All set for the next gas crisis in the EU?

As Europe now seriously enters the winter season, the spectre of cynical season’s greetings from Russia in the form of gas supply cuts looms over the coming Christmas break. Over in Moscow, as the regime is more nervous due to the dire economic situation, there is clearly a sense that the January 2009 gas crisis has badly ruined Gazprom’s and Russia’s reputation. This indicates that there will be caution in taking such a decision again as the ritual annual contractual fights heat up with crisis- and faction-ridden, electioneering, Ukraine.

But there are many reasons to remain worried.

Why one can expect more supply cuts

Firstly, certainly Prime Minister Vladimir Putin, who has been the one to make public statements to the EU on behalf of Gazprom, has made an effort to step up early warnings to the EU on potential supply cuts. But early warnings can as well be understood as early threats.

Secondly, while President Medvedev has taken over the lead in communicating softly to a domestic and international audience with liberal sensitivities, the real hard practice in the field of politics and economics remains illiberal and corrupt. Sacking some officials and prison wards, or tolerating a walk-out from Parliament by a few of its members after fraught local elections is maybe the first sign of changed, but it is still only a bit of powder on a ravaged face, not long-term reform policy. This means Gazprom too, despite weak-willed attempts at, for example, tackling corruption there, is not changing policies substantially, especially since its boundaries with the Kremlin remain as blurred as ever.

Thirdly, Gazprom is in a situation in which it might act unpredictably. It has been hit very hard by the financial and economic crisis. It has not managed to reform its inefficient production system. What is more, the oil price has stabilized at around 70 USD, which is to the dismay of everyone: not low enough so as to force the authorities who lead Gazprom to change their strategies, not high enough for them to give the Kremlin a free hand in its wider gas-weapon wielding ambitions. This is an uncomfortable equilibrium in which erratic behaviour is likely to be the rule.

But cosmetics to hide an ugly reality are not only a Russian specialty.

Why the EU is still not prepared

In Europe too, not much has changed. It is still not sufficiently prepared for potential new gas supply disruptions. And it has not acted seriously to do away with the structural problems in its gas markets that render the EU vulnerable to Gazprom’s divide-and-rule tactics. After the three-week supply disruptions of January 2009 a Brussels in shock launched a new Regulation to prepare its member states for supply disruptions. The member states didn’t like it, although it is simply an attempt to oblige governments to store more gas and facilitate interconnections between all those isolated small markets. In the Baltics, which are also dangerously exposed to unilateral gas supply disruptions by Russia, all the EU has been able to come up with is a “Memorandum of Understanding on the Baltic Energy Market Interconnection plan”: best endeavours, not more. Whatever actions that have been launched since the Regulation and the Memorandum were issued this summer, these are not likely to be sufficient.

The deeper truth is that the EU is only scratching the surface of a fragmented gas market that is a legacy of Soviet times in Eastern Europe and the result of the EU’s earlier failed attempts to increase EU-wide competition.

Competition deficit

Ongoing research at ECIPE (and elsewhere) shows that what is really needed is not more Memoranda or Regulations to force government to spend on storage and to collaborate, but more gas market competition. This is what has so far proven to be capable of freeing in a sustainable way the required energies to invest in infrastructure and better interconnect the EU’s currently compartmentalised national gas markets. This is based on evidence from the experience of the Dutch and UK gas markets which have dismantled previously vertically integrated national gas companies and as a result proven to be very liquid, flexible, and responsive to sudden changes in gas supply structures. This dismantling has been dubbed “full ownership unbundling” and proposed by the EU Commission in the much-discussed Third Energy Package and its Gas Directive adopted in 2009.

But “full ownership unbundling” will, it turns out, be adopted by a minority of member states in the EU. Worse, in the member states that have the least competitive gas markets there will be no change at all to the status quo. Estonia, Latvia and Finland are explicitly exempted from any unbundling provisions. Most Central and Eastern European member states, and in particular the ones that have been most damaged by the January 2009 gas crisis, Bulgaria and Slovakia, will adopt the so-called Third Option, which only imposes changes in the management structure of companies but does not dismantle ownership. This means that the market restrictive behaviour of the national gas champions will continue.

All these countries’ gas markets are run by one major gas monopoly that imports and distributes gas in the markets. In all those countries Gazprom has not only an overwhelming power on the market because it delivers up to 100% of these countries’ gas, but also because if its investments in the dominant gas company and/or its role in the intermediary gas trading companies. Not to mention because of long-term contracts with Gazprom Export.

These countries have done the least efforts to build a diversified supply mix with less reliance on imports from Russia and on the domestic companies in which Gazprom is involved. Bulgaria, for instance, has a state controlled gas sector that is fully dependent on imports from Russia. The intermediary in the market is Topenergo, which is a subsidiary of Gazprom. Slovakia is also 100% dependent on imports of Russian gas, and its market is dominated by the distributor SPP, a joint venture between the Slovak government and Slovak Gas Holding, a Netherland’s-based consortium co-owned by E.On/Ruhrgas and Gaz de France, with links to Gazprom as well. SPP has recently signed a new long-term supply contract with Gazprom. It is not surprising to find that Bulgaria and Slovakia were the two countries that were most unable to respond effectively to the gas disruption last January. All actors in the supply chain have in these countries an incentive structure linked to Gazprom. In the view of these companies, it is not economically rational to diversify imports or to invest in significant storage capacity.

One might argue that these countries are in a special position and not ready for full ownership unbundling. And what if Gazprom shuts off the taps to express disagreement? But look at Hungary. Hungary, contrary to most new member states, has chosen the path of greater competition. In 2007, it implemented full unbundling of its until then vertically integrated company MOL. Immediately, investment into new infrastructure - storage capacity, interconnections with neighbouring country pipelines etc – took off. Hungary’s new investments in its CAPEX of its FGSZ Natural Gas Transmission soared from insignificant levels in 2006, to € 60 million in 2007, and more than four-folded in 2008 (more than € 250 million). This new–won dynamism in Hungary’s gas markets explains why Hungary has been more resilient than others during the January 2009 gas crisis, and has been able to benefit from interconnections with Austria, Germany and other markets.

Antitrust action gap

 There is a parallel option available in Brussels to at least tame the behaviour of big oligopolistic companies: antitrust policy. Brussels has recently very courageously launched high-profile cases against the big gas majors in the West: ENI, Gaz de France, E.On Ruhrgas, RWE. To stress our point on the link between the state of domestic competition and insufficient investment in infrastructure, the EU accuses ENI of abuse of its market dominant position leading to “capacity hoarding and strategic underinvestment in the transmission system”. So what do you think is going on in Central and Eastern Europe? And why, why has there been no antitrust action where it is most needed? France, Italy, Germany have alternatives to Russian gas and to Gazprom. But most of the new member states don’t. Nothing in EU law stops the Commission from taking such action.

Supply disruptions by Gazprom can in some cases be considered abuse of market dominance. This is because member states which are strongly dependent on Russia as supplier have been subjected to them even it they have not breached their own contractual obligations towards Gazprom. If a gas intermediary, a Gazprom subsidiary, or a company invested by Gazprom are investigated or even fined, then Gazprom might well think twice next time before it shuts off taps. Furthermore, domestic gas monopolies should also be forced to act more competitively anyway, regardless of the status of gas market legislation, simply to comply with the EU’s basic Single Market rules.

Competition policy has been the weakest link in the response to the EU’s rising dependence on Russian gas imports and to Gazprom’s monopolistic and abusive behaviour. It is good to force governments to store more gas, or to subsidize investments in interconnectors, or to support the Nabucco pipeline, and investment in alternative energy sources. But these policies will never be truly sustainable if the underlying market structure remains as it is.