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Europe’s Energy Dilemma

Tim Boersma

On May 28 the European Commission published its energy security strategy. In the midst of sanctions and strong rhetoric on the need to reduce dependence on Russian gas, this was to be the first salvo in a long term plan to reduce dependence on Russian natural gas. Unsurprisingly, this will not happen any time soon.

The ongoing crisis in Ukraine has confirmed two things: Europe continues to be divided on energy security issues, and the importance of energy related matters is modest compared to concern about the right and left wing drift of European politics. That last point only puts energy issues in perspective, which is probably good for many scholars and observers working on the topic, including this author.

Energy Security in Europe

Reaching European consensus on energy security was rarely successful, despite attempts to develop an overall supranational energy policy ever since the Declaration of Messina in 1955. With the entrance of 10 new, predominantly eastern European member states to the EU in 2004 however, achieving consensus has de facto become impossible, unless policy makers step over their own shadows and move beyond narrow parochial national interests. Over the last decade, the world has witnessed increased divergence between eastern and western European matters related to external suppliers of energy resources, the fuel mix and ambitions over renewable energy.

Both sides have a reasonable story to tell. In the western part of Europe, trade relations with Russia are by and large stable, and prices for natural gas competitive from a global perspective. Historically, natural gas markets have been reasonably well developed, and in recent years successful efforts have been made to integrate markets, increase storage facilities, build interconnectors, reverse gas pipeline flow options, construct liquefied natural gas (LNG) regasification terminals and become attractive for diverse suppliers, making this part of Europe resilient to the risks of supply shocks. In addition, countries like Germany, Denmark and the United Kingdom are at the forefront of a push to a low-carbon economy, which is crucial considering global warming, but also makes sense from an energy security perspective.

In Eastern Europe, with the exception of Romania, natural gas historically has played an insignificant role. This is because the resource was not available in this part of the continent, and thus economies were built on widely available coal and to a lesser extent oil. As a result, natural gas markets are small in terms of total consumed volumes, not well developed in terms of available infrastructure and network integration and market models are outdated, with prices still often regulated. It thus makes sense that the modest amount of natural gas that is supplied here often comes exclusively from Russia. Because of the lack of competition, arbitrary pricing is more the rule than the exception. Add to this the historical backdrop of political subjugation and the outcries for diversification away from Russia sound reasonable.

These outcries sound even more reasonable considering that during the accession talks of these member states, prior to them joining the EU, decreasing the usage of coal, which does not mesh well with Europe’s renewable and climate ambitions, was actively discussed. Alternatively, natural gas markets had to be developed, and EU funding was to be available to cover a share of the costs. However, once these countries joined the EU, it became apparent that European institutions, in fact, have very limited capacity (in 2004 they had none, both legally and financially) to help develop infrastructure. Thus, these countries felt that they were left in the cold.

On the other hand, a question that cannot be answered satisfactorily by policymakers from Eastern Europe is how large the threat of Russia really is. To put it bluntly, if Russia is the existential threat as is often portrayed, then it does not make sense that policymakers have not invested immediately to grant access to alternative sources of natural gas. In the case of Poland, for example, this could have been done by spending several dozen million euros on increased interconnector and reverse flow capacity with Germany, or alternatively, by constructing a pipeline to Denmark. Both these options would have given Poland access to alternative natural gas–albeit from the Netherlands, Norway or liquefied natural gas–and thus would have made Poland more resilient to supply shocks, and less dependent on Russia. Yet Polish policy makers decided not to do this, and instead to make a lot of noise in Brussels. As another example, the Baltic States have barely made a collaborative effort to address their energy security considerations, and prefer to construct their own LNG terminal, which given the very modest size of their respective gas markets, does not make commercial sense and thus complicates these efforts. This behavior does not correspond with that of nations that feel under threat.

Energy Policy in the European Union

To outside observers, policymaking in the EU can seem like a labyrinth. With regard to energy policy, the European Commission has played a prominent role in adopting a policy framework, revolving primarily around two pillars.

First, since the late 1980s, the Commission has been pushing to liberalize European markets for both electricity and natural gas by issuing three legislative packages. The legislation aimed to unbundle traditionally integrated energy companies to foster competition, increase price transparency and ensure a level playing field throughout Europe. These efforts also included measures to increase transparency in what was essentially a patchwork of nationally developed electricity and gas markets, while safeguarding third party access to energy infrastructure. It is worth noting that this existing European legislation has not been implemented in all member states in full everywhere, and the infringements procedures that the Commission has started against these member states, and that were pending against 14 member states in late 2012, were witness to that.

Second, the Commission has a substantial mandate on environmental and climate-related issues. This is most apparent when looking at the EU 20-20-20 strategy, which comprises a national target for the different member states to utilize 20 percent of renewable energy by 2020, to achieve a 20 percent carbon reduction and to improve energy efficiency by 2020. The environmental ambitions of Brussels, though, have lost support, in particular, in Eastern Europe, where efforts to curb the usage of coal are expected to hurt national economies. Thus, it has been increasingly difficult to reach an agreement on a post-2020 legislative framework, a debate that may be concluded in June 2014.

Nevertheless, European institutions hold a greater mandate in streamlining energy market functions and addressing environmental concerns, rather than having an actual mandate to safeguard energy security as evidenced by the following. First, the 2007 Lisbon Treaty refers to European energy policy, and states that it aims to ensure the functioning of energy markets, ensuring security of supply, promoting energy efficiency and renewable energy, and promoting the interconnection of energy networks. However, this “shall not affect a member state’s right to determine the conditions for exploiting its energy resources, its choice between different energy resources, and the general structure of its supply.” Therefore, in essence, European member states have the final say with regard to ensuring their energy supplies. The open letter of UK Prime Minister David Cameron to European Commission President Manuel Barroso telling him to tone down European ambitions to draft binding legislation regarding shale gas was an excellent illustration of this.

Second, with regard to energy networks, European institutions lack the mandate and financial means to solve bottlenecks. It was only in late 2011 that the European Commission received a structural mandate to co-invest in energy networks, albeit electricity or natural gas. Yet the available budget under the Connecting Europe Facility – 5.85 billion euros in the period until 2020 – does not match the estimated required investments to integrate European networks fully, which are estimated to be around 200 billion euros. Furthermore, politicians from all member states have been eager to make sure that a part of the available budget is invested in their respective home countries, in fear of having to explain that all the taxpayers’ contributions were invested elsewhere in the EU. As a result of this dispersed division of financial means, the available money is sufficient to carry out feasibility studies, and barely to construct additional physical infrastructure. Numerous studies have shown this structural deficit, yet the Commission continues to report that the internal market will be completed in 2014, as scheduled. Of course the crisis in Ukraine, and the fear of a supply disruption, made it painfully clear that Europe is nowhere near an integrated and resilient market. Despite the progress that has been made since the supply disruption of 2009, several member states would still be in dire need of help in the case of a physical disruption. It is interesting to note how current policymakers respond to these observations. They decided to first make a more detailed assessment of the problems and ensured that it would be published long after the May 2014 elections. In other words, this issue was left to the newly elected members of the European Parliament and the European Commission, which are commencing their activities in the fall of 2014.

The Way Forward: Increased Integration and Significant Market Reform

Despite the increasing divergence and limited progress on completion of the internal market, the bottom line for the 28 European member states, as always, is overwhelmingly simple: they are in this together. The current trajectory is one that muddles through for a number of years, undoubtedly shaken up on occasion, for example, by a supply disruption, as Ukraine continues to be unstable or by outcries over arbitrary price increases by Gazprom in Eastern Europe.

Here is an alternative approach. The infrastructural bottlenecks in the European Union are well documented. Necessary investments in interconnectors, reverse flow facilities and extra storage capacity are required in eastern and southern Europe. In some of these cases, political and economic realities do not match. To give an example, the Commission’s ambitions urge Bulgaria and Greece to physically connect their markets with an interconnector by 2016, but natural gas from the Southern Corridor is only expected by 2019. What countries would invest in such an interconnector until then? Projects like these are where the available European funds should flow, and nowhere else. Politicians from other European member states should stop lobbying for their pet projects at home that would like some EU funding, and instead explain to their constituents why this targeted investment is, in the end, better for all European citizens. Obviously, governments in eastern and southern Europe themselves make the largest financial contribution to their energy networks, something that other member states have done too.

At the same time, in particular, Eastern Europe needs structural market reforms. Several member states still have regulated prices, are entirely dominated by integrated incumbent energy companies and do not invest adequately in infrastructure to make their markets more attractive for competition. A good start would be to implement all existing European legislation – note that the so-called Third Package should have been implemented in the spring of 2012. In order to make sure that this actually happens, the Agency for the Cooperation of Energy Regulators requires a larger mandate to check the implementation, better streamline regulations between member states and, if required, impose hefty measures on those member states that do not comply. Endless arbitration through infringement procedures and the European Court of Justice will take a number of years, which is something worth avoiding.

Author

Additionally, while investment in Eastern Europe is urgently required, policy makers should continuously watch out for superfluous subsidies and waste of public funds. The LNG regasification terminal off Poland’s shores provides an excellent example. As described earlier, the Polish authorities could have invested in significantly cheaper alternatives to LNG, but chose not to. The European Commission subsequently decided to finance around 30 percent of this multi-billion euro project. However, as the contracted LNG from Qatar will be significantly more expensive than pipeline gas in Poland, and since the Polish authorities do not want to raise domestic gas prices, the net effect of this policy decision is that the Polish regulator will have to regulate the prices of this LNG. Through a detour, the Polish tax payer coughs up this premium price for “security,” and a few individuals fill their pockets on the side. This is a waste of public funds that has to be avoided at all cost in future projects.

Once European markets have been developed, integrated and opened up for competition, vulnerability to supply shocks will decrease substantially, and in case of a disruption, alternative suppliers can increase supplies and ship their produce freely throughout the EU. Attempts to “move away” from Russian natural gas are useless, as prices will dictate that the cheapest available reserves always find a place in the market. For Europe, that includes a substantial share of Russian natural gas, as recently confirmed by the International Energy Agency. The key is to develop a harness against market abuse by any dominant market player in the form of sufficient competition, liquidity and access to alternative supplies. Once these issues have been addressed, it is reasonable to assume that member states can agree on a long-term framework to stimulate investments towards a low-carbon economy, including increased shares of renewable energy, a solid and increasingly high carbon price and mandatory building standards and efficiency targets. That is where the future of Europe lies. Not in geographic boundaries, national interests and polluting fossil fuels. It is time to collectively move forward.

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