Refreshing European Energy Security Policy: How the U.S. Can Help

The U.S. can help Central and Eastern Europe and Ukraine by refreshing its European energy security policy. The current crisis validates America’s long-term policy goal of diversifying Europe’s energy supply to diminish Russia’s ability to use energy as a coercive tool against its neighbors. While much progress has been made, with bipartisan support, Russia still dominates Central and Eastern European (CEE) natural gas supply, and recent events call for refocusing our efforts. Stiffening the EU’s spine to create a truly competitive internal energy market, promoting the efforts of the International Monetary Fund (IMF) on internal market reform in CEE countries, supporting indigenous gas production and taking steps to building a reliable energy bridge to Europe through U.S. exports should be the cornerstones of U.S. policy. While no panacea, respected U.S. energy experts have been too quick to dismiss a linkage between Europe (and Ukraine’s) energy insecurity and the utility of expediting U.S. hydrocarbon exports.

Indeed, a clear signal that liquefied natural gas (LNG) exports to European allies are “deemed to be in the national interest”[1] would indeed have an immediate impact on Russia’s market power and help accelerate the build out of gas transportation infrastructure in Europe. The U.S. has already caused Russia to renegotiate current gas contracts and discount renewed contacts due to the displacement of LNG flows once meant for our markets. An immediate signal that future U.S. LNG exports will be available to Europe will send a message to Russia that within a few years, despite its current ability to pressure Ukraine and other nations once part of the USSR, this will no longer be possible. Expectations of future supply will impact price expectations and infrastructure investment decisions made today. Ukraine’s future energy security lies in greater reverse flows of gas from Europe and well managed gas storage in Ukraine. To the extent that the firm promise of U.S. LNG exports in the 2017-2022 period sustain lower LNG prices and help finance new interconnections from LNG import terminals on the continent, Ukraine will benefit indirectly as well.

Success in Ensuring European Energy Security Since 2009

U.S. policy has promoted redundant infrastructure as a cornerstone of energy security policy since the 1990s. Long gestating projects like the Baku-Tbilisi-Ceyhan (BTC) pipeline and the Southern Corridor were fundamental goals. Enhancing pipeline interconnections to move gas freely across the continent, internal pricing and efficiency reform and development of clean energy alternatives were the additional core elements.

Much progress has been made over two decades. BTC is operational, Azeri gas flows to Turkey and there will be a Southern Gas Corridor (although not as ambitious as the Nabucco project), which will bring gas to Turkey, Italy, Greece and Albania. Norway is providing competitively priced gas to the continent. The European Union’s Third Energy Package[2] has eliminated destination clauses (allowing free sale of gas) and should advance internal reforms. EU competition policy should restrict Russia’s ability to monopolize midstream and downstream energy infrastructure as well as gas supply, including barring Russia from completing the South Stream pipeline intended to allow Russia’s gas flows to bypass Ukraine.

The U.S. shale gas boom, as noted above, has had the greatest impact on the competitiveness of the European gas market by creating a glut of LNG supply that has opened a spot market and driven down long-term contract prices.  

The Unfinished Energy Security Agenda

But much remains to be done. The important work ahead depends more on policy reform than pipelines.

EU Natural Gas Market Reform

EU gas market integration efforts are highly incomplete. As my colleague Pierre Noel has incisively noted: “What emerges in Europe is a patchwork of tightly regulated, interconnected national gas systems governed by ever more detailed and complex rules that Brussels then wants to harmonize.”[3] The commoditization of gas, and the price pressure of spot pricing, has not yet reached the CEE states. While Russia may have renegotiated some of its contracts with Western European buyers to reflect lower gas prices, it remains the dominant gas supplier in CEE. Although EU rules ostensibly prevent destination charges, “the rules governing the Yamal-Europe pipeline, the pipeline across Romania and Bulgaria into Greece and Turkey and the Trans Austria Pipeline” essentially amount to preventing the resale of Russian gas by Western European importers.[4][5] Natural gas cannot yet flow freely across the European pipeline system, even from Spain to France.[6] True point-to-point gas sales from LNG importing terminals from West to East should a priority goal.

Internal Energy Market Reform

The price of natural gas in many CEE countries remains below the cost of import.  Domestic pricing formulas (weighting Russian and domestic gas) ironically favor higher priced Russian gas over potential imported gas. While intended to provide price relief to domestic economies, this policy inhibits both imports of gas from the West, and the economic viability of new infrastructure that would rely on imported LNG.[7] Price reform must therefore precede new infrastructure. The U.S., EU and IMF have important roles to play on this agenda.

New LNG Terminals and Pipeline Interconnection Infrastructure.

EU market reform and CEE price reform will provide the price signals needed to flow LNG into CEE states. These can come both from new (closer to market) LNG terminals or enhanced interconnection. Accurate price signals can also make heretofore-uneconomic projects viable.

Fortunately, there are both LNG import projects [see Table 1] afoot in Europe and interconnections planned [see Table 2] that could advance this vision. While some of these projects may still be far afield and face considerable challenges, they demonstrate the level of commitment CEE nations show towards ensuring diversity of supply. These LNG import terminals are planned to be operational between 2016 and 2020, the same timeframe in which U.S. LNG exports would begin to flow.

TABLE 1: Planned LNG Projects in Central and Eastern Europe


[8]

TABLE 2: Planned Pipeline Interconnectors in Central and Eastern Europe


[9]

How Would LNG Export Certainty Help Promote European Energy Security?

While policy reform will play the greatest role in enhancing CEE energy security, unfettered exports of U.S. LNG to Europe could play a powerful role in advancing this market –with immediate impacts on Russia’s market power and market share. Skeptics make four errors in dismissing this connection, 1) assuming most U.S. LNG exports will go to Asia, 2) assuming the post 2016 delivery time for U.S. LNG will not impact price formation today, 3) underestimating the importance of securing Henry Hub based LNG supply for financing European infrastructure projects and 4) failing to see the immediate strategic importance of degrading Russia’s future share of the European gas market.

LNG Exports to Europe.

Multiple skeptics assume U.S. LNG exports will go to Asia and not Europe because price differentials are higher. This is simplistic. Companies like Poland’s PGNiG are currently trying to renegotiate high priced, oil-linked contracts with suppliers like Qatar, and would value alternative supplies on the market that would lower global prices. Given the opportunity to buy U.S. LNG, Europeans buyers (BG, Spain’s Gas Natural, France’s Total, and UK based Centrica) have contracted 65 percent of the supply of the only fully licensed U.S. LNG export project (Cheniere’s Sabine Pass).[10] Asian demand may be impacted by a larger share of nuclear power generation than expected and Asian buyers are pushing hard to erode oil-linked pricing as well. Meanwhile, the governments of CEE nations are using diplomatic channels to make it clear that they see imports of U.S. gas to be a vital component of their energy diversification strategies.[11] Purchasers weigh price heavily of course, but they also weigh the diversity of supply source, and the likelihood of timely project completion.[12]

Price Formation.

Prices for long-term gas supply are based on future expectations. This is why Russia is now offering discounts on renewals of its gas supply contracts to Europe. Energy is a business of long lead times, where the marginal barrel (or cargo) sets the price. Every decision, from investing in oil or gas production, to building a power plant, or financing an LNG import or export terminal is based on future price expectations. Multiple studies, including those conducted by the U.S. Department of Energy, have concluded that U.S. natural gas supply will rise to meet new LNG export demand.[13] It defies logic to believe that creating more certainty with respect to U.S. LNG exports will do anything other than increase supply and add price pressure to oil linked gas suppliers like Russia. Europe enjoys the price benefits of a short term glut in LNG supply, today, but allowing U.S. Henry Hub priced exports may be the only way to sustain this price pressure over the long-term.

Financing New Infrastructure.

Analysts rightly point out that commercial parties, not governments, decide whether to build pipelines or LNG plants. Securing reliable supply, however, is indispensable to those transactions. (Governments can also make these transactions easier by providing credit support or harder by delaying permitting). Making U.S. LNG supply available, priced competitively against Russian piped gas, or oil-linked Qatar gas, will add significantly to the ability to finance these projects. Russia may indeed compete for market share by offering short-term discounts to some customers, but enabling buyers to access other sources is the entire point of the policy. Our litmus test (and time horizon) for helping Ukraine, Poland, Lithuania, Latvia and others highly dependent on Russian gas should extend beyond how we help them next week to how we help them next year and beyond.  

Degrading Russia’s Market Share.

Skeptics cite the delay in actual delivery of LNG supplies till post 2016 as a reason to dismiss the utility of unfettering LNG exports now. This is short sighted at best. American policy concerning energy security for Europe has been built almost entirely on pursuing long-term projects to create diversity of supply: Baku-Tbilisi-Ceyhan and the Southern Gas Corridor, to name two. Commercial entities that buy LNG have already locked up their supply through 2016 or so; they are shopping today for supplies after that date. The best way to limit the attractiveness of investment in Russia’s upstream, or its revenue stream over the medium term, is to enable other suppliers to capture market share and erode the oil/gas price linkage so critical to Russia’s income stream.  In its study on the global impacts of U.S. LNG exports, Deloitte found that moderate exports of U.S. LNG, 6 billion cubic feet per day, could result in a wealth transfer of up to four billion dollars from Russia to European consumers, simply through reduced contract prices and market share.[14]  (Allowing U.S. LNG exports to Asia also damages Russia’s future market, but countries on Russia’s periphery have fewer choices of supply than Asian buyers do). If U.S. LNG exports were deemed to be in the national interest now, the potentiality of that supply would be scored by every banker – and every public shareholder of Russian companies.

Conclusion

The focus of U.S.-European energy security policy must move from pipeline promotion to policy reform. The progress Western Europe has made on diversity of supply and competitive pricing has not reached CEE states largely due to their own policies and incomplete EU market reform. But U.S. policy can help move this progress eastward through diplomacy, and through a clear and unequivocal signal that U.S. LNG is available for export to these markets in a useful time frame. A business as usual approach will further entrench the current energy situation, in which Western Europe, where most countries have access to diverse sources of LNG, will continue to be distanced from the reality of Central and Eastern Europe, where Russian dependence persists.    

We can urge others – the EU, the IMF and host countries – to do their part to create a competitive market for gas and an investment climate commercial parties will want to invest in. But providing LNG supply to Europe is a lever we control and one we should exercise.

If the U.S. deemed sales of LNG to Central and East European countries (or NATO allies or countries cooperating on Iran sanctions) to be in the national interest, there would be a race to lock up those supplies. Every molecule a European buys from the U.S. is a molecule subtracted from another supplier’s gas market- and in Europe that supplier is most likely to be Russia, given its large market share. Russia’s pricing power declines today, as does its negotiating power for future supply – and investment. The current process makes it highly uncertain whether or when U.S. LNG export project developers can deliver gas to European customers and the pace of the U.S. Department of Energy approvals risks delaying project approval and construction for too long.

A Brookings LNG task force suggested that the optimal U.S. policy would be to let the market decide where exports should go, and to neither promote nor restrict them. I share that view. But as the current environment makes the optimal policy unavailable, we should consider unfettering our future LNG exports to Europe as a first step. Many influential voices from both sides of the partisan aisle have contributed to this discussion in favor of supporting U.S. LNG exports in order to reduce Russia’s dominance in European energy markets, including Larry Summers, former adviser to President Obama, and former Secretary of State Condoleezza Rice. The geopolitical imperative is clear. Both Republicans and Democrats have introduced numerous pieces of legislation that would authorize exports of U.S. LNG to allies, be they NATO or WTO members, in the U.S. Congress.

We have spent nearly two decades of intense diplomacy trying to diversify Europe’s energy supply by getting Azerbaijan, Kazakhstan, Turkmenistan and even Iraq to sell them energy. Baku-Tbilisi-Ceyhan. Nabucco. The Southern Corridor. The Trans-Caspian Gas Pipeline. We finally have a tool at our disposal that can provide direct relief to Europe over time, and accelerate the competitiveness of that market today. We want everyone else to help. Shouldn’t we?

[1] This status would make exports to these allies equal to that granted to countries with which the U.S. has free trade agreements. Once applicants have FERC approval, they would be fully licensed for export.

[2] The European Union’s Third Energy Package, entered into force in 2009, seeks to create a single energy market within Europe. The Third Energy Package applies to both electricity and natural gas. Among its numerous components, the Third Energy Package seeks to unbundle the ownership of natural gas production and transmission lines. This is intended in part to alleviate the high degree of vertical integration within the European market. Investment decisions made by vertically integrated companies are generally biased to the needs of supply affiliates. They are therefore disinclined to invest in areas to increase competition such as increased interconnection or gas import capacity.

[3] Pierre Noel, “European Gas Supply Security: Unfinished Business,” in Energy and Security: Strategies for a World in Transition (2013: Woodrow Wilson Center Press/Johns Hopkins University Press), p. 172.

[4] Noel, p. 179.

[5] Noel notes that a 2011 agreement between Poland and Russia governing the Yamal pipeline promises to allow more flexible resale, yet the effectiveness of this agreement remains uncertain.

[6] Noel, p. 169-186.

[7] Noel, p. 179-80. Noel also notes that this policy also created resistance to EU climate policy by raising the cost of substituting gas for coal.

[8] Compiled by Goldwyn Global Strategies, LLC.; Country demand statistics from BP Statistical Energy Review 2013

[9] Compiled by Goldwyn Global Strategies, LLC

[10] For the Sabine Pass project, Cheniere has signed supply contracts with European buyers for the following volumes: BG, 5.5 MTPA; Gas Natural, 3.5 MTPA; Total, 2 MTPA; Centrica, 1.75 MTPA.  Cheniere has also signed MOUs with Klaipedos Nafta of Lithuania, Enel/Endesa, and EDF. Some of these buyers are merchant buyers that can service consumers in Europe, Asia or Latin America, while others are primary European consumers with firm utility loads buying for domestic consumption. Actual flows will depend on European demand, competition among project developers, and (as Poland demonstrated) the weight buyers put on the reliability, nationality and timeliness of the supplier. We should all be a bit humble about predicting the market. But insecure buyers, from currency to wheat, like to buy American.

[11] Multiple nations have been vocal about their desire to import U.S. LNG. The Ambassadors of the Visegrad 4 nations (Poland, the Czech Republic, Hungary and Slovakia) sent a letter to Congressional Leadership asking them to remove the bureaucratic hurdles surrounding export permits; meanwhile plans are in the works to create a lobbying group named “LNG Allies,” which will represent a larger group of countries and lobby the U.S. government in favor of LNG exports. (Amy Harder, “Europe to America: We Want Your Gas,” National Journal, January 16, 2014; Veronika Gulyas, “Central Europe Turns to U.S. for Natural Gas,” Wall Street Journal, March 10, 2014)

[12] While LNG projects are being developed globally, many of the projects abroad have suffered from major delays and cost overruns, including some of the large-scale projects under development in Australia and the South Pacific. (Ed Crooks, “Cost of Australia’s Gorgon LNG project rises to $54bn,” Financial Times, December 12, 2013)

[13] “Macroeconomic Impacts of LNG Exports from the United States,” NERA Economic Consulting, December 2012.

[14] “Exporting the American Renaissance: Global impacts of LNG exports from the United States,” Deloitte Center for Energy Solutions and Deloitte MarketPoint, 2013.