With Russia having retreated from the Energy Charter Treaty (ECT) last year, it is high time the European Union (EU) start regulating its relations with Russia in a bottom-up fashion. The only means the EU has to regulate the behaviour of the major source of gas supply disruptions in the last years, Gazprom, the Russian gas export monopoly, is its own body of laws. Competition law is one of these, and it is one of the most powerful. Gazprom has a dominant market position in most Central and Eastern European markets, which have been the Achilles Heel in Europe’s dependency-ridden relationship with Russia. Not only does Gazprom supply up to 100% of their gas, but it is also a major investor in the local gas companies, be it the gas monopolies or the intermediary traders. Furthermore, most markets are locked into long-term supply contracts with Gazprom. More competition in these markets would trigger investment into alternative sources of supply and force Gazprom to think twice before it resorts to the gas tap when the authorities use the company to further non commercial objectives abroad. The EU Energy Package adopted in 2009, will unfortunately not significantly alter the competition situation. But much more could be done by stepping up antitrust action where it is most needed, namely in the EU’s Eastern rim.
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The risk of a new gas crisis is very well alive and still looming large over the EU. This winter, although Prime Minister Putin has sent reassuring messages as to gas supplies to Ukraine and hence to the EU, and has decided to use the energy “weapon” in the oil rather than the gas sector in its dealings with Belarus, the Kremlin is maintaining the pressure.
Russia is very likely to resort again to gas supply disruptions in its dealings with its partners to its West. Although it has been battered by the financial and economic crisis, the ruling elite in Russia has not modified its foreign policy outlook. Furthermore, 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. There are no signs of long-term reform policy. This means Gazprom, the company that holds the monopoly over gas exports from Russia, is not changing policies substantially. Its boundaries with the Kremlin remain as blurred as ever.
Gazprom is in a situation in which it might act erratically. It has been hit very hard by the financial and economic crisis. It has not managed to reform its inefficient production system. The oil price has stabilized at around 70 USD, which represents an uncomfortable equilibrium: the price is not low enough so as to force the authorities who lead Gazprom to drastically change their strategies, nor is it high enough to give the Kremlin a free hand in using the gas tap to score foreign policy points.
The solution to Europe’s vulnerability to supply disruptions lies within EU law itself. The EU cannot discipline and depoliticise Russia’s behaviour in the gas markets by the means of international treaties such as the Energy Charter or the World Trade Organization (WTO), let alone the ever-elusive bilateral Partnership and Cooperation Agreement talks. Indeed, in the summer of 2009, Russia silently withdrew from its commitment to provisionally apply the ECT, the plurilateral agreement regulating investment protection and transit in the energy sector in Europe and the former Soviet territory. Russia is neither a member of the World Trade Organisation (WTO) nor signatory to any other international economic agreement that could limit the discretionary power of its government in the field of energy.
The fact that the EU is increasingly dependent on imports of gas, especially from Russia, is not per se a problem. But in the case of Russia, it is faced with a foreign monopoly state-owned supplier, Gazprom. The EU’s gas market is currently organised in such as way as to reinforce the market power of that supplier. Europe’s energy markets remain strongly in the hands of the state, and continue to be fragmented along national lines. Too often there is too little competition among too small a number of suppliers. This must finally change.
The policy focus now should be on achieving, for real, the Single Market in gas. After the three-week supply disruptions of January 2009, Brussels, in shock, launched a new Regulation to prepare its member states for supply disruptions. The latter did not appreciate a move they considered an undue encroachment on their national sovereignty. The regulation is however simply an attempt to bring governments to store more gas and facilitate interconnections among the individual parts of the patchwork of isolated, generally small, markets that make up Europe’s gas landscape. A new Strategic Energy Review stated similar goals. In the Baltics, which are also dangerously exposed to unilateral Russian gas supply disruptions, 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. In all these texts, any mention of market-based mechanisms remains hortatory at best.
This means that the EU is only scratching the surface of the fundamental problem of gas supply insecurity: insufficient levels of competition within national markets. This makes them particularly vulnerable to the behaviour of a potentially abusive dominant economic player. Whilst most other economic sectors of the new EU member states have successfully plugged into the EU’s markets, the gas markets have not. These have remained a legacy of Soviet times. Therefore, the policy response that is really required is not so much another set of Memoranda, Strategic Reviews or Regulations to force often inefficient, currently cash-strapped, governments to spend on storage and to collaborate, but more gas market competition.
Providing an effective framework for competition is the most sustainable tool to free the required energies to invest in infrastructure and better interconnect the EU’s gas markets. Yet competition has turned out to be the weakest link in the string of policy responses to the rising challenges in the field of energy. An increasing number of voices from academic economics, and the EU Commission itself after is thorough Energy Sector Inquiry of 2005-2007, have voiced this view. This is based on evidence from the experience of the Dutch and UK gas markets which have dismantled previously vertically integrated national gas companies. Their markets have, as a result, proven to be very liquid, flexible, and internationally well integrated. They are responsive to sudden changes in gas supply structures, not least because they have fostered an environment in which Liquefied Natural Gas (LNG), the new easily transportable gas technology, and spot markets, which allow for last-minute purchases, have flourished most. These help respond to short-term needs, such as those resulting from the failure of a supplier to deliver. This dismantling of companies into separately owned entities in charge of production, distribution and transmission, has been dubbed “full ownership unbundling” and proposed by the EU Commission in the much-discussed Third Energy Package and its relevant Gas Directive of 2009.
Yet “full ownership unbundling” will, it turns out, only 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 alter 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 an overwhelming power because it delivers up to 100% of these countries’ gas. This power is reinforced by its investments in the dominant local gas company and/or its role in the intermediary gas trading companies. This highly asymmetric relationship is reinforced by long-term contracts between Gazprom Export and the local, generally government-owned, national monopolies.
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 Netherlands-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 three-week-long gas cuts in January 2009.
The Baltic States have also been victims of gas supply disruptions since their independence from the former Soviet Union. Here too, the incentive structure in their small isolated markets is biased in favour of Gazprom. In Estonia, Gazprom holds a 37% stake in Estonia’s Eesti Gaas, which itself has shareholdings by E.On Ruhrgas (in which Gazprom has a 6.4% share), Finland’s Fortum Oy, and Itera (which has links to Gazprom too). A similar pattern can be found in Latvia: 34% of Latvijas Gaze is owned by Gazprom, whilst the rest of the company is co-owned by the same E.On Ruhrgas and Itera.
Because all actors in these countries’ supply chain have an incentive structure linked to Gazprom, they are the ones have done the least efforts to build a diversified supply mix with less reliance on imports from Russia. The domestic companies with links to Gazprom do not consider it economically rational to diversify imports or to invest in significant storage capacity. Indeed, all benefit from the rents provided by the current situation and high energy prices. Should one local actor seek to diversify imports, it is likely to face sanctions from the dominant supplier. When competition is the name of the game, however, then it is the local player that can “sanction” abusive market behaviour by switching to an alternative supplier in the EU or beyond.
Hungary, for its part, a country that is also almost entirely dependent on Russia for its gas imports, has started moving in a new direction. This has had positive results on its security of gas supplies. In 2007, it implemented full unbundling of its until then vertically integrated company MOL. Immediately, investment into new infrastructure - storage capacity and interconnections with neighbouring country pipelines – took off. In its CAPEX FGSZ Natural Gas Transmission, new investments 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.
Unfortunately it is not likely that a new legislative proposal such as the last Gas Directive will be put forward soon. The politics of “ownership unbundling” are still not ripe enough. But 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. In the ENI case, the EU suspects the company of abusing its market dominant position so as to engage in “capacity hoarding and strategic underinvestment in the transmission system”. This vividly stresses the link between the absence of domestic competition and insufficient investment in infrastructure.
Given the current market structures prevailing in Europe’s Eastern rim, one can safely assert that similar things are occurring there too. So why has there been no antitrust investigations where they are probably 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”, which is prohibited by EU law. This is because member states which are strongly dependent on Russia as supplier have been subjected to them even if 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 before it shuts off taps again without sound contractual justification. 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.
The EU’s policy response to its rising dependence on Russian gas imports and to Gazprom’s monopolistic and abusive behaviour combines forcing governments to store more gas, subsidizing investments in interconnectors, supporting the Nabucco pipeline, investing in alternative energy sources, and promoting energy efficiency. All this makes sense. There are many arguments in favour of doing this even more forcefully. But none of these policies will ever be truly sustainable if the underlying market structure remains as monopolised as it is.
Gazprom is present in other EU markets such as the Netherlands, where competition conditions are better. This means that the presence of Gazprom in the EU markets is not per se a problem, as long as the markets are well regulated. Gazprom has benefited from previous liberalization of EU member state gas markets be it the 1990s privatizations in Central and Eastern Europe, or the Brussels-led liberalization Directives of 1998 and 2003. It has been able to gain a foothold, not only in the gas trade but also in downstream distribution. But Gazprom has fiercely resisted any move to increase competition in its invested markets. Gazprom is not alone. E.On Ruhrgas and Gaz de France, which have also invested in some Central and Eastern European countries don’t like seeing their comfortable market position jeopardized either.
In fact, Gazprom is very well likely to benefit from greater competition. The gradual but yet incomplete liberalisation achieved so far has posed a dilemma for the Russian gas giant. On the one hand, as spot trading and short-term gas sales are likely to constitute an ever greater share of the gas market to the detriment of the current model based on long term contracts with domestic monopolies, there is an incentive for Gazprom to participate in such trade. This would allow it to exploit margins between its marginal costs and short-term spot prices. On the other hand, it is exactly this short-term trading that will contribute to permanently lower gas prices in the European market, which is not what Gazprom wants under its current business model, and as the company is becoming increasingly inefficient. Furthermore, the undermining of long-term supply contracts would diminish the bilateral leverage Gazprom - and by extension the Kremlin - has over individual EU member states.
Gazprom’s business model is currently under strain. It has lost revenues during the crisis. It is faced with severe investment gluts. And it is loosening its grip over its cheap Central Asian suppliers, after gas-flush Turkmenistan recently opened a pipeline towards China. Forceful implementation of the EU’s own Single Market tools would probably help the gas behemoth to decide for good in favour of playing it on a fair competitive grounding in the EU markets, which will remain its main export outlet for many years to come.
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Iana Dreyer is Trade Policy Analyst at the European Centre for International Political Economy.
She is co-author of “The Quest for Gas Market Competition - Fighting Europe’s Dependency on Russian Gas More Effectively” and “Russian Commercial Policies and the European Union – Can Russia be Anchored in a Legal International Economic Order?”. These articles can be downloaded for free at www.ecipe.org.