic Times, May 23, 2012, available at www.baltictimes.com/news/articles/31283/.

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