June 20, 2014

Countering Russian Energy Diplomacy

Moscow`s “energy weapon” has the potential to create a wedge in the U.S. strategic partnerships with Europe.

Europe faces the challenge that global energy demand will rise by an estimated 27 percent by 2030 while EU domestic energy production is falling. EU countries already rely on external suppliers for more than half their energy needs at a cost of over one billion euros each day. Dependence on external uranium (mostly from Africa) is almost total, but EU members rely on external sources for 88 percent of their crude oil and 66 percent of their natural gas consumption. Even in the case of solid fuels such as coal, the EU receives almost half its deliveries from non-EU members.

Dependent and Divided

Russia is by a considerable measure the largest single supplier of oil and gas to the continent. Last year, Gazprom supplied Europe with a record 161.5 billion cubic meters of gas. As gas production in Norway – the other primary source of European gas imports – continues to decline over the next decade, Russia’s share of the EU market is likely to increase.
The EU is trying to compensate for this decline by importing costly LNG and especially cheaper U.S. coal, but many Central and Eastern European countries depend on Russian oil and gas for high shares of their imported energy. Six EU members, including the three Baltic countries and several Balkans states like Bulgaria, rely on Russia for all their natural gas. Furthermore, few alternative suppliers have the size and proximity advantages of Russia, leaving Europe reliant on Russian hydrocarbons for the foreseeable future.
EU governments rightly fear that this situation deprives them of bargaining leverage while making them vulnerable to external supply shocks and political blackmail. For example, Europeans’ dependence on Russian energy supplies makes them reluctant to challenge Moscow’s policies on Ukraine by supporting energy sanctions. Moscow’s most recent pressure on Ukraine has included threats to cut off further energy deliveries to that country unless it repays a multi-billion debt incurred for past Russian energy purchases and agrees to pay higher prices for future supplies. A cutoff could easily affect other European countries since half of Russia’s gas deliveries to Europe pass through Ukraine, whose citizens would be tempted to divert some of the transiting supplies. Moscow could wield its energy weapon against other countries in coming years, including EU members.
The EU’s reliance on Russian energy imports has been compounded by its lack of a unified energy policy. This state of affairs only began to change after the 2009 Russo-Ukrainian pipeline crisis, when the EU-wide “Third Package” of energy reforms, which entered into force in 2011, made modest progress towards harmonizing member states’ energy markets. Nevertheless, Russian President Vladimir Putin has skillfully cultivating independent ties with European leaders, thereby bypassing EU-wide mechanisms that he holds in as much disdain as U.S. Assistant Secretary of State for European and Eurasian Affairs Victoria Nuland.

Moscow’s Energy Muscle

Exporting energy is the primary driver of the Russian economy and main source of the Kremlin’s revenue and international influence. The Russian Federation has the world’s largest natural gas reserves. Although its natural gas production rates have remained relatively stable if enormous over the course of the last decade, Russia under Putin has steadily enhanced and expanded its oil production over that same period. Russia has become the world’s second largest oil producer, after Saudi Arabia. The most important players in the Russian oil industry are the state-controlled energy giants of Rosneft, Transeft, and Gazprom. OAO Rosneft is one of the largest oil companies in the world, while OAO Transneft controls much of Russia’s oil pipeline system, including the most important one for delivering oil to Asia, the Eastern Siberia-Pacific Ocean (ESPO). The first stage of this pipeline was completed in 2010 and the second stage opened in December 2012. Russian oil is also exported to Asian markets from the Russian Far East ports of Prigorodnoye on Sakhalin Island, Kozimino Bay, and DeKastri.
Natural gas exports are very important to the Russian economy as well. Roughly 35 percent of Russia’s natural gas exports are sent to other members of the Commonwealth of Independent States. About two-thirds of Russia’s exports not going to these former Soviet republics go to the members of the EU. Most Russian gas is exported via pipelines, often controlled by OAO Gazprom, which has a monopoly on Russia’s gas export pipelines. Russia also exports small amounts of liquefied natural gas (LNG), for which Rosneft has an export license. About two-thirds of the output of Russia’s first LNG terminal on Sakhalin goes to Japan. Gazprom’s plans to build a LNG terminal in Vladivostok that might send gas to China, Japan, South Korea, and other East Asian countries. The gas that Russia aims to produce in the Arctic might also be exported as LNG.
The Russian government has employed a multi-pronged strategy to increase Moscow’s influence in foreign energy markets. First, it has invested billions of dollars to expand its domestic pipeline system, allowing Russia to supply oil and gas directly to many countries. Since many of these deliveries occur bilaterally, Russia is able to practice price, supply, and other discrimination. The existing Soviet-era pipeline infrastructure gives Moscow control over much of the energy supplies in the former Soviet Union. Second, the government operates its domestic energy market through quasi-monopolies subject to the Kremlin’s direction. These state champions include Gazprom, which manages Russian natural gas production and gas pipelines, and Transneft, which operates oil transit pipelines. It has sharply restricted foreign investment or access to its domestic energy resources or firms. Third, the Russian government has assisted its state-owned enterprises to acquire strategic energy production and transportation infrastructure throughout Europe and Asia.
Finally, the Kremlin has used these instruments and exploited Russia’s control over Eurasian energy flows to coerce and punish foreign governments that impede its energy or their goals. For example, in 2002, when Lithuania and Latvia prevented Russia from buying major energy holdings, Moscow sharply cut oil deliveries to both states. Russia has frequently exploited Ukraine’s dependence on Russian gas supplies to force Kyiv to follow pro-Russian policies, including forcing a 2010 decision to extend Russia’s Black Sea Fleet’s lease of the naval base at Sevastopol for an additional 25 years. Russian energy pressure now aims to force Ukraine to join Putin’s Eurasian Union project. Although Russian officials have repeatedly pledged to remain a cooperative energy supplier, they have pushed for changes in EU policies that would favor energy-exporting countries, including guarantees for suppliers and risk-sharing between suppliers, transit states, and consumers.

European Opportunities and Challenges

Russia’s position as a major energy player in Europe is ensured through long-term energy contracts and other mechanisms. Nonetheless, opportunities for further growth are constrained by economic and political factors, including marginal growth in hydrocarbon consumption, Europeans’ stringent environmental regulations, the growing availability of some alternative energy sources (including LNG and Caspian hydrocarbons), and renewed post-Crimea concerns about EU dependency on Russian energy supplies.
Moscow’s annexation of the Crimea, and Russia’s demand that Ukraine pay billions of dollars for past Russian gas deliveries or suffer a suspension of further deliveries, has reinforced European concerns over the continent’s continued high dependence on Russian gas. Speaking shortly after the announcement of the deal at a session of the St. Petersburg International Economic Forum. President Vladimir Putin acknowledged that Europe accounts for more than 70 percent of Russian oil exports, but added that, “we have to admit that energy consumption in Europe is growing slowly due to low economic growth rates, while political and regulatory risks are increasing.” Putin went on to say, “Given these circumstances, our desire to open up new markets is natural and understandable.”
Of these new markets, Russian officials and energy firms have clearly prioritized potential sales to the faster-growing Asian energy markets, especially China. Demand for energy in Asia is projected to grow at an annual rate of 2.5 percent through 2035, amounting to an 83 percent increase in demand over that period and at a rate that is almost a full percentage point faster than the rest of the world. Obtaining a large share of this most rapidly developing regional market would give Moscow considerable funds and geopolitical influence. Among the benefits from selling to Asia is that China is willing to provide loans or prepayments that provide Russia’s often indebted energy companies with ready cash to build pipelines and modernize their production at low financial risk.
Yet, Russia’s ability to leverage its new energy deals with Asia against Europe are limited. The two new fields that Russia will develop to provide gas to China are too distant from any existing or planned Russian pipelines to reach Europe, limiting any positive energy incentives Moscow might offer Beijing for its support. Meanwhile. Russia’s need to sell gas to Europe will persist due to the existing network of fixed pipelines and the long-term “pay or play” contracts signed between Gazprom and European countries, which will oblige Europeans to pay much higher prices than Asian clients for years. Gazprom now receives about 80 percent of its revenue from European customers, who buy only two-thirds of its gas exports.
In addition, the unbalanced nature of the Russian economy, with its dependence on energy production for one-third of Russia’s GDP and its limited diversification into non-energy exports besides arms, means that a gas shutoff to Europe would result in a significant and unreplaceable loss of revenue for the Kremlin and a further slowdown in the Russian economy, threatening Russia’s political stability since the Russian government relies on energy exports to generate rents that they use to pay off key stakeholders as well as support general public services. If Europe is over-dependent on Russian gas, Russia is equally if not even more reliant on European revenue. If it loses its European oil and gas markets, Russia’s export revenues will decline for years to come.
Russian officials recognize that their country needs to diversify its economy beyond hydrocarbons to exploit the other forms of capital (human, intellectual, land) in which Russia is rich. Innovation is important not only in the energy sector but also in manufacturing, where Russia lags far behind the countries with more developed economies. Investment in high-tech industries such a renewable energy, semiconductors, chemicals, and aerospace would raise labor productivity and render Russia’s economy more sustainable and competitive. Even Siberia, besides its oil and gas reserves, is rich in other natural resources (timberland, fresh water reserves, etc.) that could be practically utilized if efficiently organized and managed. But innovation is a risky long-term business that rarely brings quick profits and often results in failures that never pay back. Rather than modernize their oil and gas production, Russian energy oligarchs more often invest in foreign real estate, bonds and precious metals, which bring relatively quicker and safer benefits. High world prices for Russia’s oil, gas, and other commodity exports have rendered Russia’s non-energy exports less competitive and hampered increases in productivity and innovation.
Alarmed by events in Ukraine, the European Council in March instructed the Commission to execute an in-depth study of the topic and prepare a comprehensive strategy how to reduce EU dependence on external energy sources. In addition to energy security, the EU Lisbon Treaty has enhanced the Commission’s powers on issues relating to energy competiveness and sustainability. On May 28, the European Commission released its comprehensive energy security strategy. Although its immediate goal is to avert another winter energy crises such as Europe experienced in 2006 and 2009, the long-term objective is to reduce Europe’s reliance on venerable foreign energy supplies, especially from Russia. In releasing the proposed energy security strategy, Commission President José Manuel Barroso said that: “The EU has done a lot in the aftermath of the gas crisis 2009 to increase its energy security. Yet, it remains vulnerable. The tensions over Ukraine again drove home this message. In the light of an overall energy import dependency of more than 50% we have to make further steps.”  Referring to Russia, European Energy Commissioner Günther Oettinger added that, “We want strong and stable partnerships with important suppliers, but must avoid falling victim to political and commercial blackmail.”  The European Council will discuss the proposed plan at its June 26-27 session.
To deal with immediate threats of interrupted gas supplies next winter, the Commission wants to conduct regional or EU-wide stress tests that simulate gas supply disruptions and assess how EU energy systems respond. When the outcome is unsatisfactory, the EU would develop new or expanded contingency plans and emergency response mechanisms such as stockpiling more gas (by expanding storage facilities), developing more fuel-switching options (having a gas-fired electricity generating plant use coal), assessing means to urgently reverse gas flows (e.g., sending Russian gas back from Western Europe towards Russia’s EU neighbors), and pooling energy supplies in emergencies (allowing countries suffering the most serious shortages to quickly obtain more supplies). To enhance the EU’s medium- and long-term energy security, the Commission emphasizes diversifying external energy supplies, upgrading energy infrastructure, completing the EU internal energy market (by raising the interconnectivity of installed electricity capacity), constructing missing infrastructure (such as links that allow for rapidly redirecting energy flows within the EU), promoting further energy conservation (especially for buildings), and coordinating national policy decisions better to present a united front with external negotiating partners.
Diversification of energy supplies and transportation routes remains a serious challenge. Last year, 39 percent of EU gas imports by volume came from Russia, 33 percent from Norway and 22 percent from North Africa. The EU has been struggling for years to develop new supply sources from the Caspian Basin region (from Azerbaijan, Kazakhstan, and Turkmenistan in particular) by expanding the Southern Gas Corridor through the South Caucuses; recent efforts have also focused on developing a Mediterranean Gas Hub by increasing LNG deliveries to southeastern Europe.
To reduce opportunities for third parties to exploit EU divisions through “divide and rule tactics,” the Commission seeks greater transparency and competition in European energy activities. It specifically wants EU governments to inform the Commission early on regarding energy supply negotiations with non-member countries. But speaking with a single voice to external energy partners remains a challenge given how many actors might engage in a large energy project. In addition, EU leaders, despite the post-Lisbon enhancements to the Commission’s role in energy matters, often treat energy as a vital national security or domestic political issue that should not be hindered by other, often competing EU member states.
The effort to increase renewable energy use in the EU has also encountered problems due to the continued difficulties facing by nuclear energy, the most available renewable energy source. Although the French government has relaxed the anti-nuclear energy stance that Socialist Francois Hollande adopted during his presidential campaign, and the United Kingdom is in the process of launching new nuclear energy plants, Germany is still decreasing its long-term nuclear energy capacity. Europeans’ interest in nuclear energy remains contaminated by the March 2011 disaster in Fukishima. Meanwhile, environmentalists in Europe resist proposals to rely more on coal or gas fracking. When they meet in June, EU leaders may need to take bold action to overcome resistance to these critical energy sources.

The U.S. Role

Despite being the world’s largest energy consumer, the United States only has limited direct dealings with Russia’s oil and gas sector. Moscow has blocked attempts by the largest U.S. energy corporations to purchase significant stakes in Russian energy companies, even private firms such as YUKOS. On the other hand, Gazprom considered and abandoned plans to export LNG to the U.S. West Coast.
The main U.S. concern has been that Russia will exploit its energy leverage in Europe at U.S. expense. The United States encourages EU countries to diversify their energy sources, especially by supporting to develop of new pipelines connecting Europe with other Eurasian energy suppliers, and develop a common energy policy toward Russia. The United States and the EU have systematically financed pipeline construction projects such as the Baku-Tbilisi-Ceyhan (BTC) oil pipeline and the Baku-Erzurum (BK) gas pipeline.
As Russia’s Eurasian influence has recovered since the fall of the Soviet Union, it has sought to prevent further challenges to its influence in European energy markets caused by such alternative pipelines. Russian opposition, along with many other challenges, helped derail the planned Nabucco Trans-Caspian gas pipeline project to bring gas from Turkmenistan and Kazakhstan across the Caspian Sea to Europe via Turkey. Meanwhile, Gazprom and Transneft have constructed competing Russian-controlled pipelines such as Nord Stream and South Stream. The Nord Stream pipeline provides natural gas to Germany by traversing the Baltic Sea, bypassing Ukraine, Belarus, and Poland and other countries that have impeded Russian gas deliveries to Europe in the past. South Stream, which travels across the Black Sea through Bulgaria to Italy, has displaced the Nabucco pipeline project by supplying Caspian gas to Central and Southern Europe. Russian firms have also maintained control over a large share of Eurasian energy production and distribution, especially in Central Asia and the Caspian Basin region, though Azerbaijan and Turkmenistan have been able to develop independent means of supplying their own energy to Europe and, in the case of Turkmenistan’s gas, China.
This state of affairs has the potential to create a wedge in the U.S. strategic partnerships with Europe. With key NATO members increasingly depending on Russian imports, a Sino-Russian strategic partnership could exploit the energy trade to destabilize, or threaten to destabilize, the European economy. Under such conditions, major U.S. partners such as Germany or France would find it politically and strategically difficult to back controversial U.S. foreign policies opposed by Moscow.
The low cost and abundance of U.S. natural gas and shale oil have transformed the United States into a hydrocarbon energy exporter for the first time in a generation. The United States’ return as an energy exporter due to its massive coal exports, developing LNG technologies, and possible shale oil exports will help blunt Russia’s energy weapon in Europe. By developing its own energy export potential and helping develop and spread the use of energy production and exporting technologies, the United States can help reduce Europeans’ dependence on Russian energy while making Russia value even more its increasingly venerable European energy markets, doubly weakening Russia’s leverage over Europe.
Fortunately, U.S. coal exports to Europe are at record high levels. European countries are eager to use U.S. coal to fuel their power plants because it is much cheaper than Russian natural gas. Unfortunately, because large-scale hydrocarbon exports are so novel in the United States, the government does not have a coherent policy for these sales. Although many believe that such exports provide net gains to the United States, fears prevail that the exports could raise U.S. energy prices. Though most studies conclude that any rise would be low, Congress has declined to remove the ban on U.S. crude oil exports, while U.S regulators have approved construction of only a half-dozen LNG plants. Besides this, it takes years to construct such facilities, which are costly and face stiff opposition from key domestic interest groups. U.S. manufacturers that use natural gas fear that increasing exports too quickly could adversely impact their production costs. Although environmentalists want to reduce U.S. coal production and use, many worry about water pollution and other ecological challenges presented by gas fracking and shale oil production. The controversy has delayed U.S. government approval of U.S. gas exports and means that U.S. hydrocarbons will not soon displace Russian gas sales in Europe. For now, U.S. efforts will focus on developing alternative energy pipelines to Europe and working within NATO and the EU to bolster mutual energy security.


This article was published in ICDS Diplomaatia magazine.

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