Nord Stream 2: a bad deal for Germany and Eastern Europe (Bruegel, 18.06.2016)

Nord Stream 2: a bad deal for Germany and Eastern Europe

Georg Zachmann．18.06.2016

Georg Zachmann argues that the Nord Stream 2 project is a danger to the European consensus on relations with Russia. What is more, it could undermine efforts to diversify Europe’s gas supply and might risk higher prices for Eastern Europe.

At the end of last year, Gazprom reached a deal with five Western European companies (BASF, E.ON, ENGIE, OMV and Shell). They agreed to add two additional lines to the Nord Stream gas pipeline across the Baltic Sea, increasing the capacity of the pipeline from 55 billion cubic metres per year to 110 billion from 2019. The project has provoked controversy, as it sharpens divisions among EU members about energy and foreign policy.

In terms of energy policy, the EU has two goals. It is trying to make itself more independent from individual suppliers, and also aims to do without fossil fuels in the medium term. In recent years the market position of the EU has improved markedly. Thanks to low global energy prices and unexpected falls in gas demand – which in 2015 was around 40% lower than expected according to 2005 predictions – European users have been able to push for significantly lower gas import prices. Prices have halved in the past 2 years, to about $170 per thousand mᶟ.

Due to enduring stagnation in demand for gas in Europe, overcapacity in the global gas market, and continuing underuse of European gas import infrastructure, another expensive pipeline from Russia is not needed to supply the EU in the near future. It would work against current efforts to diversify supply, as Gazprom is already the largest supplier in the EU. And in the medium term there is the question of whether -because of climate change commitments – gas demand in the EU will actually fall faster than domestic and Norwegian production. The time frame in which the Nord Stream 2 project could pay for itself is thus relatively short at best.

Against these concerns are stacked the interests of the Western European companies taking part. They expect Nord Stream 2 to guarantee them a preferential supply of Russian gas, and hope to strengthen their existing business interests in Russia.

With Nord Stream 2, Germany would also become a gas hub for all of continental Europe. It would therefore benefit not only from the business related to Nord Stream 2, but also from lower gas prices than its neighbours. But this would be a zero-sum game– Germany would only profit at the expense of its neighbours, who would find themselves paying more at the end of the transport route through Germany.

Most alarmingly, Gazprom would gain another tool to discriminate between countries. Gazprom could then credibly threaten to cut off gas supplies in Eastern Europe without threatening its markets in Western Europe. In this way Gazprom could achieve higher prices in Central and Eastern Europe, without having to use illegal “destination clauses” (which allow buyers of Gazprom’s gas to only sell it to domestic consumers).

In terms of foreign policy, the EU supports Ukraine in its efforts to defend its sovereignty and territorial integrity against Russian interference. Nord Stream 2 would undoubtedly make this task more difficult. On the one hand, Ukraine would lose revenues from gas transit of up to 2 billion US dollars a year, equal to about 2% of Ukrainian output. On the other hand, a large scale cutback in gas transit would make it harder to supply Ukraine with gas.

Because of lower Ukrainian demand for gas and a large increase in gas imports from Slovakia, at this moment Ukraine can do without direct gas imports from Russia. As a result, it has sourced no gas from Gazprom since November 2015. This has offered Ukraine significantly increased political leeway, for example regarding much-needed radical reforms of the corrupt gas sector.

If Nord Stream 2 gets built, Central and Eastern Europe (especially Slovakia and Hungary) might be supplied with Russian gas from this pipeline, bypassing Ukraine altogether. In this situation Moscow could, at worst, press for reduced western gas exports to Ukraine, and could certainly demand higher prices for any gas sent on such an indirect journey. That would increase readiness in Kiev to once again accept ‘mates rates’ for gas supplied directly from Russia, which would be tied to political concessions.

Even within the EU, Gazprom is still a tool of Russian foreign policy. This was shown in autumn 2014, when Gazprom unilaterally cut supplies by up to 50% to countries (Poland, Slovakia, Austria and Hungary) which sold gas on to Ukraine. Strengthening the market position of such an actor therefore has costs for foreign policy.

What is more, Nord Stream 2 threatens one of the few European foreign policy successes of recent years. Despite the economic concerns of many member states, Europe and Germany in particular managed to find an unexpectedly clear united answer to the annexation of Crimea and Russian involvement in eastern Ukraine.

However, the European compromise to implement economic sanctions in response to Russia’s legal violations remains fragile. If Germany positions itself as a friend of Russia and supports such a large project, without concessions from Russia on foreign policy disputes, it risks breaking the fragile European consensus on Russia — which has only been laboriously held together until now. The resulting loss of trust among European partners would hardly be offset by the improved relationship with Russia.

These disadvantages of Nord Stream 2 could largely be cushioned through extra investment in the domestic European gas network, more financial support for Ukraine, and German guarantees on security of gas supply for Central and Eastern Europe. But the cost of this would be paid by German gas consumers and taxpayers. On the other hand, the indirect foreign policy costs are difficult to measure. To sum up, building Nord Stream 2 would be a bad deal for both Germany and its Eastern European partners.