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Global Energy Center Working Paper

Nord Stream 2: Understanding the Potential Consequences

AlanRiley

Atlantic CouncilGLOBAL ENERGY CENTER

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WorkingPaper:

NordStream2:UnderstandingthePotential

Consequences

Ifbuilt,NordStream2wouldnotonlyunderminetheEU’ssupplysecurity,butalso

itscoherenceandintegrity.

Dr.AlanRiley,Non-ResidentSeniorFellow,AtlanticCouncil.1

1.0.Introduction:ATroublesomePipeline

At first sight, it is difficult to understandwhy there is somuch controversy about

Nord Stream 2. The Nord Stream 1 pipeline, constructed and put into operation

between2011–2012,didnotgenerateanythinglikethecurrentlevelofcontroversy.

Thus,why should the reaction toNordStream2be sodifferent?Why shouldone

more natural-gas pipeline running through the Baltic Sea, along the route of the

existingNordStream1pipeline,beasourceofsuchcontroversy?

Thisdifferenceinreactionstems,inpart,fromtheradicallydifferentcontextinthe

early2000s,whenNordStream1wasbeingplanned.Politically, therewerebroad

hopes thatmodernizationand liberalizationwould take root inRussia. In contrast,

the Russian Federation under middle-to-late Putinism has shown no interest in

reform.In2014,RussiainvadedandannexedCrimea,andcurrentlyfundsanddirects

occupyingforcesineasternUkraine.2Thischangingcontextreinforcestheviewheld

1Intheinterestoffulldisclosure,Dr.AlanRileyadvisesPGNIGandNaftogaz.2ThereissubstantialevidenceofRussiancontrol,funding,anddirectionoftheoccupyingforcesineasternUkraine.See,forinstance,MaksymilianCzuperski,JohnHerbst,EliotHiggins,AlinaPolyakova,andDamonWilson,HidinginPlainSight:Putin’sWarinEasternUkraine(Washington,DC:AtlanticCouncil,2015),http://www.atlanticcouncil.org/publications/reports/hiding-in-plain-sight-putin-s-war-in-ukraine-and-boris-nemtsov-s-putin-war.

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in much of Central and Eastern Europe, and in the Baltic States, as to Russia’s

intentionsandwillingnesstousegassuppliesasapoliticalleveragainstthem.3

ThisconcerniscompoundedbythefactthatNordStream2willresultinasignificant

reductioninroutediversity,makingEuropeanUnion(EU)statesdependentonone

narrowchannel intheBalticSeaformuchoftheirRussiangassupply.Bycontrast,

NordStream1at leastenhancedroutediversity.4Hence,onecouldarguethatthe

effectoftheNordStream1pipelinecomingintooperationatleastaddedadegree

ofroutesecurityforRussiangasdeliveriestotheEuropeanUnion.

FromaRussianperspective,thepipelinealsoactsasaneffectivewedgedividingthe

Central and Eastern European (CEE) states from Western Europe. What seems

overlooked in someWestern European states, particularly inGermany and among

supporters of Nord Stream 2, is that they are supporting a project that will

undermine three major EU objectives: the liberalization of energy markets, the

integrationof theCEE states into theEuropeanUnion, andeconomicandpolitical

reforminUkraine.

This paper argues that, taking into consideration the broad range of negative

impactsfrombringingNordStream2intooperation,itbecomesclearhowdamaging

NordStream2istoEuropeanenergyandsecurityinterests.

This paper outlines the negative consequences Nord Stream 2 could have for

European supply security, aswell as the integrity and coherence of the European

Union, and critically examines the three principal defenses raised by advocates to

3Thisisalsonotanewphenomenon.R.L.LarssonprovidesevidenceofmorethanfortypoliticallymotivatedenergycutoffsinitiatedbytheRussianstateanditsstate-controlledenergycompaniesbetween1991and2004.R.L.Larsson,RussianEnergyPolicy:SecurityDimensionsandRussia’sReliabilityasanEnergySupplier(Stockholm:SwedishDefenceResearchAgency,2006),https://ntrl.ntis.gov/NTRL/dashboard/searchResults/titleDetail/PB2007106453.xhtml.4NordStream1atleastprovidedanewroutetotheEuropeanmarket,addingtotheroutesprovidedbytheYamalandBrotherhoodpipelines.AsNordStream2followsthesamerouteasNordStream1,itdoesnotaddtoroutediversity.Furthermore,asexplainedinmoredetailbelow,abuiltandoperatedNordStream2pipelineislikelytoleadtothelossofall,ormost,oftheBrotherhoodpipelinenetworkcapacity,furtherunderminingroutediversity.

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justifythepipeline.ThispaperconcludesthattheNordStream2projectshouldbe

reconsidered.Italsoexaminestheadditionallegislativeandsanctionsmeasuresthat

maybeleviedagainstthepipeline.

2.0.TheDamageThatWillFlowfromNordStream2

MuchofthecommentaryanddiscussiononNordStream2,evenwhencritical,only

focusesononeortwopointsofconcern,suchastheimpactonUkrainiantransitor

the supply-security risk to theCEE states.As a consequence, it is not immediately

apparenthowtrulydamagingNordStream2 is to theEU’s supply security,and to

theintegrityandcoherenceoftheEuropeanUnion,untilonelooksattheimpactof

NordStream2onEurope’senergymarketasawhole.

ThemainnegativeeffectslikelytooccurifNordStream2comesintooperationare:

2.1UnderminingTransitSecurity

ThestatesofCentralandEasternEuropecurrentlyhaveadegreeoftransitsecurity.

To access markets in Western Europe, most Russian natural gas needs to pass

through the Yamal pipeline running through Belarus and Poland, and the

Brotherhoodpipelinenetwork running thoughUkraine and Slovakia. Thismakes it

difficulttocutoffstatesinCentralandEasternEuropewithoutalsocuttingoffstates

inWesternEurope.

However, if Nord Stream 2 comes into operation, the current natural gas flow

through the Brotherhood pipeline will largely cease. Various Nord Stream 2

advocates have argued that this is not necessarily the case.5 However, if 55–60

billion cubic meters (bcm) are removed from the flows through Ukraine and

dispatchedviaNordStream2,verylittlegassupplywillbeavailabletoflowthrough

the Brotherhood pipeline network. There is also precedent for the loss of transit

5See,forinstance,AlexBarnes,NordStream2:FriendorEnemyofEnergySecurityinEurope(Brussels:CentreforEuropeanPolicyStudies,2017),p.5,https://www.ceps.eu/publications/nord-stream-2-friend-or-enemy-energy-security-europe.

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flows. Once the Nord Stream 1 pipeline became operational, gas flows through

Brotherhoodpipelinenetworkdeclined,while they rose inNordStream1.6Unlike

NordStream1,whosetwopipelineswerebuiltsequentially,NordStream2pipesare

to be constructed at the same time. This simultaneous approach to pipeline

construction will ensure Gazprom does not need to enter any significant transit-

contract negotiationswithUkraine in 2019, as long as those pipelines are up and

runningbythebeginningofthe2019–2020winter-heatingseason. Inotherwords,

Gazprom is positioning itself so that, by the end of 2019, it does not need the

Brotherhoodpipelinenetworkforanyofthesubstantialgasflowsthatcurrentlyflow

intoCentralEurope.7GiventhatRussiaandUkraineare locked inarmedconflict in

easternUkraine,itseemsreasonabletoassumethatRussiawouldtakeadvantageof

Nord Stream 2 coming online to further undermine the Ukrainian economy, by

removingasmuchtransit revenuefromKyivaspossible.The impactonUkraineof

NordStream2comingintooperationisdiscussedinsection2.7.

WhileUkrainemay lose transit revenue, the states of Central and Eastern Europe

wouldlosetransitsecurity.Theycouldnolongerrelyonthefactthatthesupplyof

gastotheWesternEuropeanmarketpreventsthemfrombeingcutoff.

Oneresponse to thisargument is tosay thatCEEstatescanbeguaranteedsecure

flowsviaNordStream1and2,assuppliescanbeguaranteedbygasflowingacross

the west-to-east interconnectors. However, CEE governments are less than

enthusiasticwhenitcomestothis“guarantee.”Whereastransitsecuritywasavery

solid guarantee of delivery, that cannot be said of west-to-east gas flows. The

fundamental concernofCEEgovernments is that thegas flowscanbe reducedby

6Thereisalsoamorerecentprecedent.InOctober2016,theEuropeanCommissionpermittedGazpromtomakegreateruseoftheOPALpipeline(oneoftheconnectingpipelinesforNordStream1).AssoonasGazpromgotthegreenlightforBrussels,gasflowsfellthroughtheBrotherhoodpipeline,androsethroughNordStream1andtheOPALconnector.Thelegalityofthecommission’sdecisioninthiscaseisunderlegalchallengebeforetheEUGeneralCourtinLuxembourg.SeeCasesT-849/16,T-883/16,andT-130/17,PGNIGSupply&TradingandOthersv.Commission.7TheremaybesomegasflowingintoUkrainetobringnaturalgasintotheWestBalkanpipelinenetworkdownthroughMoldova,Romania,andBulgariamaycontinue.However,ifGazprommanagestoconstructandoperatethesecondstringofTurkishStreamwithafurther15bcmofcapacity,theWestBalkangasflowswillalsocease.

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Gazprom,andthat—whiletheremaybeenoughgasforGermany—theremaynotbe

enoughforCEEstates.Thisisnotatheoreticalproblem.In2014,CEEstatesstarted

sendinggasbyreverseflowtoUkraine.8Inresponse,Gazpromthreatenedtoreduce

gas flowstosomeCEEstates inanattempttostopreverse-flowgas fromentering

Ukraine—andthenactuallydidso.9

2.2.ReducingRouteDiversity

Apositive featureofNordStream1was that it diversified thenumberofdelivery

routes for Russian gas to Europe. However, Nord Stream 2 does the opposite.

EuropewillbeleftwiththeYamalpipelinecarryingabout30bcmofRussiangasinto

Poland and onward into Western Europe, and the Nord Stream pipelines with

approximately110–120bcmofcapacity.NordStream2concentrates theavailable

supply routes, creating one supply route, which would carry approximately 70

percentofRussiangasimportsintotheEU.

It is also important to recognize that removing gas flows from the Brotherhood

pipeline network will likely result in a significant degradation of the pipeline

network. Its current maximum carrying capacity is around 140 bcm; with much

smaller gas-transit flows, much of the network will no longer be able to be

maintained,andwillquicklydegrade.10Oncegas-transitflowstoUkrainearelost,it

will be difficult to resurrect them, leaving the EU with a significantly more

concentrateddeliverysystem.

8“Reverseflow”isclassicallywheregasintransitseeslegaltitlepassinguponenteringthehomestateofthecustomer;itisthenthecustomer’sgas.Oneoptiontousingthegasistoinsteadsellittoathirdparty.Thiscanbedonephysicallywherethecapacityexists,includingsellingbackonreverseflowtothetransitcountryfromwhichdirectionthegasoriginallycame.Itmaybepossibletoarrangevirtualreverseflowsthroughswaps.9“HungarySuspendsGasFlowstoUkraineUnderPressurefromMoscow,”AFP,September26,2014,https://www.theguardian.com/world/2014/sep/26/hungary-suspends-gas-supplies-ukraine-pressure-moscow;andAgataLoskot-Strachota,CentralEuropeanProblemswithRussianGasSupplies(Warsaw:OSW,2014),https://www.osw.waw.pl/en/publikacje/analyses/2014-09-17/central-european-problems-russian-gas-supplies.10InordertosustainasignificantcapacityoftheBrotherhoodpipelinenetwork,substantialtransitflowsneedtobeabletomovethroughthenetwork.Withoutsuchflows,degradationwillsoonbegintodisablethenetwork.

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ThedangersofrouteconcentrationwereunderlinedinDecember2017,whenthere

was an accidental explosion at theBaumgarten gas hub.Natural gas flowing from

Nord Stream 1 was unable to flow downstream of Baumgarten. Though this

temporarydisruptiononlylastedforaday,itstill ledtoelectricitypricesincreasing

to €118 per megawatt hour and the Italian government declaring a state of

emergency.11Withmoregasflowinginthesamedirectionassoonaslate2019,asa

resultofNordStream2andthelossofmuchoftheBrotherhoodpipelinenetwork,

any disruption to gas flows at Baumgarten—or anywhere else along that supply

route—wouldcreateamuchgreatersupplyriskforEUmemberstates.12

2.3.CreatingaStraitsofHormuzRiskforEurope

NordStream1and2willrunparallelformostoftheroute,withseriousimplications

for the supply security of the European Union. There will be four pipelines five

hundredmeters apart, in a two-kilometer channel. The Baltic Sea is also shallow,

withthewaterdepthlessthanfiftymetersatsomepoints.

The argument that Nord Stream 2 not only reduces route diversity, but actually

creates amajor supply-security risk, is compelling. If built andoperated, one two-

kilometerchannelinashallowseawillbethetransitpointforflowsamountingto70

percentoftheEU’stotalRussiannaturalgasimports.

The security threat here is not about Russian cutoffs, but the less politically

dramatic—thoughstillveryseriousrisk—ofputtingallenergysupply-securityeggsin

onebasket.Riskscouldinclude:acollisionatseanearthepipelines;munitionsbeing

11Italygenerates44percentofitselectricityfromnatural-gasCCGT(combinedcyclegasturbine)powerplants.ItisalsoanetimporterofelectricityfromotherEUcountries,whichwereaffectedbythepriceimpactoftheBaumgartensupplydisruption.ForananalysisofthestateoftheItalianenergymarket,seeDeloitte,“EuropeanEnergyMarketReform,CountryProfile:Italy,”2015,https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Energy-and-Resources/gx-er-market-reform-italy.pdf.12“EnergyMarketsLeftReelingAfterBaumgartenExplosion,”ICIS,December12,2017,https://www.icis.com/resources/news/2017/12/12/10173356/energy-markets-left-reeling-after-baumgarten-explosion/?redirect=english.

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set off by local fishing vessels (Nord Stream 1 does, and Nord Stream 2 will, run

throughtwomunitionsdumpsfromWorldWarII);oraterroristattack.13

It is disturbing that the clear energy-security threat that such route concentration

representshasbeenallowedtoproceedwithoutbeingthesubjectofintensedebate

from any of the states along the route. It remains a puzzling question as to why

regulatoryagencies,andthestatesthemselves,havenotquestionedtheprospectof

routingsomuchofEurope’sgassupplydownonenarrowroute.14

2.4UnderminingtheSingleMarket

Since1998,theEuropeanUnionhasworkedthroughthreeiterationsof itsenergy-

liberalization legislation, to open the gas and electricitymarkets. Additionally, the

EuropeanCommission’santitrustarm,DGCompetition,hasbroughtanumberofkey

casesagainstEuropeanenergymajors, includinganongoingcaseagainstGazprom.

Slowly but surely, a more liberalized European gas market has emerged. North

WesternEuropehasalreadydevelopedasignificantdegreeofsupplydiversityand

market liquidtyuponwhichanumberof gas tradinghubswith significant liquidity

havebeendeveloped.TheEuropeanCommission seeks toensureEU liberalization

rules are applied, interconnectors are constructed, and competition, liquidity, and

gas trading are introduced across the whole continent. However, a lack of

interconnectorsandthelackofalternativegassourcesstilllimittheeffectivenessof

energyliberalizationinCEEstates.15

NordStream2threatenstounderminethelasttwentyyearsofworkestablishinga

European single market in natural gas. By connecting to the proposed EUGAL

13ThesedumpsareBornholmDeepandtheCentralBalticneartheislandofGotland.DuringtheSovietperiod,asignificantnumberofmunitionswerealsodumpedintheGulfofFinland.14OnealternativetoactuallyblockingNordStream2entirelywouldbetoinsistthatitatleasttakeadifferentroutefromNordStream1.Asfarastheauthorisaware,thisoptionhasnotbeenconsideredinanyofthepermittingprocessesyetunderwaywithrespecttothepipeline.15Forexample,seethelatestreportfromENTSOG,CentralEasternEurope-GasRegionalInvestmentPlan(Brussels:ENTSOG,2017),https://www.entsog.eu/publications/gas-regional-investment-plan-grips/2017.Clearly,ifalltheinterconnectorslistedinthereportwerebuilt,thesupply-securitypositionoftheCEEstateswouldbestrengthened.However,theseinterconnectorsdonotexist,andthevolumesofnaturalgasthatNordStream2willprovidetotheCEEstatesislikelytomakeitmoredifficulttoincentivizeprivateinvestorstoprovidethefundstobuildtheproposedinterconnectors.

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pipeline, the entire Nord Stream 2 capacity will be brought through eastern

Germany, the Czech Republic, and Poland, flooding the west-to-east

interconnectors.These interconnectorsweresupposedtobringalternativesources

of natural gas into the CEE states. However, once Nord Stream 2 becomes

operational,theseinterconnectorswillbeutilizedbyGazpromonsuchascalethatit

willbemuchmoredifficultforcompetinggassuppliestoreachCEEcustomers.The

combined gas flows of EUGAL at 55–60 bcm of supply, plus the additional OPAL

supply fromNord Stream1,which follows the same route as EUGAL,will bring in

around90bcmofGazpromsupplyintoCEEstates.Thissignificantgasflowislikelyto

deter investors from financing any new infrastructure or alternative sources of

supply,representingasignificantfollow-onconsequence.

The likely consequence of the establishment and operation ofNord Stream2 and

EUGAListounderminethedevelopmentofasingle,liberalized,andopenEuropean

market,byconsolidatingsourceofsupplyintheNordStreamsystemanddeterring

investmentinalternatives.IfNordStream2isbuilt,itwilldampenprogresstowarda

singlemarket in gas, instead creating twomarkets—an increasingly liberalized gas

market in Northwestern Europe, and a less-liquid market in CEE states, with one

dominantsupplier:Gazprom.16

2.5.IncreasingGermanSupplyVulnerability

AfterthestatesofCentralandEasternEurope,Germanyislikelytosufferdamaging

effects fromNordStream2.At first sight, thismightbeasurprisingconclusion,as

Germanyappearstobeasignificantbeneficiary.Germanywillbecomeahubforthe

importationofRussiangasintotheEU,itsmarketwillobtainamuchgreaterdegree

ofliquidity,and,asaconsequence,gaspriceswillbelower.17

16GeorgZachmannalsomakesacompellingcasethatthepricingimpactinCEEstateswillbesignificant,withtheregionfacinghigherprices.Germany,bycontrast,withadditionalliquidityfromNordStream1and2,willseelowerprices—whichwillsubsequentlyberecoupedintheCEEstates,asthosestateswillhavefarlesssupplydiversityandwillbesubjecttomarketdominancebyGazprom.GeorgZachmann,NordStream2MeansGainsforGermanybutPainforEurope(Brussels:Breugel,2017),http://bruegel.org/2017/06/nord-stream-2-means-gains-for-germany-but-pain-for-europe/.17Ibid.

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However, this view does not consider the impact of reducing route diversity on

German supply security. Germany received approximately 35 percent of its gas

importsfromRussiain2016,whileNordStream2willreducetheroutediversityof

Russiangas.18 InsteadofhavinggasflowingviaNordStream1,theYamalpipeline,

and theBrotherhoodpipelinenetwork, therewouldonlybe two routes: theNord

Stream pipelines and Yamal. Germany is undermining its own energy security by

reducing the number of routes throughwhichmore than one-third of its imports

flow.

This loss of route diversity is no small matter. As indicated above, running Nord

Stream 2 alongside Nord Stream 1 creates a Strait of Hormuz-like supply-security

risk.ForGermany,anyfailureoftheNordStreamrouteswouldresultinascramble

forsupply,atascalethatwouldbedifficulttoreplace.Thisriskwasillustratedbythe

September2017maintenanceworkonNordStream1,which tookplaceover two

weeks.19AstheBrotherhoodpipelinenetworkremainedoperational,gasflowscould

be increased via Brotherhood to maintain supply into Germany. However, that

option isunlikelytobeavailableafterNordStream2comes intooperation,asthe

increased capacityof theNordStreampipelinenetworkwill negatively impact the

abilitytomaintainthefullcapacityoftheBrotherhoodnetwork.20

2.6.UnderminingtheEuropeanUnion

Aside from the geostrategic benefits of undermining EU energy liberalization and

reinforcing Gazprom’s energy leverage across the CEE states, Nord Stream 2 also

assistsRussiainunderminingtheintegrityoftheEUitself.Thecontroversyoverthe

18AurelieBros,TatianaMitrova,andKirstenWestphal,German-RussianGasRelations:ASpecialRelationshipinTroubledWaters(Berlin:SWP,2017),p.10,https://www.swp-berlin.org/fileadmin/contents/products/research_papers/2017RP13_wep_EtAl.pdf.19“NordStreamShutsforPlannedMaintenanceUntilSeptember22,”Interfax-Ukraine,September11,2017,http://en.interfax.com.ua/news/economic/447503.html.NordStreamcan,ofcourse,arguethatitwillnowhavefourpipelineswithNordStream2and,therefore,significantflowscanbemaintainedwhileeachpipeisundergoingmaintenance.However,thisavoidsconsiderationofthechoke-pointissue—thatallfourpipesareinthesamenarrowchannel,andthesubstantialcapacityoftheBrotherhoodpipelineisunlikelytobeavailableinthefuture.20Afurtherconcernhereisthatrepairsandmaintenancetounderwaterpipelinesarealwayslikelytotakemoretime,andrequirethelossofuseoftheentirelengthofthepipeline,comparedtoland-basedpipelines,inwhichproblemscanbelocatedandfixedmuchmorequickly.

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pipeline operates as awedge, splitting the CEE states from theirWestern Europe

partners,principallyGermany.

Germansupport forNordStream2 isacidic in its impacton intra-EUrelationships.

Berlinappears tobeunawareof,orunconcernedabout, the impact itsdecisionto

supportNord Stream2hason the supply securityof its EUandNATOpartners in

Central and Eastern Europe. From a CEE perspective, the pipeline is a route to

greaterRussianleverageandinfluence,whilealsounderminingCEEstates’accessto

alternativenatural-gassuppliesandtheliquidtradinghubsoftheEuropeanmarket.

The consequences of German support for Nord Stream 2 are likely to last a long

time, making it harder to bring the EU together to develop other projects in the

commoninterest,fromrefugeepolicytodefenseinitiatives.

2.7.TheNegativeImpactonUkraine

Themostobvious impactofNordStream2onUkraine isthe lossofannualtransit

revenuesofapproximately$2billion.21TheUnitedStatesandtheEU—principallyvia

funding from the International Monetary Fund (IMF), the European Bank for

Reconstruction and Development (EBRD), and the World Bank—are seeking to

financially support reform in theUkrainianeconomy.Removing transit fees,which

representmorethan2percentofgrossdomesticproduct(GDP), isunlikelytohelp

thefunctioningoftheeconomy,oritsreform.

The less-obvious, but potentially much more serious, impact is the danger of

Ukraine’sisolation.Currently,UkraineisparticularlyimportanttotheEUbecauseof

thesignificanceof thetransit route.OnceUkraine isno longera transitcountry, it

becomes far less important to Brussels, Berlin, and Paris. The risk here is of the

effective abandonment of, or weakening of support for, Ukraine by some EU

memberstates.

21Thismaybeanunderestimate,asInterfaxreportsthetransit-revenuefigurefor2017as$3billion.AndreasWalstad,“UkraineEyes$3BillionforTransitRevenuesin2017,”InterfaxGlobalEnergy,November28,2017,http://interfaxenergy.com/gasdaily/article/28581/ukraine-eyes-3-bln-for-russian-gas-transit-in-2017.

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There is also a significant risk of energy isolation. Once the Brotherhood pipeline

network isno longer transferringsubstantialgas flows into theEU, thecapacityof

CEE states to deliver gas by reverse flow—which largely uses the Brotherhood

network—willbecomeproblematic.Anyfuturereverseflowswillbeundertakenina

context of increased Gazprommarket dominance and influence over the pipeline

networks.ThereverseflowsthathaveprovidedUkrainewithalternativesourcesof

gas,andreducedsupplydependence,willbemuchmoredifficulttosustain.

3.0.DefendingNordStream2

Tocounterargumentsdeployedagainstthepipeline,GazpromandNordStream2,

itswhollyownedsubsidiary,offerthreeprincipallinesofdefense.

3.1.Argument1:NordStream2isaCommercialProject

ThefirstargumentisthatNordStream2isacommercialproject,claimingGazprom

anditsWesterncorporatealliessupporttheprojectbecauseitisintheirlegitimate

commercial interest. Support from Gazprom’s corporate allies is deployed as

evidencethattheprojectisapurelycommercialoperation.22

The difficultywith this argument is that it amounts to nomore than an assertion

underpinnedbyvocalsupportfromvariousWesternenergycompanies,andfailsto

standuptocloseexamination.

For example, it is far from clearwhy any energy companywould seek to build an

entirelynewtransmissionpipelinetodelivergastoitscustomerswhenonealready

22Originally,GazpromplannedtohaveaseriesofcloseWesterncorporatealliesasshareholdersinNordStream2.AfteraPolishantitrustinvestigationwasinitiated,GazprombecamethesoleshareholderofNordStream2.However,thosecorporateallies—Shell,Engie,Wintershall,OMV,andUniper—arenowassistingGazprominfinancingtheproject.Thereisalsoadegreeofopacityinthefinancingarrangements,andinthebenefitsthatthecorporatealliesmayreceivefromthedeal.RafalBajczuk,SzymonKardas,andAgataLoskot-Strachota,TheNordStream2FinancingArrangements(Warsaw:OSW,2017),https://www.osw.waw.pl/en/publikacje/analyses/2017-04-26/nord-stream-2-financing-agreements.

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exists. Furthermore, the existing Brotherhood pipeline network (which Gazprom

intendstodisplace)issubstantiallyamortized,andtheownerhasindicatedthatthe

post-2019 tariffs will be extremely competitive.23 In addition, the gas market in

Ukraineisbeingreformed,ensuringthattheownernowhastherevenuestreamsto

undertakeanynecessarynetworkmaintenanceand repair.24However,Gazprom is

proposing tospend€9.8billiononbuildinganentirelynewpipeline, toprovidean

alternativesupplyroute.

Furthermore,the€9.8billionpricetagonlyincludesthecostofthe1,200-kilometer

pipeline fromtheRussianBaltic coast, through theBalticSea toGreifswaldon the

German Baltic coast. It does not include the cost of the 3,100-kilometer overland

pipeline from the gas fields on the Yamal Peninsula to the Russian entry point of

NordStream2.25Incommercialenergyprojects,investorsusuallyincludethewhole

costoftheinvestment—includingthedeliverypipelineandanynewfieldexpenses—

whencalculatingcosts,notjustthetransmissionpipeline.

The only argument that can be deployed to justify Nord Stream 2 in commercial

termsistoarguethattheUkrainianpipelinenetworkisunreliable.Thisisdifficultto

do, as gas-market reforms have put Ukrainian energy firms and regulators in a

position to fund, repair, and maintain the network.26 Ukraine has also agreed to

comply with modern European energy regulation, by committing to the Energy

23Naftogaz,pressrelease,“DeliveryofRussianGastotheEUWillCost3-4TimesLessViaUkrainethanViaNordStream2,”June17,2016,http://www.naftogaz.com/www/3/nakweben.nsf/0/EC3471DEE32B7266C2257FD50020AFAC?OpenDocument&year=2016&month=06&nt=News&.Seealso“MinimumAnnualInvestmenttoSupportStableOperationofUkraine’sGTSis$200-300—Kobolev,”Interfax-Ukraine,November27,2017,http://en.interfax.com.ua/news/economic/464680.html.24Aconsiderableamountofreformhasalreadytakenplaceinthegassector,includingpriceliberalizationandinstitutionalreform.Moreisclearlyneeded,butitisdifficulttoarguethattherehasnotbeensignificantprogressoverthelastthreeyears.MariaShagina,“GasSectorReforminUkraine:UnfinishedBusiness,”GlobalRiskInsights,January17,2018,https://globalriskinsights.com/2018/01/gas-sector-reform-ukraine/.25FrankUmbach,TheMythofCheapRussianGas(Vaduz,Liechtenstein:GeopoliticalIntelligenceServices,2017),https://www.gisreportsonline.com/the-myth-of-cheap-russian-gas,energy,2323,report.html.26“MinimumAnnualInvestmenttoSupportStableOperationofUkraine’sGTSis$200-300—Kobolev,”Interfax-Ukraine.

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CommunityTreatyin2011.27Despitewar,revolution,annexation,andinvasion,the

Ukrainian transit system has continued to ensure natural gas has flowed

uninterruptedacrosstheBrotherhoodpipelinenetwork.28

3.2Argument2:FallingEUDomesticProductionRequiresMoreRussianGas

A second argument deployed in defense of Nord Stream 2 is that the pipeline is

required because of falling natural-gas production within the EU. North Sea gas

production is dwindling, particularly in the giant onshore Groningen field.29

However,NordStream2 isnotgoingtoremedyanyfalls ingasproduction,as it is

only a diversionary pipeline, shifting natural gas from the Brotherhood pipeline

networkwithoutaddingadditionalgassupplytotheEuropeanmarket.Asexplained

above, shifting gas flows from the Brotherhood network to Nord Stream 2 will

undermine theBrotherhood’sability to transfer significantquantitiesofgas to the

EuropeanUnion,asthepipelinenetworkneedsaminimumtransitflowtomaintain

the capacity to flow gas through the network.30 As the Brotherhood pipeline’s

capacityislargerthanthatofNordStream2,atapproximately140bcm,theactual

impactofNordStream2istomakeitmoredifficulttoexportmoreRussiangasinto

theEuropeanUnion.

TheunderlyingtenetoftheGazpromargumentisthatthereisnochoicebuttorely

on Russian gas as the EU’s domestic production declines. However, while this

27ForthestateofUkrainianEnergyCommunityTreatyregulatoryimplementation,seeEnergyCommunity,“Implementation:Ukraine,”https://www.energy-community.org/implementation/Ukraine.html.SeealsoShagina,“GasSectorReforminUkraine:UnfinishedBusiness.”Itisalsoworthnotingthat,asaresultofitsreformsinthegassector,UkraineisalreadymuchmorecompliantwithEUnormsthantheRussianFederation.28Aspointedoutabove,Gazpromhasbeenwillingtothreaten,andactuallyreduce,suppliestoEUmemberstates,RafalBajczuk,SzymonKardas,andAgataLoskot-Strachota,TheNordStream2FinancingArrangements.29ExtractionsfromtheGroningenfieldhavebeenidentifiedasasourceofearthquakes.Asaconsequence,theDutchgovernmenthascappedthelevelofproductionfromGroningen,whichhasexacerbatedtheDutchsupergiantfield’sdepletionproblems.30Theminimumamountnecessarytomaintaintransitisunclear.Somestudiessuggestthatitcouldbeapproximately25bcm.SimonPiraniandKatjaYafimava,RussianGasTransitAcrossUkrainePost-2019(Oxford,UK:OIES,2016),p.56,https://www.oxfordenergy.org/publications/russian-gas-transit-across-ukraine-post-2019-pipeline-scenarios-gas-flow-consequences-and-regulatory-constraints/.However,giventhecomplexityoftheBrotherhoodpipelinenetwork,theseminimumfiguresshouldbetakenwithsomecaution.

15

argumentmayhavehadsomecredibilityin2006,priortothedevelopmentofshale

gasandthegrowthinliquefiednaturalgas(LNG)production,thatisnotthecasein

2018.Theworldisawashwithnaturalgasfromdiversesourcesofsupply,andthere

areseveralpipelinedevelopmentsthat,ifundertaken,couldprovidesignificantnew

suppliesintotheEU.31Oneexamplewouldbetoexpandthecapacityofthepipeline

carrying gasbetweenFrance and Spain,which currentlyhas a carrying capacityof

only7.5bcm.32Spainhas61bcmofLNG-gasificationcapacityand20bcmofpipeline

capacity from Algerian fields.33 Given the low utilization rate of both the LNG

terminals and the Algerian pipelines, it would be possible to provide the EUwith

significant additional supply by increasing the capacity of the Franco-Spanish

interconnectors.34Thiswouldcostsignificantly lessthanNordStream2and,unlike

thatpipeline,wouldprovideadditionalsupplyfortheEuropeanUnion.

3.3Argument3:NordStream2isNoThreatBecauseoftheSingleEuropeanGas

Market

The last major line of defense is to argue that Nord Stream 2 works with the

functioningofthesingleEuropeangasmarket.This lineofargumentmaintainsthe

project is not a threat, because customers for gas supplies within the European

markethaveadiverse rangeof supplyoptionsas themarkethasbeen liberalized,

31GazpromiscaughtinadevelopingcostviceasthecostofproductionandtransportationfromthenewYamalfieldsraisescosts.Meanwhile,LNGpriceshaveloweredthroughcheaperfeedstockandcostreductionsintransportationandliquefaction.Fornow,aslongastheexistingNadym-Pur-Tazfieldsproducesignificantgasflows,thenGazpromcanundercutLNGpricesifitsacrificesaconsiderablelossofprofit.However,evenincurrentcircumstances,Gazpromwillbedeeplyreluctanttomakesuchasacrifice,becauseitmakesasignificantcontributiontofederaltaxrevenues.Asaconsequence,thereisaconsiderabledisincentivetoloseprofitabilitybyundercuttingLNGimports,evenbeforeproductioncostsrise.32JuanVila,“TheElusiveGasConnectionBetweenSpainandFrance,”EnergyPost,August23,2016,http://energypost.eu/elusive-gas-connection-spain-france/.33SpanishEnergyRegulatorReporttotheEuropeanCommission(Madrid:CNE,2015),p.82,https://www.ceer.eu/documents/104400/3739509/C11_NR_Spain-EN.pdf/e4456fa8-4a02-4ab0-9cb3-26043918c851.34Evenwithexistinginfrastructure,iftheFranco-Spanishinterconnector’scapacityincreased,gasflowscouldreachasfareastastheCzechRepublic.Swapsandadditionalinterconnectorswouldprovidethemeanstobringsuchgassuppliesfurthereast.Swapsareamarketmechanism,andanyadditionalinterconnectorswouldbefarlessexpensivethanthecostofNordStream2.

16

opened, and is sufficiently deep and liquid. If customers do notwant to take gas

fromNordStream2,theargumentgoes,theyhaveotheroptions.35

WhiletherehasbeensignificantliberalizationoftheEuropeangasmarketoverthe

lasttwentyyears,itisfarfromcomplete.TheEuropeanmarketthatNordStream2

advocates describe does exist, but it is largely confined to Northwestern Europe,

where there is significantsupplydiversity,deeply liquid tradinghubs,andplentiful

interconnections,whichprovidecustomerswitharangeofoptions.

That situation is, unfortunately, not the case in the states of Central and Eastern

Europe.Inlargepart,thatisbecauseofthepostwardivisionofEurope.TheWestern

European statesbegan liberalizing theirenergymarketswhile theCEE stateswere

still under Soviet occupation. The process gathered pace in the 1990s and early

2000s, before any of the CEE states actually joined the European Union.

Furthermore,bothwhennewly liberatedandthenasnewmemberstates, theCEE

states were still grappling with the Soviet legacy of a single east-to-west pipeline

network,whichgaveGazpromsignificantmarketpower.Theselegacyissuesmakeit

much more difficult to put in place new sources of supply, pipelines, and

interconnectorsthatwillprovidetheCEEstateswithalternatives.36

Hence, while it is true that the EU’s liberalization rules have been adopted as

required under EU law in the CEE states, effective liberalization requires more

interconnectionstoensureacoherent,singlegasmarketpermittinggastoflow,and

the development of alternative sources of supply. However, for the reasons

discussed above, only a limited number of interconnections and new supply

sources—suchasSwinoujscieonthePolishBalticcoast—havebeenputinplace.

35AlexBarnes,NordStream2:FriendorEnemyofEnergySecurityinEurope.36ForanillustrationofthelackofinterconnectioninCEEstatescomparedwithNorthwesternEurope,seeENTSOG,CentralEasternEurope-GasRegionalInvestmentPlan.TheEUisprovidingsomefundingforinterconnectorsandnewfacilities,suchasLNG-gasificationterminals.However,thereisstillapressingneedformarketcapitaltoenterCEEenergymarketstoprovidethesubstantialfundingtomatchEUfunds.GiventheSovietlegacypipelinenetworks,long-termsupplycontracts,andcapacityforGazpromtopricediscriminate,capitalcanbedisincentivisedfromenteringthismarket.

17

InthecurrentnascentstateofenergyliberalizationintheCEEstates,NordStream2

effectively divides the European gas market. The liberalized Northwest European

marketremainsliberalized,whiletheCEEstatesfacetheprospectofdrainingforces

ofmarketliberalizationandare-energizationofGazprom’smarketdominance.The

interconnectors that have been developed will be flooded by Nord Stream gas,

making it difficult for competitors to provide an alternative source of supply.

Furthermore, the scale of gas flows from west to east could undermine investor

incentivestoeitherbuildnewinterconnectorsorestablishnewsourcesofsupply.

4.0.TheThreatPosedbyNordStream2andPotentialChallengestothePipeline

Viewed in this context, the scale of damage that an operational Nord Stream 2

would inflict on the EU and the CEE states will likely be substantial. The project

wouldsimultaneouslyunderminethepoliticalandsupplysecurityoftheCEEstates,

aswellasthesupplysecurityofWesternEuropeanstates,suchasGermany,androll

backthetwenty-yearcampaigntocreateasingleEuropeangasmarket.NordStream

2isalsowieldedbyMoscowasawedge.ItpowerfullyassistsRussiaindividingand

weakeningtheEuropeanUnion,oneofitslong-termstrategicaims:divideetimpera.

Given the scale of the potential damage to the European Union, and Western

supportfortheUkrainianreformandindependenceproject, itshouldbeclearthat

NordStream2shouldbeabandoned.Anumberofmovesnowinplaymayresultin

theabandonmentofthepipeline.

First, in November, the European Commission published proposals to formally

extend the application of the 2009 gas directive to import pipelines. The

consequenceofsuchaformalextensionwouldmakeitextremelydifficultforNord

Stream2tocomeintooperation,asthepipelinewouldneedtofullycomplywithEU

liberalizationrules, includingownershipunbundlingandArticle11of the2009Gas

18

Directive—the energy-security assessment for any new transmission-system

operator,whichGazpromwouldbelikelytofail.373839

EUlawhasalreadybeenappliedtoimportpipelineslikeYamalandSouthStream.40

Hence,evenifthegas-directiveamendmentisnotenacted,theremaywellbelegal

challengestothepipeline,inwhichtheargumentwillbemadethatEUlawalready

appliestoNordStream2(andNordStream1).SomeEUstatesorenergycompanies

mayseektochallengeNordStream2inthecourts,withthecaseultimatelyheardin

theEuropeanCourtofJusticeinLuxembourg.41

Second, inNovember2017,stepsweretaken in theDanishParliamenttoenhance

Denmark’s sovereignty over its territorial sea. The Danish Parliament enacted

legislation granting the foreign minister the power to prohibit pipelines within

Danishterritorialseas,andtheforeignministerisnowconsideringapplyinghisnew

powers to Nord Stream 2 to block the construction of the pipelinewithin Danish

territorialwaters.Applicationof thispower toNordStream2wouldat leastdelay

thepipelinefromcomingintooperation.42

37EuropeanUnion,ProposalforaDirectiveoftheEuropeanParliamentandCouncilAmendingDirective2009/73/ECConcerningCommonRulesfortheInternalMarketinNaturalGas,November8,2017,http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52017PC0660.38Ownershipunbundlingrequirestheseparationofthepersonsupplyingthenaturalgasfromthepersonrunningthepipeline.AsGazpromwouldbothowntheNordStream2pipelineandprovidethenaturalgasflowingthroughthepipeline,ownershipunbundlingisasignificantbarriertothepipeline’soperation.ThisisreinforcedbytheGazprom-pipelineexportmonopoly,whichonlypermitsGazpromtoexportpipelinenaturalgasfromRussia.39Article11oftheGasDirective2009imposesanobligationonnationalregulatorstoassesswhetheranon-EUownerwouldposearisktothesupplysecurityofthememberstateortheEUasawhole.TheargumentisthatitwouldbeextremelychallengingforGazpromtoeversurviveanassessmentunderArticle11,givenallthesupply-securityissuesdiscussedabove.40ForadiscussionofthelegalissuessurroundingtheapplicationofEUlawtotheYamalandSouthstreampipelines,seeRiley,APipelineTooFar:EULawObstaclestoNordStream2(Washington,DC:IELR,forthcoming).41Forexample,theGermanenergyregulatorcouldbechallengedforfailingtocertifyNordStream1and2beforetheGermanadministrativecourts,andthatissuewouldthenmakeitswaybyreferencetotheEuropeanCourtofJustice.AnalternativeapproachwouldbeforanothermemberstatetobringacaseagainstGermanyforfailuretocomplywithEUlawdirectly,beforetheEUcourts.42ErikMatzenandStineJacobsen,“DenmarkPassesLawthatCouldBanNordStream2GoingThroughitsWaters,”Reuters,November30,2017,https://www.reuters.com/article/us-denmark-pipeline/denmark-passes-law-that-could-ban-russian-pipeline-from-going-through-its-waters-idUSKBN1DU19L.Itmay,infact,killthepipeline.ThereissomedoubtastowhetheritispossibletoconstructthepipelinenorthofDanishterritorialwaters—whereNordStream2pipelinesarecurrentlyduetobelaid—duetothescaleofshippingflowsinthatverynarrowpartoftheBalticSea.

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Third, there is the prospect of more sanctions being imposed upon the Russian

Federation for interfering indemocraticelections in theWest,mostnotably in the

2016USpresidentialelection.43AsmoreandmoreevidenceofRussianinterference

entersthepublicdomainthroughout2018, itmakes it likelythattheUnitedStates

anditsallieswillseekagreaterrangeofsanctionsontheRussianFederation.Nord

Stream2isanobviousandimmediatetarget.44

AstheultimateguarantorofEuropeansecurity,theUnitedStateshasclearinterest

in ensuring the EU’s supply security, and—more fundamentally—the integrity and

coherenceof theEuropeanUnion. It isalso in theUS interest toensure thatNord

Stream2doesnotunderminetheworktheEUandUnitedStateshaveundertaken

tounderpinUkrainianindependenceandencourageUkrainianeconomicreform.

TheUnited Stateshas sought to gain recognitionamong its Europeanalliesof the

broader danger thatNord Stream2poses to all Europeans, and to the coherence

andintegrityoftheEUitself.

One immediate option for Washington would be to seek a broad European

consensus to at least reassess the Nord Stream 2 pipeline, through a common

process involving all the affected states. Currently, the project is only subject to

assessment in those states where Moscow believes there will be limited

43USDepartmentofJustice,pressrelease,“GrandJuryIndictsThirteenRussianIndividualsandThreeRussianCompaniesforSchemetoInterfereintheUnitedStatesPoliticalSystem,”February16,2018,https://www.justice.gov/opa/pr/grand-jury-indicts-thirteen-russian-individuals-and-three-russian-companies-scheme-interfere.44TheprovisionthatwouldmostlikelyapplyisSection232ofCAATSA2017,whichexpresslygrantspowertothepresidenttoimposesanctionsonimportpipelines,incoordinationandconsultationwithUSallies.InOctober,theStateDepartmentprovidedguidancethatappearedtolimitthescopeoftheapplicationofSection232.However,asignificantrangeofactioncouldstillbetakenwithintheguidanceagainstthepipeline,andtheguidancecanbeamended.ThebroaderobjectionisthatUSallies,notablyGermany,willnotcountenanceanysanctionsagainstNordStream2.However,thisviewtakesastaticpictureofEuropean—and,particularly,German—publicandpoliticalopinionbeforemuchmoreevidenceofRussianinterferenceinUSandEuropeanelectionsenteredthepublicdomain.Asmoreevidenceentersthepublicdomain,publicandelitepoliticalopinioninboththeUnitedStatesandGermanyislikelytoshiftinthedirectionofimposingfurthersanctions.

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objections.45Ithasdeliberatelyavoidedgoingthroughtheexclusiveeconomiczones

of states thatmay be substantially affected by the pipeline. Such an “all affected

states”processwouldinvolveexaminingquestionsabouttheenvironment,security,

supplysecurity,and thecorporategovernanceof theproposedpipeline,according

to common European and international standards. TheUnited States and the CEE

states have a legitimate and compelling argument that an assessment is being

undertakenthatsignificantlyaffectstheCEEstates,and inwhichtheyhave limited

input.46

Itistobehopedthatthismixoflegislativeaction,legalprocess,andtheprospectof

further sanctions will force a reassessment of a project that will otherwise

significantly damage the EU’s supply security and the integrity of the European

Unionitself.

45Although,inthecaseofDenmark,thisRussianassessmentmayturnouttobemistaken.46Thecurrentpermittingandplanningprocessrunssolelythroughthestateswhoseterritorialseasandexclusiveeconomiczonesthepipelineisproposedtorunthrough—despitethefactthattheBalticSeaisafragileseawithshallowwaters,andthepipelineisclosetotheexclusiveeconomiczonesofseveralotherBalticlittoralstates.ThisisinadditiontothebroadereconomicandsecurityimpactofNordStream2ontheunrepresentedCEEstates.