The EU’s Gas Directive and new energy security challenges of the EU

Over the last year, the European discussions on the controversial Nord Stream 2 (NS2) project has increasingly shifted to a legal debate on the application of the EU’s Gas Directive as well as the Third Energy Package (TEP) to offshore oil and gas pipelines. At present, the provisions of the Gas Market Directive and the TEP can only be applied to pipelines within the internal market and do not affect pipelines from third countries.

In November 2017, the European Commission submitted a proposed amendment to the Gas Directive to the European Parliament and the Council of the EU. The proposed amendment extends the Third Energy Package (TEP), to gas import pipelines from third countries. It will include the following four principles: (1) Third Party Access; (2) Unbundling; (3) Transparency, and (4) non-discriminatory Tariff Regulation. The European Commission has also sought a political mandate from the 28 member states for conducting political negotiations of an Intergovernmental Agreement (IGA) with Russia as a complementary process to the gas directive amendments.

The proposal was voted in ITRE Committee on March 21 and won support from a majority of its MEPs. In addition, the Commission’s revised directive needs the support of the European Council. Several governments such as Germany, Austria, Belgium and the Netherlands, all supporters of the NS2 pipeline, have voiced concerns and are opposing the revision of the Gas Directive. Germany’s position, for instance, has always been in favour of the NS2 project and skeptical about the revised Gas Directive as these offshore pipelines entering EU territory are not regulated in a ‘legal vacuum’ and uncertainties as the European Commis­sion stated, but in the context of the international law, such as the U.N. Convention of the Law of the Sea (UNCLOS) and other jurisdictions. In a letter from March 2017, Bundesnetzagentur stated that the NS2 pipeline should be governed by German regulations of general applications and a separate legal regime is not needed for the pipeline. The more, the agency does not see a need for a new regulation for offshore pipelines from third countries. Supporters of the NS2 pipeline have also warned that the Commission’s proposal could threaten security of supply, investment security and could have wider geo­po­litical implications.

The accusation that the proposal is just another attempt to stop the NS2 project, however, has been rejected by the Commission. Anyway, the final outcome of the regulation will set a precedent for other new gas import pipelines from third countries. The question is whether the Council will at least compromise on the Commission’s revisions.

These legal debates have become even more important as Russia has further increased its pipeline exports and market share in Europe – contrary to the EU’s energy security strategy of 2014 and all gas import diversification efforts since 2010. In 2016, Russia supplied 43% of the EU’s gas import demand and had a European gas market share of 35%. Germany’s gas import dependence on Russia climbed up to 58% in 2017 already before the building of NS2. It consumed 65.4 bcm of natural gas, with imports rising from Russia reaching a record of around 51 bcm of entire imports of around 88 bcm (+19% compared with 2016) last year.

The political-strategic context of the Gas Directive and the Third Energy Package

Given the difficult and ambivalent regulatory questions, it is somehow ironic that supporters of NS2 have asked the opponents not to ‘politicize’ the ‘purely commercial’ pipeline project, as Russia itself has always legitimised the project – like for all other pipelines (NS1, South Stream, TurkStream) - by circumventing Ukraine as its major transit state for Russian gas exports to Europe. Even representatives of the NS2 project admit, at least privately, that for Russia’s pipeline projects and diplomacies, the economic factors cannot be separated from its geopolitical interests.

The adopted EU laws and regulations, particularly in the gas sector, for liberalising and enhancing competition on the common European gas market since 2006 and even more 2010, in the light of the Russian-Ukrainian gas conflict in 2009, are based on the political-strategic objective to increase gas import diversification away from Russia. They cannot be explained, assessed and interpreted without the political context and political will, enshrined in the EU energy strategy of 2014 and the 2010 regulatory instrument of the TEP. It has repeatedly been confirmed by the energy policy decisions of the Council of the EU and the 28 governments of its member states as well as of the European Parliament. Energy supply security is even a legal requirement, written into EU primary law in the Treaty of Lisbon, and not just a political objective. In this regard, these regulations are not ‘neutral’ as they are instruments for the strategic objective of diversifying Europe’s gas imports and constraining Gazprom’s gas market share, particularly in those European countries which have been traditionally either completely or largely dependent on Gazprom as its single gas supplier.

The Offshore section

The Nord Stream pipelines run through the Exclusive Economic Zones (EEZ) of Russia, Sweden, Denmark and Germany, which are regulated primarily by international law (UNCLOS) and in which states have only limited economic rights. But the pipeline also runs through the territorial waters of Denmark (88 km) and Germany (50 km, including internal waters and land territory), in which national states have full sovereignty. Accordingly, at least for the territorial waters to the proposed amendment of the EU gas directive could be applicable.

According to a leaked analysis of EU legal experts, the offshore NS2 pipeline in Exclusive Economic Zones does not fall under the Third Energy Package and other EU regulation, in contrast to the connecting onshore pipelines (such as the OPAL pipeline) and would violate UNCLOS and other international laws. However, EU legal experts from different EU institutions appear divided on their legal opinion. There is no legal doubt that in the EU territory (which includes territorial waters - almost 140 km of the NS2 pipeline) the EU law (including the Gas Market Directive) is applicable as it is the case for Russia’s territory (and its territorial waters).

Regardless the outcome and any negotiated compromise, given the controversies and debates about offshore pipelines, investors need legal certainty concerning the operational rules of pipelines that are starting in third countries and ending in EU member states. In this context, the operators of existing pipelines could apply for a case-by-case derogations to be exempted from the principles of the TEP under the condition that the projects achieve the overall strategic objectives of the EU Gas Directive, such as enhancing market competition, strengthening overall energy supply security (and not just enhancing liquidity) and diversifying gas imports.

Equal treatment of gas infrastructure in the EU

The controversies come also from the fact that Gazprom and its NS2 supporters have argued that the project is just an extension of the NS1. As NS1 is not subject to the TEP, hence the subsequent pipe do not have to be either. But the regulation environment has significantly changed since 2010 and new pipeline projects need either to be compliant with the new regulations or to apply for derogations, whose defined conditions will be different to the regulatory situation before 2010.

The Commission does not want to give any privileges to the pipelines starting in a third country com­pared to those that are crossing internal EU borders. With those privileges given to import gas pipelines, they enjoy advantages in the competition with the EU’s own internal pipelines and supply options, which can undermine a real competition on and gas supply security of a single, liberalized European gas market. Taking into account that Gazprom enjoys an export monopoly on piped gas from Russia, the third-party access rule might not be feasible for NS2.

The Commission also seeks to avoid that offshore pipelines are subject to different rules compared with LNG-import terminals, which are already subject to rules on TEP under the existing Gas Directive. Treating LNG-import terminals differently from offshore gas import pipelines would hinder and undermine the much wanted and politically agreed competition between (Russian) pipeline gas and (U.S.) LNG imports on the playing field.

In this context, Russia has already a huge advantage compared to the U.S. LNG exports as its gas supplies for the European gas market are heavily subsidised from very expensive new gas fields in the permafrost region of Yamal. If Gazprom would have to price in all investment costs for these new gas fields as well as its new connecting gas pipelines from its Bovanenkogo gas field to near St. Petersburg where the offshore pipelines of Nord Stream 1 and 2 begin, those Russian gas exports would hardly be competitive. Those investment costs of the Yamal peninsula (growing further from presently US$150 bn up to US$250 bn by 2025) and partly also regional production costs, are heavily subsidised by the Russian state budget and its economic development programme as well as by Gazprom’s amortised and very cheap old gas fields. By contrast, private U.S. energy companies may receive some cheaper credits and currently benefit from cancelled environment regulations by the Trump administration, but need almost their entire investment costs to price in their offered gas prices.

While U.S. LNG exports to Europe won’t replace Russian pipeline gas as the largest gas import source, they will strengthen and not weaken Europe’s energy supply security by becoming an important counterweight to Russian pipeline gas as a diversification source. It will push for more liquidity, flexibility, bargaining power of the ‘buyers’ market’, transparency and lower gas prices. Hence, it should be strongly welcomed by all European governments and gas companies, including in Germany.

Conclusions and strategic perspectives

Regardless of being a supporter or opponent of Gazprom’s NS2 pipeline, one can say that it is the EU’s most politically divisive pipeline. It leads to an even more divided Europe, which is in Russia’s interest as it works against European sanctions and the EU’s ability to speak with ‘one voice’ towards Moscow. In the absence of more effective EU tools for implementing its gas import diversification strategy, Gazprom and Russia won’t really accept the EU’s Gas Directive and the TEP as it could marginalise its market share and geopolitical interests in Europe.

An intergovernmental agreement between the EU and Russia could overcome many legal uncertainties and problems, however neither the Russian side has any strategic interest in negotiating such an agreement, nor does the European Commission has so far a sufficient support among all 28 member states.

The legal debates in the context of the Gas Directive and TEP are important in various respects. But they have also deflected from the political and public debates on the even more important implications of the rapidly changing European gas market such as: (1) the impact of proclaimed ‘cheap’ Russian pipeline gas versus ‘expensive’ U.S. and other LNG supplies, (2) the impact of TurkStream (with at least two pipes and an annual capacity of 31.5 bcm) in combination with NS2 and (3) the perspective of rising Russian LNG exports to Europe in addition to Gazprom’s pipeline exports.

All EU-governments (including the European Council and the EU-US Energy Council) and many European gas companies have welcomed and strongly supported increasing U.S. LNG exports to Europe for diversifying Europe’s gas imports and decreasing its gas import dependence on Russia. But those hopes for rapidly expanding LNG exports for diversifying Europe’s gas imports appear presently rather unrealistic with heavily subsidised “cheap” Russian pipeline gas. Furthermore, despite President Trump’s proclaimed “energy dominance” on the world markets, private U.S. LNG companies sell their LNG where they get better prices and profits. As the LNG demand of China and other Asian countries have increased since the second half of 2017, most of U.S. LNG exports are shipped to Asia as Europe’s gas prices are lower and much less profitable than the higher prices in Asia.

New challenges might also arise with Russian LNG exports from the Yamal peninsula. In 2013, Russia already liberalised its export regulations, which has allowed Rosneft and Novatek to export LNG to Asia. A final decision by President Putin also to allow LNG exports to Europe has not been made yet despite the growing pressure by Rosneft and Novatek on the Kremlin due to fears that those LNG exports to Europe could compete with its own pipeline gas exports to Europe. Nevertheless, thefirst LNG shipments have already made to UK and operators of the European LNG import terminals are very interested to receive any LNG supplies as their capacities had been used for just 27% in 2017.

NS2 supporters and some European experts have argued in their studies that a ’depoliticised’ European gas market already exists, as it no longer matters from which countries gas is being imported as the diversified gas pool of various imported gas resources can be transported freely throughout the EU-28 without any major constraints. Therefore, the EU’s efforts for implementing new instruments and policies for diversifying the EU’s gas imports are superfluous. Even regional countries (including Poland and Ukraine) would benefit from the higher liquidity of the German gas hubs. In their view, the role of the European Commission should be restricted just to a regulatory watchdog. But their studies on the impacts of NS2on Europe’s energy supply security are based on assumptions that all planned regional gas interconnectors will be build and that Russia would accept the new rules of the game on the European gas market. However, that is presently at least not the case (yet) as Gazprom still tries to block them, offer supposedly ‘cheaper’ Russian gas supplies and pushing for new own pipeline plans in SEE. Symptomatically, Gazprom’s gas (price) policies in SEE are based on a different business strategy that follows rather its old objectives and instruments, such as preserving bilateral long-term oil-priced contracts as well as prevent­ing third-party access to pipelines, hub-price based gas prices and reverse-flow capa­ci­ties. Gazprom’s different business strategy for SEE highlights and confirms again that a single, liberalised and ‘depoliticised’ European gas market does not exist yet. It is rather segmented into two different markets as ACER also confirms in its latest reports, despite some important progress made in CEE and SEE. But the planned gas interconnectors have already to cope with their financing and might become commercially even less profitable for private operators once the NS2 pipeline is operational. In this case, the EU needs to rethink its funding strategy for building the bi- and regional gas interconnectors to guarantee a diversification of gas imports and regional energy supply security.

Dr. Frank Umbach
Research Director, European Centre for Energy and Resource Security