Avoiding the next gas crisis

This article was published in the Wall Street Journal print edition on 28 January 2009.

Now that the gas is flowing again, what should be done to stop the same thing from happening next winter? Gas crises like the one this month that saw Russia shut off deliveries to Europe via Ukraine have been an annual event since January 2006. Only in 2007 did Russia provide some variety by arguing with Belarus rather than Ukraine.

The European Union, Ukraine and Russia all need to act. Fortunately it will be easiest for the EU to put its own house in order first. Brussels should set a new standard of “energy security” for member states. Some will need to invest in conservation, others in storage, others in reserve supply. All have different requirements. But Hungary, where the local company E.ON Földgáz has built up at least two months of reserves since 2006, shows that a lot can be done if the political will is there, even by next January.

On the other hand, “energy solidarity” should mean sharing the burden between Brussels and national budgets by using structural funds. Bulgaria, for example, is connected only to the Ukrainian gas network and could not receive supplies from its EU neighbors. So it and other isolated countries need more so-called interconnectors that would link them to more networks, allowing gas to flow as it would in a true market next time there is a supply shock. A temporary price spike would help redistribute supply more quickly next time, including out of underground storage and in a reverse flow from west to east.

In the longer term, however, the EU must help break the “Mexican standoff” that currently exists between Russia and Ukraine. In every crisis to date, the two have only made a deal when one side thought it was losing the PR war. Neither country has enough material leverage over the other to force a deal: Russia controls production and transit from Central Asia, while Ukraine controls transit to Europe.

The only way to break the deadlock is to change the balance of power. Russia’s proposal to set up a new consortium among Gazprom and Gazprom-friendly companies like Germany’s E.ON Ruhrgas or Italy’s ENI will not do this. The Ukrainians would see themselves outnumbered. A more feasible alternative is for Ukraine to retain ownership of the pipeline, but for a genuinely tripartite consortium to run it on the basis of a long-term lease (30 years or more) and an international treaty establishing clear rules of transparency, longer-term price deals, supply reliability and dispute settlement.

The gains for European customers from such an arrangement are clear. Ukraine could be brought to the table with promises of a broader program of assistance in energy reform: more link-up to Europe’s electricity grid, the unlocking of domestic production potential, and a serious conservation drive. The EU might also link the creation of a consortium to the new Association Agreement it promised Ukraine in September.

Here, the EU will need both sticks and carrots. The crisis has already weakened Ukraine’s European ambitions by sowing distrust among the member states that found themselves without gas for more than a week earlier this month. But if the negotiations go well, the EU could help compensate for some of Ukraine’s declining NATO prospects and consequent security weaknesses. An EU mission to Ukraine’s most vulnerable trouble spot in the Crimea would be a good start. The peninsula is the one Ukrainian region with an ethnic Russian majority, and is home to the Russian Black Sea Fleet at Sevastopol on a lease that is due to run out in 2017. A highly visible EU program should help diversify the peninsula’s economy and boost its trading potential.

Russia would gain, too. There would be no more risk of gas theft, its customers downstream could relax, and there would be fewer political obstacles to its alternative pipeline schemes. Russia also needs urgent relief from a quadruple economic crisis. Its stock market has taken one of the biggest hits in the world over the last 12 months, with the RTS index down more than 70% from its 2008 peak. The slide started with Vladimir Putin’s July attack on mining company Mechel for allegedly evading taxes and selling its coal more cheaply abroad, then continued with the war in Georgia, before the global economic crisis even hit.

Second, Russia has structural problems that go far beyond the falling oil price and the gas price that will soon follow it down. One result of Mr. Putin’s policy of creating state-backed “national champions” is $480 billion of commercial debt, as Western banks lent too much money to Russian firms that ostensibly could not fail.

Third, Russia is facing an energy production crisis. Its national champions are champion profiteers, but they do not invest as they should. Russia simply cannot get enough gas out of the ground to supply everybody. Energy is still incredibly cheap in the inefficient domestic market, and the Kremlin will not risk social protest by putting up prices to discourage usage. Then it has to supply the Ukrainian pipeline, alternatives like Nord Stream and South Stream, and other distribution routes.

Fourth, when there is a choice between modernization and mobilization, Russia prefers to manufacture crises and enemies rather than real solutions. Whoever started the present crisis, Russia has exploited it to play triple divide-and-rule: widening splits between Ukraine and Europe, within the EU, and within Ukraine itself. A depoliticized and strictly commercial pipeline system through Ukraine will slowly leverage change throughout the Russian system.

Ukraine has plenty of accumulated problems, too. Its property boom has crashed, and its steel and chemical industries are almost at standstill. But it mainly needs relief from the political problems that have accumulated since the Orange Revolution in 2004. Corruption in the gas industry is the factor most responsible for driving the revolution off track. The notorious intermediary RosUkrEnergo made a publically stated profit of $795 million in 2007, but its payment in kind, 20% of gas deliveries to Ukraine, was worth more like $4.35 billion. That kind of money buys influence and fuels the constant gridlock in Ukrainian politics.

Prime Minister Yulia Tymoshenko has long campaigned in public against RosUkrEnergo, but the key agreement with Mr. Putin this month was made behind closed doors. The company may diversify into the domestic market, where it now controls 75% of distribution. But removing the cancer of gas corruption is a necessary precondition for cleaning up the political system in Ukraine.

No one has emerged well from the current crisis. But all will benefit if it prompts a serious search for a radical solution.