European reliance on Russian Gas and Its Deep Implications
By Vladimir C. — Master in Political Sciences (Germany) — Blue Europe 2021 Contest — Review by Grzegorz Wiśniewski and Brian Fabregue
The European Union’s 27 member states now rely on Russia for a major share of their imported natural gas; this reliance will grow considerably bigger if European states continue to pursue their terrible existing energy policies. With plans to phase out nuclear power in several European countries, the EU’s goal of reducing coal consumption and thus greenhouse gas emissions, and the depletion of domestic gas sources, reliance on Russia has increased considerably even compared to only 10 years ago. Regardless of evolution of relations, EU countries must immediately collaborate to develop a coordinated diversification policy.
Nearly two decades ago, the European Union began introducing competition into the European natural gas market. As a result, a process emerged that fundamentally altered the gas market’s organization and coordination, as well as the function — or even the presence — of specific sorts of individuals. In the mid-2010s, the restructuring of the energy market process was still ongoing. Simultaneously, significant changes in the geopolitical, environmental, and technological factors of the European and worldwide energy and gas markets may be noticed. These changes have had a significant impact on the development of ‘reactive’ policies inside the European Union, both in Brussels and in the Member States. The progression of Europe’s natural gas policy toward a highly regulated form of a ‘well-functioning’ gas market continues to be a highly contentious and unstable experiment. Natural gas’s worth is continually fluctuating between economics, supply security, and sustainability. Additionally, the weight accorded to these values and their operationalization varies across Europe. As a result, establishing a ‘well-functioning’ EU gas market will always be a politically charged and never-ending story.
The notion that ‘the market’ requires additional development is a recurring message, and new rules, laws, and interventions are proposed on a regular basis. Initially, it was thought that these difficulties were caused by delays in the market restructuring process. The persistent exercise of market power by producers, wholesalers, and retailers harmed the EU gas market’s ability to function as an efficient coordination system. Indeed, competition between many suppliers has developed mostly in northwestern Europe, while other regions continue to be supplied by a single source, Russia, or a few. The solution is to increase competition through deeper restructuring, stricter oversight and control of market actors’ behavior, and more effective regulation of transportation and storage infrastructure.
Simultaneously, significant changes are taking place in the European and worldwide energy and gas markets, as well as the world in which these markets operate. To begin, the EU has been extended geopolitically by admitting additional Member States in central Europe that were previously Warsaw Pact members. Additionally, the erstwhile Soviet republics have achieved independence and are pursuing their own political and energy agendas, impacted or not by domestic conflicts. Second, in terms of energy and environmental policy, the growing acceptance of global warming as a result of the usage of fossil fuels has affected the EU countries’ preferences and priorities for energy supply. Thirdly, in terms of technological progress, the quick maturation of both LNG and unconventional gas (and oil) production has significantly affected both the local availability and transportability of gas resources. The latter, in particular, has had an economic influence on integrating the world’s three major continental gas markets: America, Eurasia, and southwest Asia.
As will be seen below, changes in these geopolitical, environmental, and technological drivers have had a significant impact on the development of ‘reactive’ policies in the European Union, both in Brussels and in Member States. Meanwhile, the overall energy and gas market policy objectives remain constrained by the EU’s unique vision of how to construct a ‘well-functioning’ market in a sector that exhibits at least some of the characteristics of a natural monopoly.
This begs the intriguing question of whether the existing European gas policy can continue on its current course of primarily establishing a ‘well-functioning’ gas market through more or less constant regulatory involvement. This, while in the second row, a slew of changes are occurring that affect the assessment of critical values such as natural gas’s role as the primary energy input in the European economy, supply security, sustainability, and the economics of gas supply. It is critical to highlight that these ideals are valued differently in different parts of Europe.
We will begin by discussing some of the essential aspects of the gas sector. Following that, we will briefly discuss how the European gas market has been restructured by later EU Commission directives and actions. Following that, we will address the fundamental changes in the European gas market and the global energy landscape briefly. We finish with a discussion of how these factors combine and the implications for gas in Europe.
The European Gas Industry
The natural gas industry is divided into three distinct sectors: Upstream, gas exploration and production occur. The midstream segment is responsible for transporting gas to local distribution grids, industrial users, and power plants. Generally, gas is transferred on a continental scale by high-pressure transmission pipelines. Overseas, the gas is transferred as LNG through tankers. Storage of gas is possible in salt caverns or depleted gas fields. Local distribution grids distribute gas to small home and corporate consumers downstream.
Developing, operating, and exploiting these production, transportation, distribution, and storage systems are difficult and risky endeavors. To begin, they necessitate significant capital expenditure; capital expenditure accounts for the lion’s share of total cost. Second, the assets involved are very specialized; once developed at a particular place, they cannot be withdrawn or repurposed if either the supply or demand of gas ceased. These charges have been’sunk’ literarily. Thirdly, all parties are entangled in some degree of interdependence with respect to one another. Pipelines, LNG facilities, and storage facilities are critical infrastructure for producers, traders, and end users. Thus, access to these facilities is a critical determinant of the supply system’s operation and the economic well-being of the parties involved.
Volume and price risk are critical in this regard. Gas producers and infrastructure operators will earn a profit only if their assets are operated at a fair rate of throughput and generate revenues sufficient to pay their costs over the long run. They require expect security. By investing in specialized gas-fired appliances and installations, users demonstrate their commitment to utilizing gas. They require supply assurance, certainly at a price that is acceptable in comparison to the cost of alternative energy sources.
Generally, as a result of these circumstances and the economy of scale associated with their technical and spatial characteristics, gas systems have been seen as natural monopolies incapable of competition. Historically, economic notions such as market flaws, market failure, and public goods have prompted governments to interfere and regulate the business in order to protect the public interest and the industry’s economic stability. In those countries that produced gas, the public interest in resource management served as an additional justification for state engagement.
In Europe, public coordination was almost often accomplished through direct official intervention. International gas transmission and wholesale commerce were administered by joint ventures between gas producers and national and local governments, while municipal gas firms managed local distribution networks and retail trade. Commercial transactions and market coordination were facilitated through long-term contracts, which included take-or-pay and destination clauses and linked the gas price to the price of oil products, which served as the primary substitute for gas, while gas producers received revenues on a net-back basis. The net-back principle states that producers (and governments) receive a residual amount after all costs are covered. Public finance and economic coordination were critical elements in this scenario. Gas production and sales were governed by complex exploration, production, and taxation systems. Frequently, gas price was employed to stimulate regional and sectoral economies.
Restructuring the European Union’s Gas Market
Since the late 1970s, such types of public involvement and market coordination have come under growing fire, originally primarily in the Anglo-Saxon world. ‘Rolling back the state’ in the manner of Margaret Thatcher and Ronald Reagan, as well as the introduction of competition, would enable more efficient provision of energy, water, public transportation, and other public services. The European Community established the Single European Market as a broad strategy for liberalizing the EU economy in 1985, followed by ‘The Internal Energy Market’ in 1988, which supported a similar reorganization of the EU’s energy sector. The fundamental justification was to remove restrictions to intracommunitarian commerce in products and services, but the neo-liberal perspective on competition and efficiency, as well as economic interests, also played a part.
On this foundation, a vision for a European gas market eventually emerged, with competition between gas producers and suppliers in the upstream segment and traders in the wholesale and retail segments. To accomplish this, it was anticipated that long-term contracts would give way to short-term transactions. The market price would be determined by scarcity situations, thereby balancing the supply and demand for gas. Liquid spot markets were predicted to develop in areas where diverse sources of supply met demand. A precondition for this was that competing traders would be granted access to critical transportation, distribution, and storage infrastructure necessary to reach their clients. To this purpose, Europe has embraced three fundamental regulatory ideas.
To begin, critical facilities would have to be ‘unbundled’ from production and trading activities, in the sense that their operators would have no commercial incentive to manipulate gas flows or to profit from the market intelligence generated by their systems’ operation. In the case of transmission and distribution pipelines, an increasing degree of legal and management unbundling has been required over time. The majority of networks were spun off from previous wholesalers and local gas utilities to be administered as either transmission or distribution system operators (TSO or DSO). In the case of other LNG, storage, and conversion facilities, other regimes were authorized with possible exemptions from third party access restrictions, to be provided on a case-by-case basis, depending on their position as a (local) monopoly in a ‘relevant’ market.
The second principle entailed the granting of ‘discriminatory access’ to these critical facilities for trading parties. This clearly included not only access to transportation infrastructure, but also to storage, LNG, and quality conversion facilities as needed. Initially, this was accomplished through relatively straightforward ‘first come–first served’ contracts, under which traders may reserve a given quantity of capacity for a specific time slot at a specified rate. Nonetheless, a more complicated technique developed through time, in numerous levels. Access to transmission pipelines has evolved into a so-called entry-exit model, in which ‘shippers’ of gas reserve their entry and exit rights for particular volumes of gas to be supplied into or removed from the transport system at certain places.
The core of this model is that it abstracts away from the real paths taken by gas molecules on their way to their destination. As a result, it gives shippers the greatest possible flexibility in terms of purchasing and selling to market partners regardless of their location. Tariffs for entry and exit at certain sites are uniform for all shippers. In general, when it comes to distribution networks, so-called postage stamp tariffs are used, in which a seller books his admission into a certain zone based on the location of his client at a pre-specified tariff. Other facilities’ access criteria are determined by their exemption status; either their owners or operators must grant access to any interested users under pre-specified conditions, or they are free to select how they use their capacity.
A critical component of providing access, in conjunction with the tariff system, is allocating available capacity to interested shippers. Beginning with simple first come–first serve regulations, a complicated series of processes was devised to maximize the utilization of the physically restricted capacity available to shippers, therefore decreasing so-called contractual congestion. On the other hand, the purpose became to allocate scarce capacity efficiently to those shippers who place the greatest value on it. As a result, a range of mechanisms for tendering and secondary trading capacity, as well as re-allocating underutilized capacity, have been devised. The overarching goal was to enable shippers to match the commodity transactions they organized in the gas market with the proper handling arrangements for transporting the gas to their clients or storage facilities.
A third principle was that the gas infrastructure inherited from the conventional gas sector still reflected the inherent monopoly status of the industry. The primary factors in this regard were ‘gold-plated’ excessive investment in assets, high operational costs, high tariffs that did not represent the actual, economically efficient costs of transportation, and difficult procedures discriminating between different types of consumers and regions. To reduce the cost of infrastructure, tariff and/or revenue regulation would have to compel TSOs and DSOs to improve their operational efficiency and system use. This eventually evolved into a slew of price cap, yardstick, and RPI-X regulations. To this purpose, each Member State was required to establish a National Regulatory Authority (NRA) for the energy sector, which would be responsible for approving and monitoring tariffs (or procedures) that would assure non-discriminatory access to unbundled networks.
Implementation of the European natural gas strategy
Following some first experiments in the early 1990s, this liberal proposal for a gas market was adopted in stages. The European Commission issued progressively detailed and strict standards for Member States to implement with three consecutive Gas Directives. The 2009 Directive, often known as the Third Package, was particularly significant in that it united the many national approaches. This was in response to the Commission’s Directorate-General for Competition’s ‘Sector Enquiry’, which determined that a lack of access to infrastructure and the concentration of power in a few corporations were impeding the establishment of a healthy gas market.
Another significant part of the Third Package was the expansion of EU-wide collaboration. Concerning NRAs, the Commission established the Agency for the Cooperation of National Energy Regulators (ACNER) in 2009. (ACER). Since March 2000, the regulators have been cooperating freely through the Council of European Energy Regulators (CEER), in conjunction with the Commission-established European Regulators Group for Electricity and Gas (ERGEG). ACER was established to resolve regulatory gaps in cross-border circumstances and to facilitate EU-wide regulatory coordination. Its mission is to harmonize national market and network operation standards and to encourage investment in trans-European infrastructure. Additionally, in 2009, the unbundled national TSOs joined the European Network of Transmission System Operators for Gas (ENTSOG) to promote cross-border gas commerce and enhance the European transmission network, including by developing a 10-year gas network development plan.
The expanded EU-wide cooperation resulted in additional efforts toward attaining ‘frictionless’ cross-border gas trading in the EU through the gas target model (GTM) program. The GTM is intended to establish cross-border connections between national or regional entry/exit areas, suggesting that the price of gas in the area will be determined by instantaneous supply and demand, as in a virtual spot market. The delivery of long-term contracted volumes of gas will then occur at the entry/exit area’s boundaries, establishing the market price, which will also be influenced by occasional inter-area volumes acquired on a short-term basis.
Concerns concerning the security of gas supply were raised during the first decade of the twenty-first century. In 2004, the European Commission enacted a Directive (2004/67/EC) with the objective of establishing a standard framework for Member States’ security-of-supply policies that is compatible with the needs of a single gas market. Between 2006 and 2009, disputes between Russia and Ukraine created supply concerns in central and south-eastern Europe, prompting the implementation of a new rule (994/2010). This rule aimed to integrate national actions and establish universal minimum requirements for readiness in order to increase inter-state solidarity in the event of a catastrophe.
As tensions between Russia, Ukraine, and the EU grew, a so-called stress test was conducted in 2014; security of gas supply; and, more recently (in 2016), a draft proposal for a more comprehensive security of supply legislation was issued. This draft targets industry, Member States organized geographically, who are responsible for ensuring supply to protected customers, and the European Commission, which is responsible for overall coordination and consistency. The document emphasizes the importance of regional cooperation in developing preventative action plans and emergency plans. Additionally, it proposes an infrastructure standard that ensures gas delivery even when the largest infrastructure is unavailable, while allowing for permanent bidirectional transmission capacity.
The Role of Gas in the Energy Union’s Policy
The Commission presented its Energy Union agenda in February 2015, announcing a radical restructuring of Europe’s energy system.
