Gas Transit, Liquefied Gas and Connectivity with Europe: Interview with DiXi Group

September 26, 2019
Energy-related issues revolving around Ukraine are as numerous as they are significant these days. Facing suspension of gas transit passing through its territory in 2020, Ukraine is under immense pressure to find alternative sources of income, as well as new political leverage. We discussed Ukraine’s options in the existing situation, as well as some sectoral initiatives that are currently on the table, with Olena Pavlenko and Roman Nitsovych, President and Research Director at DiXi Group, a Ukrainian think tank engaged with energy-related issues.
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Whether Ukraine and Russia will manage to negotiate the prolongation of gas transit to Europe after 2019 is a major intrigue these days. What are some of the key differences between the two countries that prevent them from doing so?

R.N.: The fundamental stumbling block consists in the approach of Gazprom, as its strategy is to control the entire value chain, starting with extraction of gas at the site all the way to its consumption at an enterprise or a household in Europe. To achieve this, Gazprom is trying to win control over the gas transportation infrastructure. This is what happened in Belarus, and this is what Russia attempted to do numerous times in Ukraine. Having failed to do so, Russia resorted to another tactic, namely construction of bypass pipelines that it is going to control. By controlling different routes of gas supply to Europe, Russia can switch pipelines on and off, thus exerting political influence. So the bottom line is this: Gazprom's strategy is maximum monopolization, whereas that of the EU and Ukraine is the maximum development of a competitive market, characterized by unbundling of control over different elements of infrastructure from vertically-integrated entities, as prescribed by the Third Energy Package.   

O. P.: Speaking about specific ways this reflects on the negotiated agreement, there are several concrete divergences that should be mentioned. First, Ukraine wants to stipulate that Russian gas is being transferred to the buyer at Ukraine's eastern border, rather than western one, as is the case now. The latter situation makes Ukraine virtually invisible for European companies, because they only start seeing Russian gas in certain points on the Slovakian, Hungarian and Polish borders with Ukraine. Ukraine is absent from their vision of the process. We want to make the Ukrainian transmission system operator a real player in the market with whom European companies can conclude agreements on gas transit. This is a question of Ukraine's political and economic subjectivity, as well as that of money that Ukraine will receive from buyers of Russian gas. As of now, it is only Gazprom which receives the money and pays part of it to Ukraine for transit.

Another divergence is the issue of backhaul (virtual reverse flow). During several crisis periods, reverse flows literally saved Ukraine -- and thus irritated Russia. The latter hoped that we would not survive the suspension of supply and plunge into a real crisis, but we turned out able to sort it out.  Given that, Russia does not want to admit legal provision of a backhaul possibility in the new agreement. Our stand on this matter, though, is very robust, because backhaul is allowed in the EU, which means we do not break any European laws.

Another principal divergence is the term for which the negotiated contract is going to be concluded. Russia is currently finishing construction of the Nord Stream 2 pipeline. They may need up to one more year, taking also into account legal procedures related to changes to the Gas Directive but 70% of the pipeline has already been built. This is why Russia wants this contract to be short-term and thus have a possibility to abandon commitments as soon as the Nord Stream 2 pipeline becomes operational. Ukraine, to the contrary, wants its transmission system to be operational for as long as possible.

What is the position of the EU on the terms of the negotiated agreement?

R.N.: The EU is Ukraine's ally in this matter, because there are some evident risks for EU member states that are dependent on gas flows going through Ukraine's territory, primarily southeast European countries like Romania and Bulgaria. Keeping the Ukrainian transit route operational is very important from the standpoint of their energy security. Even Germany has agreed with this. There have been recurrent statements by Angela Merkel regarding the need to keep Ukraine's role as a transit state. However, exactly how should this statement be understood? A one-year contract that does not meet European rules will not provide for Ukraine's ability to keep its transiting role. Obviously, we need to talk about the long-term booking of transmission capacities. Only this approach will allow Ukraine to keep its transiting role, not only for its own economic standing, but also for security in the entire region.

There have been messages on another possible compromise between Ukraine and Russia, namely the exchange of the signing of the new contract for Ukraine's surrender on its wins in international arbitration against Russia. How realistic is this scenario?

O.P.: The contracts are being concluded between the two companies, not between the two governments. There have, indeed, been messages on attempts to include gas issues in a broader package decision, as  in 2010, when gas issues were exchanged for the stationing of Russia's Black Sea fleet in Sevastopol. Later, there was a similar package decision on Ukraine's association with the EU -- refusal from signing the Association Agreement in exchange for a gas price discount. Are we ready to step into the same river for the third time?

R.N.: The above is the political framework. Speaking about arbitration per se, there is an official position of Naftogaz that was presented a couple of months ago. It comes down to its readiness to withdraw the lawsuit under the new arbitration, filed in 2018 and touching upon gas transit issues in 2018 and 2019. This may be an acceptable concession, at least from the standpoint of Naftogaz's leadership. What touches upon the arbitration on which there has already been a decision, and under which there are pending attempts to collect respective sums of money from Gazprom, international law is on our side, and it makes no sense to withdraw or refuse from the ruling of the arbitration.

What is the worst-case scenario for Ukraine in the story with the new contract? What damages will we suffer, and how should we act?

O.P.: The worst-case scenario will be Russia's decision to stop transit at the beginning of 2020. It can do so, because it has accumulated enough gas in storage facilities of European countries. Ukraine is also ready for this scenario, because we have been accumulating gas in our own storage facilities, too. In circumstances where no gas is delivered to us from Russia, we shall both import it from Europe and use the stored volumes. Ukraine will manage to endure a certain period of time, presumably around three months. It will be a psychological battle which, we expect, we'll be able to survive. However, Gazprom will most likely try to prepare additional "crisis hot spots", too, in order to pressure Ukraine and the EU into signing the contract on Russia's terms as soon as possible.

R.N.: This is precisely why the trilateral format is important. Participation of the European party guarantees at least some protection from manipulations, as well as from attempts to impose certain conditions, as happened in 2009. Contracts concluded back then were presented as a victory at first. However, after some deeper examination was done, they turned out to be absolutely unbeneficial for Ukraine.

Are there any evaluations as to exactly how suspension of gas transit through Ukraine will impact its GDP?

O.P.: Ukraine is bound to lose approximately $2 billion each year, which is around 3% of its GDP.

R.N.: To put this into perspective, gas transit brings Naftogaz 28% of its revenue. Last year the enterprise paid around UAH 138 billion in taxes and dividends. Roughly taken, the share that Naftogaz will fall short of, and will not pay any taxes or dividends on, will be a similar figure.

O.P.: Naftogaz will probably try to profit from other things, too. For instance, gas storage for European companies, as is the case now. We have many storage facilities.There might be attempts to use existing infrastructure to make money, but we are not talking about sums that would be compatible with those we receive from gas transit to the EU.

There is a political aspect, too. When Ukraine is transporting up to 40% of Europe's gas imports from Russia, the EU cannot ignore Ukraine, its energy sector and support thereto. This helps us keep up the dynamics of energy reforms. If you compare reforms Ukraine is implementing in the energy sector with reforms in other sectors, you'll see that they are moving quite quickly, including because they enjoy the close attention of the European Union. In the event that this disappears, and we are then nothing more than just another market, this might considerably slow down the attention of the EU to this sector and the dynamics of our reforms.

A noticeable information newsbreak in the last couple of weeks has been the signing of a trilateral memorandum between Ukraine, Poland and the US on deliveries of American liquefied gas to Ukraine through Poland. In your opinion, what are the prospects of its implementation, given that much technical work needs to be done between Ukraine and Poland to that end?

R.N.: Talks about the expansion of the interconnection between the Ukrainian and Polish gas systems have been going for quite a long time, and there even is a respective project for the construction of an interconnector. As of now, we can technically import as much as 2.1 billion cubic meters of gas from Poland a year. Last year, a preliminary evaluation of demand was carried out. The result was 5 billion cubic meters a year.

Indeed, the question is not only in political agreements or commercial contracts, but also in certain technical works aimed at the expansion of the interconnection capacity. According to the mentioned memorandum, 2021 has been declared the year of the launch of gas supplies. At the same time, work on the arrangement of other gas supply routes is also being carried out. Ukraine, in particular, works with Moldova and Romania regarding arrangement of gas reverse flow in the amount of 1.5 billion cubic meters a year. Generally, the course taken in 2014 regarding the gradual integration, including legal and technical, of our gas system with the European one, is being sustained. The goal is to be less dependent on gas flows from the East and to develop gas flows from other directions. There were even talks held about the expansion of cooperation with Belarus, but given that the latter's gas system is owned by Gazprom, this initiative did not go any further than preliminary talks.

O.P.: American gas is considered more expensive now, plus LNG delivery is generally more expensive than pipeline supply, but all the forecasts of experts say that liquefied gas is bound to gradually become cheaper. Hence, quite soon  its price will be completely compatible with that of gas delivered via a pipeline. Therefore, this is an economically viable initiative that Ukraine had better start working on now in order to have substantial results in a year or two.

R.N.: Apart from that, it should be said that diversification and security cannot come gratis. For instance, Lithuania has built an LNG terminal because the country needed it for the purposes of its energy security. Poland has also built a terminal, and is now building a connection with Denmark, the so-called Baltic Pipe, because this is a matter of energy security. The EU is investing billions of Euros into the expansion of interconnections between different countries to enable the movement of gas flows in directions that promise demand. This is a security issue, too. Generally, the strategy of the EU for years to come consists of ensuring that all countries have access to more than one source of gas.

Apart from the United States, what other potential partners does Ukraine have when it comes to the import of liquefied natural gas, especially at a lower price?

O.P.: There was an initiative called "White Stream", that touched upon possible gas imports from Azerbaijan. It was discussed in 2005 but later abandoned, then reanimated and abandoned again. Ukraine essentially wanted to receive Azerbaijani gas through Georgia via the sea. I have not seen specifications of the project, and hence cannot make any conclusions on its technical capacities and whether the project was at all realistic. However, it seems that the project was abandoned precisely at the stage of technical calculations. Nowadays, another major concern would be the security of supplies through the Black Sea, given that Russia de-facto controls the majority of its waters.  The bottom line is -- there is little chance that we will be able to bring this project back to life. However, it is useful to keep it in mind and remember that Azerbaijan can also be a gas supplier for Ukraine.

The major obstacle in this respect, however, is that we do not have an LNG terminal...

O.P.: Indeed. There has been much discussion on the construction of one, but it never happened. Back in the day, there was also an idea to build an LNG terminal for the purpose of delivering liquefied gas via Turkey, through the Bosporus and Dardanelles. However, it was short-lived, because Turkey blocked this scenario altogether. Almost every time that new people come to power in Ukraine, they pay a visit to Turkey and try to convince the latter to allow gas deliveries to Ukraine, but Turkey has been adamant so far.

R.N.: Another problem is that the amount of Caspian-originated gas is not too significant. Apart from that, the TANAP pipeline has already been built in Turkey. We will  probably be able to gain access to its resources, but from the south, namely through Bulgarian and Romanian reverse flow.

When it comes to gas from other countries, the major actors include Qatar and North African countries. These are the main suppliers of liquefied gas to EU countries. And, of course, there is the US, which now ranks third according to the volume of delivered gas.

O.P.: There are two more options. They are very theoretical, but they can still be considered. First, there is a possibility of using a future LNG terminal in Croatia. Second, Greece has its own terminal. So, it's possible that we'll be able to use either of them in the future.

Regarding the high price of American gas, I'd like to remind that, for instance, in 2014 when Russia entirely blocked its gas supplies to Ukraine, we resorted to reverse supplies. These were tiny volumes at first, as we were in a hurry to compensate for at least some capacity by receiving gas from the West rather than from the East. However, even operating with this small capacity, as soon as it appeared, Gazprom's readiness to negotiate increased immediately. Hence, the response to your question is: the very fact of existence of an alternative, even if it comes at a higher price, makes our negotiations with Russia significantly cheaper when it comes to gas prices.

Another recent story have been mixed signals about the viability behind the construction of the EU-Ukraine energy bridge. The last several weeks have shown doubt on the part of sectoral enterprises and politicians on whether this project is, indeed, beneficial for Ukraine. What is your insight?

R.N.: Let's start with what the Energy Bridge essentially is. This is a project that was initiated by Energoatom (Ukrainian state enterprise operating Ukraine's nuclear power plants - ed.) and was supported by the previous leadership of the Energy Ministry. It consists of connecting the second unit of the Khmelnystkyi nuclear power plant to Poland's energy system via a separate line, and thus exporting the entire volume of energy produced by this unit. Revenue received from such operations is planned for the construction of two other units at the very same nuclear power plant. The selling prices for Energoatom are set low, which is why there are no other ways of receiving a compatibly big investment. At the same time, there is the position of the system's operator, Ukrenergo, according to which Ukraine has already begun the process of synchronization with the ENTSO-E, which is to be completed in 2023. By that time, the entire energy system of Ukraine will have been integrated with that of continental Europe. Hence, there is no need to build any additional energy bridges.

Given the above, there is a dilemma about what should be done with the project. If we refuse to implement it, this will result in a certain lack of confidence in Ukraine on the part of its partners. In the event that implementation of the project persists, we will integrate our energy system into that of the EU in parts, rather than as a whole, which is hardly efficient. Which option should be chosen is at the Ukrainian government's discretion.

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