European Energy Grip Loosening

BMI View: Russia's economic and political influence in Europe is in decline as its grip on Europe's energy markets diminishes. While the country will remain a major supplier of European energy for the foreseeable future, its footprint in the region is being undermined by tighter EU legislation and energy diversification, both of which have been largely driven by a desire to reduce dependence on Russian energy.

Russia's attempts to exert political influence over emerging Europe via its energy policy is backfiring, encouraging many of its eastern neighbours to speed up energy diversification, while also driving some to bolster ties with the European Union. The most recent example of this trend is Ukraine, where the traditionally pro-Russian Party of the Regions looks set to sign an Association Agreement and a Deep and Comprehensive Free Trade Agreement (DCFTA) with the EU in November.

The former Soviet state, which remains almost entirely dependent on Russia for its energy requirements, will likely be joined in November by two other former Soviet states, Moldova and Georgia (although Georgia will only sign the DCFTA in November, with an Association Agreement likely to follow next year). We believe such moves have been prompted by Russia's persistent use of its position as a major energy supplier to exert a political influence over these states, and the threat of trade restrictions by Moscow in what looks like retaliation for closer ties with the EU reinforces this view.

Coal Prices Much More Competitive
First-Month ARA Steam Coal (CIF) & German Natural Gas Price, Day Ahead

BMI View: Russia's economic and political influence in Europe is in decline as its grip on Europe's energy markets diminishes. While the country will remain a major supplier of European energy for the foreseeable future, its footprint in the region is being undermined by tighter EU legislation and energy diversification, both of which have been largely driven by a desire to reduce dependence on Russian energy.

Russia's attempts to exert political influence over emerging Europe via its energy policy is backfiring, encouraging many of its eastern neighbours to speed up energy diversification, while also driving some to bolster ties with the European Union. The most recent example of this trend is Ukraine, where the traditionally pro-Russian Party of the Regions looks set to sign an Association Agreement and a Deep and Comprehensive Free Trade Agreement (DCFTA) with the EU in November.

The former Soviet state, which remains almost entirely dependent on Russia for its energy requirements, will likely be joined in November by two other former Soviet states, Moldova and Georgia (although Georgia will only sign the DCFTA in November, with an Association Agreement likely to follow next year). We believe such moves have been prompted by Russia's persistent use of its position as a major energy supplier to exert a political influence over these states, and the threat of trade restrictions by Moscow in what looks like retaliation for closer ties with the EU reinforces this view.

Why Now?

The use of energy policy as a political bargaining tool by Russia is nothing new, but the changing nature of the global energy market over the last few years means that energy diversification for many emerging European countries is now a realistic (albeit still costly) goal. Some regional economies, most notably Poland and Ukraine, are already trying to replicate the success of US shale gas development, while others are seeking to benefit from the additional supply of liquefied natural gas (LNG) on global markets, which has been made available thanks to reduced demand for US gas imports and new discoveries and technological breakthroughs.

These changes are in marked contrast to Russia's energy sector, which has been slow in adapting to new technology, largely because its monopolistic grip over Europe's energy market led to policy inertia and a system of patronage that precluded innovation. Rather than invest in production, state-run gas giant Gazprom focused on expanding it network of gas pipelines, using a system of diversified and oil-linked pricing to keep margins high. Add to this the prevailing threat from Moscow that it could cut off gas supplies should its demands not be met, and many regional economies now have both the incentive and ability to diversify away from Russian energy.

What Will The EU Do?

A key factor in determining Gazprom's fate is the behaviour of the EU, which has become increasingly active in clamping down on what it sees as unfair pricing and the hindrance of gas flows for its central and eastern European members. If the European Commission's investigation concludes that Gazprom is guilty of such practices, the outcome will likely be a fine for the company (around 10% of last year's revenues) and a renegotiation of pricing contracts. Although our Oil & Gas team does not believe that new contracts would likely lead to a significant reduction in the cost at which Russian gas is sold to the region, any limit on Gazprom's ability to independently price its contracts would imply a significant reduction in influence for the company, and therefore the Russian government in the region.

However, while the EU crackdown on Gazprom is significant, we are wary of overstating the EU's willingness to tackle Russia's energy grip on the region. Firstly, the EU only appears willing to directly challenge Gazprom when member states are involved. For instance, Ukraine recently signed a deal with Germany's RWE to import surplus Russian gas from Slovakia, which would be significantly cheaper than gas imported directly from Russia. According to the Ukrainian authorities, though, they are still waiting for gas to flow back across the Slovak border, which the country's prime minister said "raises questions for us about the EU's politics". In other words, despite Ukraine being a member of the EU's Energy Charter, the government is frustrated by the EU's apparent lack of desire to adopt a similarly tough stance with Russia as it has done when EU member states are concerned.

Coal Prices Much More Competitive
First-Month ARA Steam Coal (CIF) & German Natural Gas Price, Day Ahead

More important to understanding the EU's approach to Russia's energy influence, in our view, will be the trajectory of the EU's environmental/energy policy, which at present is torn between the desire to make energy prices more competitive while satisfying stringent emissions and renewable targets. The use of gas in electricity generation for Western European economies has become much less competitive than coal since 2011, due to a higher volume of US coal exports in recent years (thanks to the shale gas revolution), the shift away from nuclear generation following the Fukushima disaster, spike in gas prices following the Arab Spring and an ineffective carbon emissions trading scheme.

If it were purely a question of economics, this would imply a significant reduction of EU demand for gas imports from Russia and a higher use of coal in the energy mix. However, the EU's commitment to a low-carbon economy (encapsulated by the adoption of the '20-20-20' targets) requires member states to reduce greenhouse gas emissions by 20% by 2020 from 1990 levels, while raising the share of the EU's energy consumption produced by renewables by 20% over the same period. With Germany now phasing out nuclear energy, and costs of nuclear too inhibitive for many cash strapped regional sovereigns, this increases the appeal of gas as a low-carbon energy source.

High Incentive To Lower Costs
Domestic Electricity Prices for Selected Countries in 2012, GBp/kWh

In short, if the EU chooses to continue with its low-carbon targets Russia will maintain a position of significant leverage over the region. However, we are sceptical that these targets will be met, since Europe faces much higher electricity generation costs than most other regions, in part because of the push for higher renewable/lower carbon mix. According to data from the UK's Department for Energy & Climate Change, the average price of domestic electricity for EU15 economies was double that of the US in 2012, with prices in Germany almost three times higher. While we believe Europe's economic trajectory is on a stronger footing heading into 2014, the region will struggle to remain competitive with energy prices at such high levels. For that reason we see a strong possibility that EU carbon emissions and renewables targets (beyond those already set for 2020), and therefore demand for European Russian gas, will be scaled back over the next few years.

What Can Russia Do?

Even if the EU does go down the path of lighter environmental regulation, there are still several options open for Russia to reverse its declining share of Europe's energy market. For starters, adopting a more transparent and hegemonic pricing formula could help allay concerns that it is seeking to exert political influence over its western neighbours. Indeed, it is no coincidence that a recent study by the European Commission showed much greater support for shale gas development in EU states that have traditionally suffered the most from Russia's differentiated pricing policy - the results imply particularly strong support for shale gas development in Poland and Lithuania.

Another way Russia could reverse its declining share of Europe's energy market is to liberalise its own domestic oil and gas markets, and break up Gazprom's gas export monopoly. A new bill from the country's energy ministry which allows Rosneft and Novatek to export LNG is a step in this direction, and while Gazprom still maintains a monopoly on pipeline gas, there are signs that this is also under pressure. Rosneft, whose CEO Igor Sechin is a leading figure among Russian conservative hardliners, has been pushing hard to gain a greater share of Russia's gas market, and with the liberals in the President Vladimir Putin's cabinet also pushing for greater energy liberalisation, Gazprom is likely to face ever greater competition from domestic peers over the next few years.

Questionable Economics
Proposed South Stream Route

Nevertheless, much of Rosneft and Novatek's efforts are focused towards Russia's Far East, where the potential for supplying Asian gas demand is much more appealing. Moreover, with Gazprom pushing ahead with its South Stream pipleline, which will serve South East Europe by supplying gas directly from Russia to Bulgaria via the Black Sea, at present we see no indication of any imminent change in Russia's energy policy towards Europe. Indeed, the high estimated cost of South Stream, combined with the fact that it is designed to completely bypass Ukraine (similar to Gazprom's Nord Stream pipeline, which serves Germany via the Baltic Sea, bypassing Poland in the process) implies that energy policy continues to be driven by political as much as, if not more than, economic motives.

Even if South Stream does not go ahead - the EU antitrust regulator may still block the project, and Gazprom is struggling to find financing - Russia will remain an important player in Europe's energy mix for the foreseeable future. On balance, though, we believe that the country's grip on the region's energy market is past its peak, which combined with a failure to modernise and ongoing desire to exert political influence will have severe economic consequences over the next decade and beyond.

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This article is tagged to:
Sector: Country Risk
Geography: Georgia, Moldova, Russia, Ukraine, Russia
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