I encourage you to take a short interactive quiz to see if you are able to manage an energy crisis in a hypothetical European country. Find the link to the quiz at the end of this article!
“All events are linked together in the best of all possible worlds”Dr. Pangloss in Voltaire’s novel “Candide”
This Leibnizian claim was repeated like a mantra by the self-proclaimed optimist Dr. Pangloss in his teachings to Candide. Deemed “the greatest philosopher of the Holy Roman Empire”, Pangloss believed that his pupils live in the best of possible worlds and for everything that happens in life, happens for the best. Against the backdrop of myriad calamities throughout the novel, Candide maintains his positive and wishful attitude whether it be the Lisbon earthquakes, confrontation with the Portuguese Inquisition, or the Seven Years’ War. However, Candide’s blind belief in outright optimism ends with his ultimate rejection of Pangloss’s ideology and choosing to “cultivate his own garden” instead.
After remaining essentially paralyzed for over a year, the easing of Covid-related restrictions was met by the overheating of supply chains, causing a surge in commodity prices. At the center of it, the global natural gas supply market was hit the hardest with the European market suffering the most. Natural gas supplies were already tight heading into 2022. The first shock occurred due to the inability of suppliers to adapt to the sharp growth in demand from European countries as they were dashing to refill their underground gas storages to optimum levels ahead of the coming winter. There were talks of additional gas supply from Russia but it required a fast-track approval of the Nord Stream-2 pipeline which was never launched. The second shock, a more unprecedented one, is the ongoing Russian invasion of Ukraine. While the first disruption can be attributed to short-term supply chain shock, it is the ongoing war that bears long-term side effects and carries more weight in European energy security.
Ukraine-Russia gas disputes and the “Kharkiv Pact”
Russia’s use of natural gas as a blackmail weapon for political leverage is not novel. Following the collapse of the USSR, Russia found itself needing to decide between two paths. Either depend on the existing Soviet-era pipelines running through much of Ukrainian territories or explore alternative projects for diversifying its supply to the European markets. Russia opted for the latter, which prompted negotiations over the Nord Stream pipeline with Germany (completed) and the South Stream pipeline with Turkey and several European countries (remained on paper; replaced with TurkStream). These megaprojects were largely seen as Moscow’s ambition to gradually decrease its dependence on transit through the Ukrainian territory rather than providing additional gas supply to the European continent. On one hand, Russia was uneasy about Ukraine’s increasing leverage of its Soviet-era gas infrastructure. On the other hand, it was imperative for Russia that European countries see supply disruptions as Ukrainian shortcomings.
The Russian-Ukrainian gas disputes and subsequent European supply disruptions, however, have a long history, taking us back to the 1990s and 2000s. Back then, Ukraine was paying for Russian gas according to the predetermined intra-CIS prices which were considerably lower than the European prices, thereby leaving room for illegal price arbitrage of which the Ukrainian Naftogaz was accused. Over the course of the dispute, Russia attempted to renegotiate the transit agreements under various pretenses. Immediate progress was made after the election of a pro-Russian president, Viktor Yanukovych. A set of agreements, coined the “Kharkiv Pact”, were reached in 2010 and were seen as a Russian strategic win. In this “gas for naval base” deal, Gazprom agreed to keep the prices low but raise them to European levels in the longer run. Simultaneously, Russia was awarded a lease extension of their only warm water naval base housing its Black Sea Fleet in Crimea until 2042. The “Kharkiv Pact” agreement was short-lived and was eventually terminated unilaterally by Putin following Russia’s annexation of Crimea.
Even though the headquarters of the European Union sounded an alarm and condemnation over Russian aggression, there was a minimal reaction to the gas disputes. Russia’s gradual politicization of gas supplies was left unchecked and overlooked. The launch of the Nord Stream pipeline bound directly to Germany saw its operational start prior to the Crimean invasion and the EU countries found themselves out on a limb while cautiously traversing through unpredictable waters. As much as it was relevant in the late 2000s during the Russian-Ukrainian gas dispute, Russia’s blackmail policy remains unfeathered today. EU countries were swayed by Russian lullabies of diversifying away from Ukraine as a transit territory status-quo, in hopes of a perennial supply of cheap gas. As a result, Ukraine was left vulnerable to bear hug annexation, and Europe susceptible to energy blackmail.
Europe and Asia Spar for LNG supplies
In late 2021, when the United States intelligence was sounding an alarm over the Russian accumulation of troops along the Ukrainian eastern border, little did we know that almost a year later we would find ourselves in the midst of a belligerent war in Europe. The knock-on effects of the West’s sanction packages did not stop Russian advances, but instead forced the EU to press the reset button on their energy security policies. Citing repairment problems due to sanctions and unmet demands of payment in roubles, Russia cut itself off from a major bargaining chip and at the same time, unlocked the EU energy market to its rivals. Liquified natural gas (LNG) exporters such as the US were quick to meet the gap in the market. Nevertheless, everything is still up in the air for long-term energy security.
Comparing LNG and gas pipeline value chains goes deeper than economic differences but it is crucial to understand them to get the bigger picture. Distance from the original gas field to the final end consumer matters; pipelines beat LNG costs on shorter destinations of up 3000 to 7000 kilometers, depending on the pipeline tariff rate. In addition to pipeline laying to the end consumer, there must be a compressor station along the pipeline system to squeeze the incoming natural gas and push it at a higher pressure to make the gas inside flow. On longer distances gas pressure eventually falls due to friction and requires additional compressor stations which come at a cost. Since natural gas pipeline systems have high upfront investment costs, which become sunk as soon as the pipeline is laid down — due to the durable nature of its infrastructure (life span ~40 years) — suppliers tend to structure long-term contracts and ensure firm commitments from customers, in order to mitigate investment risk and establish a stable revenue flow to recoup capital investment. Thus, as a rule of thumb, whenever you hear about groundworks for pipeline projects being laid down, think of it as a 30-40 year commitment with the supplier. Otherwise, it becomes simply economically illogical if the goal is to cover short-term demands.
The long-term nature of pipeline deals does not imply that LNG contrasts as a short-term solution. It is estimated that as much as 70% of global LNG trade is sold through long-term contracts. Yet, Europe stands out with a reported 45-50% of the continent’s LNG imports carried out through the spot market and short-term contracts. At the crux is EU 2030 net-zero ambitions that rely on its capacity to turn to renewable energy. As long as EU countries import fossil fuels, it will be harder to reach a clean energy economy by the target time. Concurrently, underinvestment in hydrocarbons and leaning on green energy as a way out of the energy crisis is not a solution at a time when fossil fuel alternatives are still not ready to be exploited. With the EU’s focus on greener energy, the market will need to pivot twice, away from both green power and Russian gas. Such policies as EU 2030 net-zero, drive a wedge in EU negotiations with countries like Qatar whose aims are to ensure long-term contracts as demand continues its skyrocketing track. The Qatari side is especially concerned about the gas pricing mechanism and destination clauses of long-term contracts. The world’s largest LNG exporter was not ready to cover European demand right away, but it looks like Germany will see its first Qatari gas arriving this winter.
Energy caps as a temporary solution?
Changing the EU’s energy systems may be complex and lengthy but policymakers are racing to find a short-term solution to the energy crisis. In response to surging energy prices, the European Commission has proposed reforms to the electricity market and announced plans for a windfall tax on energy companies earning above-average profits. The issue remains largely unsolved as European governments tackle the crisis independently. Some have protected consumers by imposing retail price caps, issuing fuel subsidies, or cutting taxes on consumption from energy bills. Other countries have let the free market dictate its rules and restraining from government intervention, allowed energy firms to pass on higher wholesale prices to customers, simultaneously choosing to alleviate the strain on low-income households directly. Nevertheless, the EU is still yet to formulate a common policy. Germany is cashing out a further €65 billion on measures including a price cap for a basic amount of electricity for households and businesses while UK’s new prime minister, Liz Truss, unveiled a plan to freeze prices for two years, which could cost more than £100 billion and will be financed through borrowing. Meanwhile, France and Belgium constantly switch their seats on who shuts down their nuclear reactors and who extends their life span.
Ahead of the EU meeting where bloc-wide measures might be approved, the uncertainty is as high as it has ever been and it is yet to see what comes out of it. At the same time, the EU Commission has taken additional efforts to sign a deal with Azerbaijan this summer to double gas deliveries to at least 20 billion cubic meters by 2027. The deal will see increased supply of gas to Italy, Greece, and Bulgaria through the “Southern Gas Corridor” pipeline project extending from gas fields in the energy-rich Caspian Sea basin. The recent inauguration of “Baltic Pipe” will also see Norwegian gas covering as much as 15% of Poland’s annual consumption.
This energy crisis is a stark reminder that it did not originate on empty grounds. For decades, European officials were convinced about Russia’s indispensable position in European energy security. The “Kharkiv Pact” events were supposed to be the first red flag but went predominantly unnoticed. As Europe pursues its path towards a broader energy diversification policy, it is crucial to ensure gas imports from reliable suppliers to avoid stepping on the same rake. In the meantime, energy caps will help the EU in encouraging lower levels of consumption and soften the economic and social impact of the crisis. Similar to Candide’s U-turn away from Dr. Pangloss’ ever-optimistic ideology, the EU’s diversification away from Russian gas will lead it on a path towards a more reliable supply composition and cultivation of its own “energy garden”.
Bonus if you made it through: Can You Manage The Energy Crisis?