The recent agreement between Naftogaz and Gazprom, reached with the intercession of the European Union, has raised various criticism and concerns. The essential elements of the agreement include the extension of the gas transit contract for five years with designated minimum levels and pricing, the immediate payment of $3 billion owed by Gazprom as a consequence of previous arbitration, the foregoing of further arbitrations and the opening of potential direct sales of Russian gas to Ukrainian buyers. This agreement has been struck under the environment created by the construction of Nord Stream 2, which will provide alternative pipeline capacity for Russian gas transit to Europe. To assess the merits or problems created by this agreement, it is important to examine the components within the present realities and geopolitical context.
A win for Ukraine
First, the extension of the gas transit contract for an additional five years should be recognized as a win for Ukraine. It is clear that if NordStream 2 was completed on the schedule originally contemplated, Ukraine’s capacity for the transit of Russian gas to Europe would be made totally redundant by the end of 2020. This could have resulted in the total loss of the $3 billion transit fee currently being earned by Ukraine. Fortunately, with the combination of EU pressure and the delay in the completion of Nord Stream 2 created by the recently imposed U.S. sanctions, Russia was forced to back down from its intention to divert all transit volumes after 2020. Future negotiations, particularly with the support of the Central European countries whose gas supplies would be threatened by the shutdown of the Ukraine pipeline volumes, may in fact sustain some levels of transit fees beyond the initial five-year period.
Arbitration win means $3 billion
The achievement of the payment of Gazprom’s $3 billion loss from arbitration by the end of the year, is again a win for Ukraine. While the arbitration award had been achieved by Naftogaz litigation against Gazprom, the collection of the award would inevitably be stalled by legal wrangling and procedures. Foregoing further arbitrations is certainly a concession made by Ukraine but the outcomes of these cases are uncertain and Gazprom is also capable of imposing counter-acting litigation which may pose risks. Fortunately, the issue of litigation for asset confiscation in Crimea was not included in the restrictions imposed by the new agreement, again a positive for Ukraine.
Getting rid of intermediaries
The question of direct gas sales by Russia to Ukraine re-opens an issue that has long been at the center of both corrupt influence and an economic security threat. For decades, Russia used gas supplies and pricing as a tool to exercise control over Ukraine. With the setting up of an intermediary between Gasprom and Naftogaz with a monopoly to supply gas to Ukraine, a significant portion of the gas trade revenues were diverted to bribes for key political figures and oligarchs in Ukraine. To ensure continued dependence of Ukraine on Russian gas, the price was discounted. The consequence was excessive gas consumption in Ukraine, massive unsustainable annual import costs of over $12 billion and exposure to the dependence on a single supplier. In fact, a cutoff of Russian gas to Ukraine was used to apply political pressure on several occasions.
Ukraine subsequently developed a response that eliminated Russia’s ability to exercise pressure through the gas trade. Effectively, Ukraine eliminated direct purchases of Russian gas by contracting with European companies for supplies. This policy was implemented by providing the pipeline capacity for reversing the flow of gas back to Ukraine from neighboring European countries. At the same time, the controlled price of natural gas for consumers was raised to market levels, drastically reducing both the volume of consumption, the opportunity for corruption and the budgetary impact of subsidies. Undoubtedly, this policy has dramatically improved Ukraine’s energy efficiency and security.
A reversion to direct purchases of Russian gas by Ukraine offers some potential pricing benefits but needs to be managed carefully to avoid once again providing leverage to Russia. Currently, the pricing of gas to Ukraine comes at a premium from what should be a fair market price. In a competitive market, Russian gas for Ukraine would sell at a discount to gas exports to Europe due to the shorter transportation distance. The mechanism of “gas swaps” in which gas destined for Europe is delivered in Ukraine would ensure such a differential. Gasprom has been allowed to effectively act as a monopolist and restrict such contracting. As a result, Ukraine is paying a premium over European prices rather than a discount and Russia, evidently, is offering a discounted price.
To avoid once again giving Russia leverage over Ukraine from gas supplies, all direct sales of Russian gas should only be permitted if the contracts are subject to EU laws and regulations. For example, the purchasing entity could be an EU incorporated company with the right to request deliveries in Ukraine. Alternatively, EU gas suppliers should be free to contract for Russian gas with the ability to “swap” gas with a Ukrainian client. Other legal structures that ensure that EU laws and regulations apply can also be envisioned. Such a market structure would protect Ukrainian buyers from arbitrary Russian shut-off or pressure as Gazprom is dependent on the EU gas trade and cannot afford to violate EU laws.
With the reservations noted, the new gas agreement between Gazprom and Naftogaz can provide for a significant win for Ukraine by maintaining a level of transit fees and also by reducing the pricing of gas to a competitive market level while avoiding the trap of renewed exposure to Russian pressure. Of course, the ultimate solution to imported gas costs is to develop Ukraine’s gas potential to achieve self-sufficiency.
Basil Kalymon is professor emeritus of Ivey School of Business at the University of Western Ontario in London, Canada.
