March 13, 2015

The new energy security environment: “Bridging” Ukraine and the EU by energy infrastructure

People release baloons in the colours of the Ukrainian flag during a rally marking the anniversary of Ukrainian poet Taras Shevchenko 1814-1861, in Simferopol, on March 9, 2015.
People release baloons in the colours of the Ukrainian flag during a rally marking the anniversary of Ukrainian poet Taras Shevchenko 1814-1861, in Simferopol, on March 9, 2015.

With less than one month until Ukraine’s Russian gas-supply agreement ends, critically low stocks of gas in Ukraine could threaten Europe’s security of supply.

An understanding that Ukraine’s energy crisis has direct implications for Europe underlines the need to integrate the Ukrainian gas network with Europe’s. The moment the state energy holding Naftogaz and other Ukrainian energy companies become equal and competitive players in the European energy market, Russia would be more restrained from using its energy as a foreign-policy tool. The dispute over gas supplies and pricing has played out in the background throughout the year while Ukrainian forces have been fighting back pro-Russian separatists in a war that has killed more than 5,600 people. There has been little progress on a new agreement on gas supply before the 31 March expiry of a short-term deal, with Russia saying it will cut gas deliveries to Ukraine and revert to a standard contract based on disputed prices that will not be reviewed by international arbitrators until 2016. Ukraine is banking on the decision to be taken by the Arbitration Institute in Stockholm, which in fact makes a short-term “winter package” signed after trilateral negotiations in Brussels beneficial for Naftogaz. Yet this time Ukraine has an issue of greater importance on its agenda—to fill its gas storage facilities—and failure to do so might affect broader European security of supply next winter. If Russian supplies stop this spring, Ukraine’s inventories may shrink to the smallest in a decade by October 2015.
Ukraine’s storage inventories are of great significance for two strategic goals: first, to secure the stable transit of natural gas to Europe, and second to cover domestic consumption during the heating season. Ukraine produces 20 billion cubic metres (bcm) annually (50% of its total gas consumption in 2014), but energy-intensive industries with stable gas demand throughout the year mainly buy domestically extracted energy resources. Ukraine’s current energy intensity—0.45 toe/US$1,000 of GDP in contrast to Poland’s 0.15 toe/$1,000—indicates a deep systemic crisis in Ukraine’s economy. Unlike the supply to industry, peak household gas demand in winter is mainly covered by imported natural gas, which requires Ukraine to top up its gas stocks every spring/summer to provide sufficient domestic supply. Yet securing heat for households is not the only driver for Kiev to get a deal signed, with the EU’s support, in another round of negotiations with Russia after the “winter package” expires on 31 March 2015.
Low levels in Ukraine’s underground gas storage facilities (UGS)—whose capacity is 32 bcm, the largest in Europe—could have a broader impact on Europe’s energy sector: creating price volatility across the EU. If the dispute is not resolved, EU countries would be forced to draw down their own inventories to supply Ukraine or to utilise it as a security-of-supply measure—which would create tightness of supply and would be likely to impact prices on Europe’s spot markets (e.g. at NPB, which supplies spot gas to Central European markets) next winter. With only 8 bcm (25% capacity) in its UGS at the end of February 2015, Ukraine is already running certain risks, even if the 2014–5 winter was mild and the next heating season is not for another six months.
Ukraine’s looming energy crisis has several causes. It has failed to develop an efficient energy consumption system or to diversify sources of gas imports. Dependence on Russian imports, which are subject to political pressure and higher prices, coupled with the country’s low energy efficiency, high subsidies on gas consumed by households, and thus inefficient management of domestically produced natural gas, keep Ukraine on the verge of gas shortages. Ukraine managed to reduce its gas consumption by 20% in 2014 (from 50 bcm in 2013 to 40 bcm), and imports from Russia by 44% (see the Graph), but mainly due to unreliable gas supplies and high prices set by Gazprom. The main driving force for reducing gas consumption should be energy efficiency, but to get there Ukraine needs investment in innovative technologies and modernisation of both domestic gas production and energy-intensive industries. The priorities sound clear, yet they require substantial investment, especially foreign direct investment (FDI). Once Ukraine has resolved its disputes with Russia, it should certainly promote an energy-efficient society and implement a number of reforms.
In the meantime the energy import bill paid by Naftogaz is one of Ukraine’s most important internal economic and political challenges. Dependence on Gazprom’s supplies has become one of the major threats to its national security, together with the destruction in the industrial region of Donbas (60% of factories are completely or partially out of action) and ongoing tensions, which left Kiev-controlled territory with shortages of anthracite, the “hard” coal used to produce electricity in Ukraine. The Donbas region, occupied by Russia-backed separatists, accounts for 75% of all coal mining in Ukraine, which gives the Kremlin real bargaining power. The pro-Western government in Kiev had to turn reluctantly to Russia for energy to cover shortages the thermal power stations started to face from August 2014. Unlike the unresolved gas disputes, the electricity agreement satisfied the Kremlin’s strategic purposes and secured electricity supplies to the illegally annexed Crimea. However, for Ukraine, gas negotiations might turn into a much more challenging battle for independence—this time in the energy sector. Even after Russian gas supplies were restored through the winter due to an EU-brokered deal last year, the disagreement over who should pay for gas supplies to separatist-held areas might put negotiations in complete jeopardy. More likely, Russia would try to apply a “Transnistria” scenario to gas supplies—to use gas transmission points on Russia’s border with separatist-held territories (e.g. Prokhorivka and Platove in Donbas). Uncoordinated changes of entry point are a clear violation of the contract, but that might not stop the Kremlin from disrupting supply unless the EU makes it clear to Gazprom that a delivery of gas to the Ukrainian border is, de jure and de facto, delivery to the border of the EU’s single market for energy.
Ukraine’s gradual integration into the EU’s single energy market can create a strong energy-security environment if strategic and commercial goals coincide. To deepen energy ties by both energy infrastructure and a legal framework, European companies should understand the rather unique strategic value of Ukraine’s energy assets among the contracting parties of the Energy Community. Ukraine’s gas transmission and storage facilities, albeit in need of modernisation, have significantly high capacities, and provide tools to address the challenge of supply disruption in a more differentiated way than those of the EU member states. The 143-bcm annual capacity of Ukraine’s gas transmission system could deliver 90% of the entire Russian gas supply to Europe. Gas storage facilities—30% greater in capacity than the largest within the EU (e.g., Germany’s)—are located on Ukraine’s western border with the EU and could boost security of supply for European energy companies. After the EU and Ukrainian transmission networks and storage facilities are integrated into one single network, the whole European infrastructure picture would change.
So-called “reverse flows” of natural gas from the EU countries to Ukraine have already provided a breakthrough in developing commercially viable infrastructure projects on their border, which could eventually create a new gas-trading hub, with Ukraine a part of it. Since Slovakia’s technical capacities were upgraded in January 2015, together with existing Polish and Hungarian reverse supply, Ukraine can count on 22 bcm a year. Reverse flows of natural gas are significant for both strategic reasons—demonstrating European support for Ukraine in standing up to external aggression—and the commercial importance of new gas network projects prompted by eastbound gas supplies. Commercial considerations prompted “bridging” the EU and Ukrainian gas networks more quickly after military and political tensions urged Ukraine to search for security-of-supply mechanisms and to turn to Europe for alternatives to Russian gas.
Due to Ukraine’s geographical proximity to Central and Eastern Europe, the integration of Ukraine’s gas infrastructure into the European energy space could be implemented via regional energy initiatives on the basis of the Visegrad Group (V4). V4 cooperation in cross-border energy infrastructure integration was efficiently implemented in the aftermath of the 2009 gas crisis. Among those most vulnerable to Russia cutting off supplies, Central European countries undertook a number of security measures, and thus finally have access to the north-western gas spot markets. Due to modernisation of cross-border gas interconnectors, Slovakia and the Czech Republic are now able to buy gas virtually at the northern hubs and physically deliver it to their consumers. Ukraine is now less of a threat to the CEE region, which succeeded in getting access to an alternative source of gas, but south-eastern EU member states (e.g. Bulgaria, Hungary and Romania) would still be able to meet gas shortages in the event of a cut-off thanks to small underground storage facilities and limited gas transmission capacities on their borders, which would congest the flow of gas from other directions in case of emergency. The latter explains Bulgaria’s and Hungary’s strong interest in keeping close ties with the Kremlin over energy cooperation. But the EU could still reduce the Hungarian leadership’s submissiveness to Russia by further integration of the south-eastern EU member states into the Central European gas network.
EU–Ukraine gas infrastructure and common commercial projects would drive deeper integration into a unified single energy market—a core priority for the whole Union—and eventually develop the energy security environment. Ukraine’s cooperation in gas trade with Slovakia and Poland meets two significant objectives: it demonstrates commercial interest, and it meets a long-term strategic goal to decrease dependence on Russian gas. In a commercial sense, as a big importer of gas—around 24 bcm annually—Ukraine represents a particular interest for future suppliers. A Polish–Ukrainian project to construct a bi-directional pipeline (of 8–10 bcm capacity) connecting Ukraine’s gas transmission system and Poland’s Świnoujście LNG terminal would create an attractive regional market connecting consumers in the Baltic (with a planned interconnector to Lithuania) and Central Europe (with the interconnectors to the Czech Republic and Slovakia to be completed by 2018). With further cross-border expansion and integration, demand and thus the supply interest would grow. Ukraine could become a part of the north–south corridor and join a regional gas hub. Geostrategic position should be a driver in commercial endeavours, coupled with the consideration of how to assist Kiev. The latter should not be a core priority—Ukraine is already learning how to resolve its political challenges by business solutions and required reforms.
On the subject of reforms, Kiev has started to deliver to Brussels a number of legal measures to boost transparency in the administration of the gas transmission system. Ukraine’s TSO, Ukrtransgaz, has already started providing European Commission observers with ongoing access to its facilities, including metering stations, in the framework of the ENTSOG transparency platform, in order to monitor the transport of natural gas through Ukraine. In addition to providing physical access to Ukraine’s gas transmission system, Ukrtransgaz has begun transmitting comprehensive daily information to the European Commission monitoring mission regarding European consumers’ Russian gas orders, gas volumes entering Ukraine from Russia and volumes destined for the EU and Ukraine. Both Kiev and Brussels are on the right legal, political and commercial track, despite Russia’s threats to cut gas supplies.
As Brussels seeks a bigger say in energy talks with Russia, Ukraine should be included as an equal partner into a broader EU effort to integrate the bloc’s energy market and wean the Union off its dependence on Gazprom’s monopoly. The EU can ease the standoff between Ukraine and Russia once Ukraine’s transparent and energy-efficient market players become equal partners with EU member states in the framework of the EU single energy market.


This article was published in ICDS Diplomaatia magazine.