June 17, 2014

Energy as a Weapon: Call Russia’s Bluff and Stem Ukraine’s Corruption

Reuters/Scanpix
A worker turns a valve at the Nesvizhskaya compressor station some 130 km (81 miles) from Minsk January 9, 2009. Ukraine has given verbal agreement for the deployment of international gas transit observers, the chief of the Russian state-controlled gas export monopoly Gazprom, Alexei Miller, said on Friday.
A worker turns a valve at the Nesvizhskaya compressor station some 130 km (81 miles) from Minsk January 9, 2009. Ukraine has given verbal agreement for the deployment of international gas transit observers, the chief of the Russian state-controlled gas export monopoly Gazprom, Alexei Miller, said on Friday.

In a moment of friendly candor, one of Russia’s most senior diplomats once told me privately, “We Russian diplomats negotiate hard because we know we are weak. When we have an issue on which we know we are strong, we will fight like mad. And, for us, that key issue is energy.”

In a moment of friendly candor, one of Russia’s most senior diplomats once told me privately, “We Russian diplomats negotiate hard because we know we are weak. When we have an issue on which we know we are strong, we will fight like mad. And, for us, that key issue is energy.”

Indeed, Russia has repeatedly used natural gas as a strategic tool, most prominently when it cut off gas to Ukraine and the EU in 2006, 2009, and 2010. Though the two countries’ dispute over gas prices stole the headlines, the real core of the dispute was Russia’s efforts to seize control of Ukraine’s natural gas pipelines and lock Ukrainian politicians and industrialists into long-term dependence on Moscow. A lesser-known case occurred in Lithuania in 2012, when Gazprom admitted it was punishing Vilnius for implementing the EU’s own directives to strengthen energy independence from Russia and imposed a gas price 15% higher than Germany’s and 30 percent higher than the average for Europe.
Today, energy is a weapon in Moscow’s “hybrid” war against Ukraine, along with covert invasion, military advisers and mercenaries, and information warfare. The Kremlin’s announced intention to double Ukraine’s gas price was a threat to bankrupt energy intensive industries and thereby destabilize Ukraine’s political system (notwithstanding Russia’s March 2010 treaty obligation to provide Ukraine gas at half the price in exchange for extension of its naval basing rights at Sevastopol until 2042).
Less obvious has been Moscow’s exploitation of Ukraine’s gravest internal weakness: massive corruption at the nexus of politics and energy. Ukrainian oligarchs (including top politicians) have generally made their fortunes by using political clout and connections to Gazprom to buy gas low and sell high. Influential Ukrainians have been able to buy gas more cheaply than those who lack such personal connections, then either use the gas to secure competitive advantages for their petrochemical and metallurgy factories or sell the gas in Europe at a markup of over 100%. These schemes have been possible because Ukraine never installed gas meters on its border with Russia, making it impossible to determine how much gas actually enters Ukraine. Ukrainian and Russian schemers are able to sell this undetected gas in Europe through shady intermediaries for billions of dollars.
The most famous such deal resolved Russia’s January 2006 gas cutoff to Ukraine. It was brokered by Russian organized criminal Semyon Mogilevich, on behalf of a shady Swiss company called RosUkrEnergo, which was jointly controlled by Gazprom and one of Ukraine’s most powerful oligarchs, Dmitriy Firtash. Under U.S. federal indictment for bribery, Firtash has been a key donor to virtually every top Ukrainian politician since the Orange Revolution of 2004 (perhaps with the exception of current President Poroshenko).
The RosUkrEnergo deal underscores the nexus of natural gas, Russian organized crime, and Ukrainian politics, which has generated legal and political vulnerabilities Moscow enthusiastically exploits. These opportunities for breathtaking self-enrichment have won Moscow loyalty of ousted President Yanukovych and many other top Ukrainian politicians, while hamstringing the state’s legitimate decision-making, especially in times of crisis such as Ukraine’s current war with Russia.
Unless he can stem this torrent of corruption in Ukraine’s natural gas sector, Ukraine’s new President, Petro Poroshenko, risks a dual threat: failing to defeat Russian-supported separatists in eastern Ukraine; and a new wave of protests by Ukraine’s vibrant civil society this autumn. Last week’s announcement of the breakup of Ukraine’s notoriously opaque national gas company, Naftohaz Ukrayiny, into three independent companies is a big and positive step. The EU can further help by pressing for three key measures: (1) Kyiv installs a gas metering station at Ukraine’s border with Russia; (2) Brussels acquires oversight and/or partial control of Ukraine’s gas transit system; and (3) Moscow accepts a single Russian gas price for all EU member states at Russia’s border, (with transit costs across Ukraine determined by a transparent formula and without middlemen).
Moscow will resist, preferring to continue its divide-and-conquer approach of pursuing gas deals with individual EU member states, while threatening them to take Russian gas elsewhere if they push back too intensely. This is precisely what Russia’s May 21 gas deal with China is about. Aiming to intimidate the EU into a softer line regarding its war against Ukraine, Russia settled on an uneconomic arrangement with China, caving in to Beijing’s demand for a lower price after holding out for over 10 years for a higher one. The gas sales price of $350 million per thousand cubic meters is 42 percent cheaper than Lithuania’s, and so low that it will likely depress natural gas prices throughout the Far East. Moreover, the deal requires at least $50 billion in new infrastructure, which must be repaid from these cheap gas sales.
In short, the China deal makes little economic sense for Russia and is instead a political bluff. In reality, Russia is positioned to rely on EU gas markets for decades to come, given its massive pipeline network that currently supplies the EU over 4 times as much gas as foreseen by the China deal. And, Russia’s dependence on European markets is set to grow through expansion of Gazprom’s Nord Stream pipeline under the Baltic Sea and possible development of the South Stream pipeline under the Black Sea.
Europe should call Russia’s bluff and demand changes in how it deals with Russia on natural gas, insisting on a single Russian price for all EU consumers. This would not only allow the EU to manage Moscow more effectively; it would also take advantage of President Poroshenko’s urgent need to tackle Ukraine’s massive corruption and thereby help Ukraine emerge as a stable and prosperous country, which Moscow is less tempted to undermine.

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