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Council Special Report No. 43

Febuary 2009

Jeffrey Mankoff

Eurasian EnergySecurity


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Eurasian Energy Security


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Council Special Report No. 43February 2009

Jerey Manko

Eurasian Energy Security


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The Council on Foreign Relations (CFR) is an independent, nonpartisan membership organization, thinktank, and publisher dedicated to being a resource or its members, government ocials, business execu-tives, journalists, educators and students, civic and religious leaders, and other interested citizens in orderto help them better understand the world and the oreign policy choices acing the United States and othercountries. Founded in 1921, CFR carries out its mission by maintaining a diverse membership, with specialprograms to promote interest and develop expertise in the next generation o oreign policy leaders; con-vening meetings at its headquarters in New York and in Washington, DC, and other cities where seniorgovernment ocials, members o Congress, global leaders, and prominent thinkers come together withCFR members to discuss and debate major international issues; supporting a Studies Program that ostersindependent research, enabling CFR scholars to produce articles, reports, and books and hold round-tables that analyze oreign policy issues and make concrete policy recommendations; publishing Freg

Aars, the preeminent journal on international aairs and U.S. oreign policy; sponsoring IndependentTask Forces that produce reports with both ndings and policy prescriptions on the most important or-eign policy topics; and providing up-to-date inormation and analysis about world events and Americanoreign policy on its website, CFR.org.

The Council on Foreign Relations takes no institutional position on policy issues and has no aliationwith the U.S. government. All statements o act and expressions o opinion contained in its publicationsare the sole responsibility o the author or authors.

Council Special Reports (CSRs) are concise policy bries, produced to provide a rapid response to a devel-oping crisis or contribute to the publics understanding o current policy dilemmas. CSRs are written byindividual authorswho may be CFR ellows or acknowledged experts rom outside the institutioninconsultation with an advisory committee, and are intended to take sixty days rom inception to publication.The committee serves as a sounding board and provides eedback on a drat report. It usually meets twiceonce beore a drat is written and once again when there is a drat or review; however, advisory committeemembers, unlike Task Force members, are not asked to sign o on the report or to otherwise endorse it.Once published, CSRs are posted on www.cr.org.

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Copyright 2009 by the Council on Foreign Relations Inc.All rights reserved.Printed in the United States o America.

This report may not be reproduced in whole or in part, in any orm beyond the reproduction permittedby Sections 107 and 108 o the U.S. Copyright Law Act (17 U.S.C. Sections 107 and 108) and excerpts byreviewers or the public press, without express written permission rom the Council on Foreign Relations.For inormation, write to the Publications Oce, Council on Foreign Relations, 58 East 68th Street, New

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To submit a letter in response to a Council Special Report or publication on our website, CFR.org, youmay send an email to [email protected]. Alternatively, letters may be mailed to us at: Publications Depart-ment, Council on Foreign Relations, 58 East 68th Street, New York, NY 10065. Letters should include thewriters name, postal address, and daytime phone number. Letters may be edited or length and clarity, andmay be published online. Please do not send attachments. All letters become the property o the Councilon Foreign Relations and will not be returned. We regret that, owing to the volume o correspondence, wecannot respond to every letter.

Cover Photo: Special liting cranes hold the Baltic Sea gas pipeline near the town o Babayevo in the Vologdaregion some 650 km northeast o Moscow (Alexander Miridonov/AFP/Getty Images).

This report is printed on paper that is certied by SmartWood to the standards o the Forest StewardshipCouncil, which promotes environmentally responsible, socially benecial, and economically viable man-agement o the worlds orests.


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Frewrd v Ackwedgmets

Map Acryms

Council Special Report 1Introduction 3Russias Resurgence 7Connecting Europe and Asia 19Conclusions and Recommendations 25

Edtes 41 At the Athr 45 Advsry Cmmttee 46

Contents


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This January brought a stark reminder o the perils o Europeandependence on Russian natural gas. A cuto o supplies connected in

part to a pricing dispute between Russia and Ukraine, the crucial tran-sit country or much o Russias gas, let millions o Europeans with-out heat and orced actories to close. The crisis not only underscoredthe challenges o managing U.S. and European relations with Russia,a country whose geopolitical reach rises and alls to some extent withthe price o oil and gas. It also highlighted the diculty or AmericasEuropean allies o breaking their dependence on a single energy sup-plier, one whose willingness and ability to provide sucient gas over

time is uncertain.This Council Special Report, authored by Jerey Manko,explores the challenges aced by consumer and supplier alike inEurope and Eurasia. It looks at Russias rise as an energy power, ana-lyzing its control o supplies and delivery systems and its investmentsin energy inrastructure across Europe, as well as questions aboutthe potential o its production. The report also examines Europesdiculties in orging a common policy on energy supply and recom-

mends a two-pronged strategy o integration and diversication. Iturges Europe to integrate both internallydeveloping a single EUgas marketand externallytying Russias energy sector to Europeand its more transparent regulations. It also recommends thatEurope seek new sources o energy rom both non-Russian suppliersand non-ossil uels.

Erasa Eergy Secrty is a thoughtul work that illustrates theneed or a coherent European energy policy and argues that the ongo-ing nancial crisis provides a unique opportunity to tackle the issue.At the same time, it recognizes that European dependence on Rus-sian energy will be a reality well into the uture and that Europe can

Foreword


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increase its energy security only by working withnot againstRussia. The report is a sophisticated contribution to the debate on anissue that can at any moment hit home or millions.

Richard N. HaassPresdetCouncil on Foreign RelationsFebruary 2009

Foreword


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ix

I am grateul to the Council on Foreign Relations or giving me theopportunity to write on such a timely and important project. Thanks

are due to CFR President Richard N. Haass and to Vice President andDirector o Studies Gary Samore or their support o this project andor their comments. I also would like to thank CFRs Publicationsteam o Patricia Dor and Lia Norton and the Communications teamheaded by Lisa Shields and Anya Schmemann or their work in pro-duction and dissemination.

I beneted greatly rom the comments and suggestions o the advi-sory group convened to discuss an early drat o the report. The mem-

bers o the advisory group, whose names are listed at the end, werevery gracious with their time and suggestions, and I am grateul to eacho them. Their comments helped me clariy the arguments and savedme rom errors o both act and interpretation. It goes without sayingthat they bear no responsibility or any remaining shortcomings. So,too, am I grateul to the numerous specialists, in the United States andRussia, who gave reely o their time and knowledge in the course omany interviews.

Special thanks are due to the George F. Kennan senior ellow orRussia and Eurasia studies, Ambassador Stephen Sestanovich, whochaired the advisory group and whose encouragement, knowledge, andpatience were crucial in guiding me through this project, and to indeat-igable research associate John Elliott, without whose labors the reportcould never have been produced. Finally I would like to acknowledgeBP p.l.c., whose nancial support made this report possible. The state-ments made and views expressed herein are solely my own.

Jeffrey Mankoff

Acknowledgments


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MapofEurasia

Source:JBC

EnergyGmbH.

Majorpipeline

controlledbyRussia

Majorpipelinenot

controlledbyRussia

Otherdistribution

infrastructurepipeline

Othersupply

infrastructurepipeline

Proposedpipeline

Pipelineunder

construction


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ACER Agency or the Cooperation o Energy Regulators

bbl/d barrels per day

bcm billion cubic meters

BTC Baku-Tbilisi-Ceyhan

BTE Baku-Tbilisi-Erzurum

CIS Commonwealth o Independent States

ECT Energy Charter Treaty

ENTSOG European Network o Transmission System Operators

or GasEU European Union

FDI oreign direct investment

GDP gross domestic product

ISO independent system operator

LNG liquied natural gas

NETS New European Transmission System

OPEC Organization o Petroleum Exporting Countriestcm thousand cubic meters

TCP Trans-Caspian pipeline

WTO World Trade Organization

Acronyms


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Cc Speca Reprt


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3

Introduction

For two weeks in the reezing January o 2009, homes and businessesacross Europe were let without heat, the result o a murky dispute

over gas prices between Russia and Ukraine. When Moscow and Kievailed to agree on a ormula or calculating price and transit ees orthe coming year, the gas simply stopped fowing. Europe, which getsa signicant proportion o its gas through pipelines that transit bothRussia and Ukraine, bore the brunt o this conrontation between thetwo euding post-Soviet neighbors.

Blessed with enormous deposits o oil and natural gas as well as alocation at the strategic crossroads between the major consuming

countries o western Europe and East Asia, Eurasia (that is, Russiaand its one-time satellites in the Caspian Basinprimarily Azerbaijan,Kazakhstan, and Turkmenistan)will be a vital source o Europesenergy in the oreseeable uture. Ensuring reliable access to Eurasiasenergy at a reasonable price is thereore among the most crucial strate-gic imperatives or Europe and, by extension, or Europes allies in theUnited States.

The emergence o Russia as the dominant player in Eurasia has made

the European Unions (EU) dependence on the ormer Soviet states orits energy security increasingly problematic, a reality highlighted all tooclearly by the Russia-Ukraine gas crisis o January 2009.

Russias resurgence, largely ueled by sales o its oil and gas abroad,has greatly complicated Europes quest to obtain direct access to theenergy riches o the Caspian. Russias stronghold on the transit cor-ridor bringing Caspian energy, especially natural gas, to the West hasincreased Europes dependence on Russia as a supplier. This depen-dence has a range o consequences or Europe and or transatlanticrelations, increasing Russian political leverage and leaving Europe toace the threat o shortalls rom both technical and political causes.As a result, European energy security has become intimately linkedwith both Russian oreign policy objectives and the interests o a small


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4 Eurasian Energy Security

number o nontransparent, oten state-run corporations such as Gaz-prom, Rosnet, and RosUkrEnergo that promote corruption and dis-tort the unctioning o markets. This situation is urther complicatedby the act that European countries do not depend equally on Russia.Addressing the sources o Europes vulnerability will require muchgreater coordination among EU member states. Their strategy, to beeective, should initially ocus on building an integrated European gasmarket with an agreed ramework governing Russian participation; inthe long run, the EU needs to diversiy the sources o its energy, reduc-ing the overall role o Russian oil and, especially, gas.

Russias ocial energy strategy observes that energy security is the

most important element in Russias national security and calls or thestate to take an active role in the energy sector so as to protect Russiarom both internal and external threats.1 Given, then, that energy isa central component o Russias oreign policy, how the EU and itsAmerican allies shape their priorities in this eld will to a large extentshape the Wests strategy or dealing with Moscow. A commitment tourther integrate Russia into Europes energy security ramework in away that is mutually benecial can be part o the Wests approach to

gaining Russias cooperation on other issues, especially in the MiddleEast.2 Getting Eurasia right will help U.S. oreign policy objectives inother ways as well. Apart rom the ormer Soviet Union, the most prom-ising source o new gas supplies or Europe is Iran. O course, turningto Iran would dramatically undermine U.S.-led attempts to isolate andcontain Tehran. I Europe can address its needs in the Commonwealtho Independent States (CIS), it will have no incentive to weaken the iso-lation o Iran. Additionally, energy security is inseparable rom other

aspects o energy policy, including sustainability and innovation. Parto the solution to Europes energy insecurity thus lies in seeking new,carbon-neutral sources o energy, including nuclear power.

Maximizing Eurasias contribution to European energy security inturn requires addressing a series o distinct yet interconnected chal-lenges. First, as Europe has grown increasingly dependent on Russianenergy, Russias own oil and gas production has leveled o, largelybecause the states role in the energy sector has grown and the states taxregime discourages investment in new production. This developmentraises the prospect o supply shortalls, should Russian production notkeep up with contracted demand. The economic downturn that began inmid-2008 threatens to exacerbate this problem in the long term becauseMoscow now has less available capital to invest in new production.


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5Introduction

Second, Russias role as Europes largest supplier, coupled with theKremlins control over Russian pipelines, has generated concernsthat Moscow could decide to withhold contracted deliveries, a ormo economic-political blackmail, as some observers argue was doneto Ukraine in January 2006 and again in January 2009. Third, Russiacould isolate upstream countries rom Europe by maintaining its near-monopolistic control o pipelines between the Caspian and Europe.Europe would thus be unable to access oil and gas rom the Caspiancountries except on the basis o agreements with Moscow. Finally,systemic corruption in the Russian energy sector reduces Russiascapacity to ollow through with planned projects and injects corrup-

tion into European politics in ways that undermine the EUs capacity topursue a common energy policy.

Although the global economic downturn and the accompanying allin energy prices have made energy security appear a less urgent problem,the structural actors underpinning Europes vulnerability remain. Byweakening or a time Russias ability to leverage its control o energy, theeconomic crisis also creates an opportunity or the Western powers toseize the initiative and address the sources o their vulnerability. More-

over, that Europe ell victim to the arcane gas transit dispute betweenMoscow and Kiev has undermined support or the status quo even incountries, such as Germany, that have in the past opposed bold steps.For these reasons, it is particularly important to get the policy right, andto seize the opportunity to do so while circumstances remain avorable.Dealing with the consequences o Russias energy-ueled resurgenceshould be among the top priorities or European leaders. Althoughthe United States is not itsel a major consumer o Russian energy, it

too has an important role to play in ostering European solidarity andenhancing EU leverage with Moscow. A successul strategy or the newreality o energy in Eurasia should aim to do the ollowing:

limit Russias ability to derive unilateral political advantage rom itsoil and gas reserves;

ensure secure access to energy or all members o the EU;

promote reciprocity between Russia and its neighbors on rules or

investment and ownership in the energy sector;ensure adequate investment in the Russian energy sector in order tomaintain high levels o production while bringing new oil and gaselds online.


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An eective strategy or promoting European energy security vis--vis Eurasia would acknowledge the reality o EU-Russia interdepen-dence while seeking to both enmesh Russia in Europes institutionaland regulatory web and develop, to the extent possible, long-term alter-natives to reliance on Russia, including sources o energy not based oncarbon. The centerpiece must be a concerted eort on the part o theEU and its members to integrate Europes gas market, which will limitthe geopolitical consequences o dependence on Russia and smooththe way or Russian investment. Achieving gas market integration willrequire treating energy security increasingly as a common Europeanconcern. An overall strategy based on integration and diversication

thus oers the best chance o both promoting Russias transormationinto a ully dependable participant in Europes energy market and insu-lating Europe against potential disruptions.

Integrating Europes gas markets while laying the groundwork ordiversication will allow the EU to address a range o challenges stem-ming rom its dependence on Russia. The Russian states growing holdon the energy sector threatens to exacerbate the problem o decliningproduction rom existing oil and gas elds, even as demand is projected

to continue growing both at home and abroad. At the same time, Russiais Europes largest supplier o both oil and gas. As the disruption o gassupplies to Europe in January 2009 during the dispute between Russiaand Ukraine clearly demonstrated, such dependence leaves Europevulnerable to political uncertainty in Russia and Ukraine. Meanwhile,Russia and the Western powers have also been engaged in a long strug-gle or control o the transport corridor bringing oil and gas rom theCaspian Basin to Europe. Thanks to its expanding infuence in the

region, Russia is increasingly winning this struggle, leaving Europe toace the prospect o still greater dependence in the uture. Only i theEU can overcome its own internal divisions (a process that ocused U.S.involvement can promote) and commit to both building an integratedmarket and diversiying its energy supplies will it be able to cope eec-tively with these challenges.


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7

Russias Resurgence

Although the geopolitics o energy were an element in relations betweenthe West and Eurasia during the 1990s, oil and gas became truly central

during Vladimir Putins presidency o Russia (20002008). In part,this development stems rom changes under way within the Russianenergy sectorparticularly, Russias emergence as the worlds largestproducer o natural gas, with output totaling 607.4 billion cubic meters(bcm) in 2007, and as the number two oil producer ater Saudi Arabia,with 9.98 million barrels per day (bbl/d) o output.3 Russias massive oiland gas reserves, moreover, are increasingly under the direct control othe state, a circumstance that has ed European ears about the strategic

manipulation o energy supplies. While energy prices remained high,Russias energy-ueled resurgence allowed Moscow to assert its infu-ence more broadly throughout Eurasia, moving aggressively to controlthe transit o oil and gas rom east to west and blocking attempts by out-side powers to build pipelines beyond its control.4 Hard power, the kindMoscow deployed against Georgia in August 2008, has only reinorcedRussian dominance in the energy sphere, raising the stakes or coun-tries in the region that would seek to escape its grip. Europes response

to the war, the recent collapse o energy prices, and the damage to Rus-sian prestige in the atermath o its decision to cut deliveries throughUkraine have temporarily checked Russias ability to expand its geo-political reach; the Western powers thus have a window o opportunityto address some o the undamental imbalances in their energy rela-tions with Moscow.

The emergence o Russia has dierent consequences or the vari-ous groups o states that depend in one way or another on Eurasiasenergy riches. For the European Union, growing dependence onenergy supplied by a single company that is at times indistinguishablerom a oreign government raises problems related to supply security,transparency, and potential political manipulation. For the United


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States, Russian energy policy is a matter o concern, primarily inso-ar as it aects the pivotal states o Central Asia and WashingtonsEuropean allies.

Russian EnERgy PRoduction:H ow R Elia b lE?

Europes dependence on Russia or energy creates serious security con-cerns, in part because o uncertainty about Russias long-term ability toproduce enough oil and gas to meet contracted demand at home and

abroad. Russian energy production remains imperiled by ineciency,underinvestment, politicization, high taxes, and alling pricesnot tomention the increasingly urgent search or ways o moving beyond acarbon-based economy. Concern about Russian production shortallsstems rom the reality o declining output rom existing sources o oiland gas and the diculty o developing new elds in primarily inhos-pitable areas, especially the Yamal Peninsula, as well as eastern Siberiaand the Barents Sea. Moreover, the consolidation o state control over

both the oil and the gas sectors in Russia since the start o the twenty-rst century exacerbates the problem, in that national champions, par-ticularly Gazprom and Rosnet, have proven less capable o channelinginvestment to either new projects or increased production than the pri-vate rmsRussian and oreignthat the Kremlins consolidation oownership has pushed out o the energy sector.5

Although the state has been the largest shareholder in Gazprom sincethe company was spun o rom the Soviet Ministry o Gas in 1992, the

Kremlin dramatically increased its control during the Putin years. Inthe oil sector, the privatization o the early 1990s has been reversed aswell, at the expense o private rms. This state-led consolidation has edworries about the Kremlins ability to use access to oil and gas as toolso its oreign policy.

During Putins second term, the Kremlin dramatically stepped up theprocess o bringing both oil and gas production under the control o thenational champions Gazprom and Rosnet, which became two o theworlds largest and most valuable companies, though both have takena beating during the recent economic downturn.6 Oligarch-ownedrms were swallowed up, such as Mikhail Khodorkovskys Yukos, byRosnet, and Roman Abramovichs Sibnet, by Gazprom. The joint


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9Russias Resurgence

venture TNK-BP has been in the governments sights as well. As aresult o this consolidation, Gazprom produces 84 percent o Russiasgas, with the remainder split between independent rms (9 percent)and oil companies that produce gas as a by-product (7 percent).7 Sinceit acquired Yugansnetegaz rom Yukos, Rosnet has been responsibleor 21.56 percent o Russian oil production, and state rms (includ-ing Rosnet) total share o Russian oil production has increased romjust 6 percent in 2000 (when Putin became president) to 44 percent in2008.8 The remaining private oil companies, moreover, are also closelyconnected with the state. These include LUKoil, whose chairman VagitAlekperov long maintained close relations with Putins Kremlin, and

Surgutnetegaz, in which several leading Kremlin gures are rumoredto be shareholders.9

The consolidation o national champions did not spare oreign rmsoperating in Russia either. For the most part, the aected companieswere operating on the basis o production-sharing agreements, whichMoscow reluctantly signed in the early 1990s in a desperate bid ororeign investment. The major oreign victims included Royal DutchShell, which was orced to cede its position in the Sakhalin-2 project;

BP, whose concession in the Kovykta eld was bought out by Gazpromater BP had its license threatened by the Kremlin; and a consortiumo oreign owners whose stake in the Vankor eld in East Siberia wasbought out by Rosnet in 2003. Where oreign rms have been allowedto stay, the Kremlin has increasingly denied them an equity share inprojects, preerring to employ them on a contract basis. Gazprom ispursuing such an arrangement or the development o the massive o-shore Shtokman gas eld, retaining ownership o all the gas eventually

produced but relying on Total and Norways Statoil-Hydro to providetechnical expertise.Despite the states growing hold over the gas sector in particular,

independent rms have carved out a niche or themselves, though theirinfuence on the market remains limited by xed domestic prices andGazproms control o export pipelines. They work primarily on pro-ducing rom smaller, postpeak, and otherwise less protable elds thatGazprom could not or would not take on. Without access to Gazpromspipelines, the independent gas rms (especially Novatek and, previously,Itera) and oil companies ocus on supplying neighboring CIS states andthe Russian domestic market, even though Kremlin-imposed price ceil-ings or both residential and commercial customers limit protability.10


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The independent gas producers have continually increased their totalproduction despite their built-in disadvantages, doubling output in theperiod rom 1999 to 2004. Private oil producers output, meanwhile,grew by 55 percent between 2000 and 2005. Gazproms productionstagnated during the same period, despite rising international prices, asthe monopoly squandered most o its nancial windall on rising oper-ating costs rather than investing in new production.

The move toward greater state control thus heightens the risk thatRussia will ace production shortalls. In 2007, Gazproms gas produc-tion declined by 1.35 percent, and though the company expected outputto grow slightly in 2008, long-term projections or Gazproms produc-

tion are essentially fat, and could be in even worse shape i energy pricesremain low or a sustained period.11Production is projected to stagnateor all largely because output rom Russias workhorse gas elds in WestSiberia, most o which were developed during the Soviet era, seemsto have largely leveled o. Gazproms major elds in West SiberiaMedvezhye, Urengoy, and Yamburgare all in decline. Without signi-cant investment in bringing new elds in the Yamal Peninsula, BarentsSea (Shtokman), and Sakhalin online in the near uture, Gazprom aces

an accelerating decline in production. Former deputy energy ministerVladimir Milov suggests that Gazproms production will slide rom545.1 bcm in 2004 to an estimated 530 bcm in 2010, and to only 340 bcmin 2020.12 Meanwhile, Gazproms commitment to building expensivenew pipelines like Nord and South Stream eats into the capital availableor modernizing its production or bringing new elds online.

Even as production has stagnated, demand or Russias gas has grown.Russias economic recovery ollowing the 1998 nancial collapse drove

a rise in domestic energy demand, and Gazprom in particular has beeneager to expand exports, to Europe as well as Asia and (with liqueactiontechnology) to overseas markets like the United States. Under pressurerom Gazproms directors, the Kremlin is moving to raise domesticprices in order to promote more ecient consumption. Nonetheless,Russias energy intensity (the amount o energy required to produce agiven amount o gross domestic product, or GDP) remains among thehighest in the developed world, andat least until the nancial crisiso autumn 2008domestic demand was growing aster than projectedby the Russian Energy Strategy. Meanwhile, Gazprom is aggressivelyseeking the gasication o Russian homes, connecting more and moreapartments to the countrys gas grid and increasing demand urther.


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11Russias Resurgence

O course, i the recession that began in autumn 2008 is both long anddeep, projections o continually increasing demand will have to berevised downward, which would reduce the immediate pressure on sup-plies and urther diminish Gazproms incentive to invest scarce capitalin exploration and production.

Similarly, in the oil sector, the rapid production growth that startedaround 1999 appears to have ended. As with gas, production rom exist-ing, easily accessible elds is declining and new production sources areall in remote, dicult-to-access locations. Russias total crude outputor 2007 reached 9.4 million bbl/d, an increase o 200,000 bbl/d rom2006. This increase was down rom 220,000 bbl/d the previous year, and

barely a third o the average annual increase rom 2002 to 2004.13 Econ-omists orecasts estimate that, ater reaching a peak level o around 10million bbl/d, Russian oil output will rapidly decline to around 6 millionbbl/d as early as the middle o the coming decade; persistent low pricesand a deep recession could make the decline even steeper.14 Addition-ally, transport bottlenecks resulting rom a lack o inrastructure andthe pipeline monopoly maintained by state-owned Transnet continueto limit expansion o production, as private companies lobby, so ar

without eect, or additional pipeline capacity. A tax structure thatheavily penalizes oil companies or windall prots also discouragesenergy companies rom producing additional oil.

Overcoming these barriers to higher production will require sub-stantially greater investment, yet neither Gazprom nor Rosnet hasshown much inclination to invest themselves or a willingness to createspace or independent producers to pick up the slack. Although the ine-ciency o Russias state-controlled energy companies no doubt bears

part o the blame or the lack o investment in new production, someocials question whether boosting output is in Russias interest. Whenprices were high, Russia swam in a sea o petro-rubles that it could notspend without urther stoking infation; with oil prices now below$50/bbl, Russia is discussing output cuts (in conjunction with theOrganization o Petroleum Exporting Countries, or OPEC) to pre-vent urther declines. In the long run, Gazprom ocials believe thatoil prices (on the basis o which gas prices are set) will trend toward$100/bbl, but price uncertainty makes it even more unlikely that Moscowwill support increased output in the immediate uture.15 In any case, thecollapse o prices over the past six months will delay investment in newproduction (on the part o both state and private rms), which could


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contribute to shortages down the road once demand rebounds. For theWest, such uncertainty suggests a need to both look or alternative sup-pliers o energy, especially gas, and to help overcome some o the sys-temic barriers to increasing production within Russia.

Russia t HE MonoPolist

A second concern or Europe has been Russias ability to use its directcontrol o oil and (especially) gas, as well as the networks to distributethem, to exert pressure on its current and potential customers. This

ability to gain political leverage, which is largely the result o scarcity, isthe most potentially problematic aspect o Russian energy policy romthe perspective o the United States and its allies. For the time being,the United States itsel buys relatively little Russian oil (approximately400,000 bbl/d) and no gas.16Yet the dependence o major U.S. partnersin both Europe and the ormer Soviet Union leaves them in a positionwhere resisting Russian political demands could have serious economicand political consequences.

Europes dependence on Russia as a source o oil and gas has increasedsince the end o the Cold War. In 1990, the twenty-seven current EU mem-bers imported 44.6 percent o their energy rom outside the EU, a gureprojected to reach 54 percent by 2010.17 Europes increased dependenceon imports is largely a result o production declines aecting indigenoussources o oil and gasprincipally Dutch, Norwegian, and British NorthSeaas well as increased demand. The EU currently imports around 33percent o its oil rom Russia and 36 percent o its gas (a gure that the

European Commission predicts will rise to over 60 percent by 2030).

18

In the gas sector, the picture is complicated not only by EU membersuneven dependence on Russia but also by the lack o an integrated marketmechanism allowing gas to move economically between dierent regionso the continent. Central Europe and eastern Europe in particular relyheavily on Russia or their gas supplies (see table 1).19

Europe depends not merely on Russia but also on a small numbero pipeline channels moving oil and gas rom east to west. Nearly80 percent o Russian gas sold to Europe passes through Ukraine;the remainder passes through either Belarus or Turkey. As theJanuary 2009 crisis demonstrated, Europe remains hostage to the


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13

TA b lE . MA jo R RECiPiEnTS o F RuSSiA n nA TuRA l G A S ( nG )Ex Po RTS, 7

2006 2007 2006 Pere Expr Expr dme ng

Rk cr (/) (/) cmp

Germany , , %

Turkey %

Italy %

France %

Czech Republic %

Poland %

Hungary %

Slovakia %

Austria %

Finland %

Romania %

Bulgaria % Greece %

Serbia and Montenegro %

Croatia %

Slovenia %

Switzerland %

Macedonia %

se b cis se

Ukraine , , %

Belarus %

Baltic States %

Azerbaijan %

Georgia %

Srce: Energy Inormation Administration, http://www.eia.doe.gov/emeu/cabs/Russia/pd.pd.


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unpredictability o Russia-Ukraine relations, the vagaries o Ukrai-nian politics, and the possibility o deliberate supply manipulationby Russia. The uneven distribution o vulnerability also has oreignpolicy implications, insoar as it inhibits the development o an agreedstrategy or dealing with Moscow.

To some degree, Russias so-called energy weapon is a two-edgedsword, in that Russia needs the revenues it generates rom energy salesto develop its economy and to uel its international resurgence. As the2009 crisis with Ukraine demonstrated, however, Russia is both will-ing and able to endure signicant short-term nancial damage to securelong-term advantage. Because constructing alternatives to the existing

pipeline network tying Russia to Europe would be slow and expensive,Russia or the time being has little alternative but to sell to the Euro-peans. In the long run, o course, the construction o new pipelines toEast Asia or o liqueaction terminals allowing Russia to ship its gasworldwide would undermine Europes position as the dominant con-sumer and would increase European vulnerability, unless Europe toosucceeds in diversiying. Russia also derives leverage rom its ability toplay one European customer against another by signing preerential

deals with avored partners, undermining EU cohesion in the process.Only i Europe can build an integrated gas market can it equalize theconsequences o interdependence.

The energy weapon could conceivably become more potent withthe construction o Gazproms new oshore bypass pipelines, NordStream (under the Baltic Sea) and South Stream (beneath the BlackSea). When built, these pipelines will increase the proportion o Rus-sian gas consumed in countries along their routes, including Germany

(Nord Stream), as well as Bulgaria, Serbia, Hungary, Slovenia, and Aus-tria (South Stream). Moreover, by bypassing current transit countriesUkraine, Belarus, and Poland, the new pipelines will allow Gazprom tocut supplies to those countries entirely without repeating the experi-ence o the two January gas crises, when Kiev responded by siphoningother countries gas rom the Russian pipeline or its own use and, in2009, Russia countered by halting all shipments through Ukraine untila new deal had been signed.

Despite these strategic concerns and the projected high price o con-

struction, Gazprom has a strong economic case to make or the bypasspipelines, especially Nord Stream. They will allow Moscow to sell moreo its gas to reliable customers, such as Germany and Italy, even at thecost o reduced sales to problematic countries, such as Ukraine or even


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Poland. Moreover, even i the initial cost o building undersea pipelinesis higher than building overland, with Nord and South Stream Gaz-prom would be reed rom having to pay transit ees, which are the larg-est single operating expense. It will also avoid the costs associated withthe political risk o doing business with Ukraine, Belarus, and Poland.The 2009 gas crisis has boosted political support or Nord Stream inparticular, which would ensure Europe against a repeat occurrence oits own supplies being halted by a renewed Russia-Ukraine quarrel.

Despite their potential to increase Russian leverage over transitcountries in eastern Europe, Nord and South Stream have the poten-tial, i careully handled by the EU, to enhance Europes energy security.

Together the two pipelines could deliver an additional 85 bcm o gas (30bcm rom South Stream plus 55 bcm rom Nord Stream) to a Europeworried about rising demand and limited supplies. Moreover, i andwhen the pipelines are built, Germany and other consumers in west-ern and central Europe would be insulated rom uture Russia-Ukraineor Russia-Belarus gas disputes. Largely or this reason, the EuropeanCommission has ocially endorsed Nord Stream and has not opposedSouth Stream.

To be sure, Europe and the United States are concerned about thepotential o pipelines like Nord and South Stream to strengthen Rus-sian infuence in Europe. These ears are compounded by unease atRussian business practices and allegations o serious corruption inthe Kremlin, specically its lobbying o states slated to host pieces othe bypass pipelines. The solution to these problems lies in improv-ing the operation o Europes energy market (above all, throughmarket integration) and seeking in the long run to boost alternative

supplies, rather than in blocking the construction o pipelines thatwould bring more Russian energy to European consumers and deepenRussia-EU economic interdependence.

Rus s ian in v Es t M En t in EuRoP Ean in f R as t Ruc t uR E

A third concern stems rom Russian participation in European energymarkets, particularly through purchases o equity in European utilitiessuch as reneries and pipeline operators. European ear is connectedboth to the nontransparent nature o most Russian energy companiesand to worries that these companies are in act proxies or the Kremlin


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and its oreign policy agenda. The Belarusian gas crisis o 2007, whichended with Gazprom taking a controlling stake in the Belarusian pipe-line monopoly BelTransGaz in exchange or agreeing to a price o $100/thousand cubic meters (tcm) or gas deliveries, rising to market pricesby 2011, urther raised European hackles about Moscows aggressivedrive to control distribution inrastructurethough Russian aims inthe CIS (where economic reintegration is an explicit aim, stated in Rus-sias energy strategy) and EU dier.

Cross-border investment is generally in the interest o both theEU and Russia. It promotes interdependence and has the potential toincrease competition. For a Europe worried about Russian attempts

at strategic manipulation, promoting such investment is among thebest ways o ensuring that Russian and European interests are aligned.Making it work, though, requires both addressing EU concerns abouttransparency and corruption, and ensuring that EU regulation is con-sistent and predictable so that Russian concerns about security odemand, which the EU agreed to take up at the 2006 St. Petersburgsummit, are adequately addressed.

Allowing Russian companies access to the European market is

broadly in line with the EUs desire to promote competition andmarket liberalization, yet disputes over how liberalization will be donein practice have created signicant obstacles. Like energy monopoliesin Germany, France, and elsewhere, Gazprom has resisted EuropeanCommission attempts to require that it unbundle its transportationand rening operations. Faced with opposition rom Germany, France,and others, the commission has been unable to orce European utili-ties to completely unbundle their operations but continues to insist that

non-EU companiesnamely, Gazpromdo so.

20

Moscow complains,not unreasonably, o a double standard and o European attempts tointerere in its internal aairs by dictating how its gas industry shouldbe structured. In the ace o EU opposition to Gazproms purchasingtransit inrastructure inside Europe, Moscow has ound it preerable todeal with individual European countries and companies, signing bilat-eral deals in Romania, Bulgaria, Ukraine, Germany, Hungary, Austria,and Finland. Such deals make it harder or Europe to coordinate itsmembers energy policies.

More genuinely problematic is the endemic corruption afictingthe Russian energy industry. This results in part rom the close link-age between the energy industry and the upper echelons o Russias


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government, and in part rom the poorly developed natural gas market,which allows Gazprom to negotiate dierential prices with its custom-ers on a nontransparent basis. Because Gazproms books are not openor scrutiny, the company is able to channel payos to selected politi-cians in downstream countries to encourage them to adopt a avorableattitude toward Russian investment and pipeline plans.

Apart rom the moral and legal costs it imposes, such corruptioncomplicates attempts to crat a common European energy policy, sinceGazprom can use payos to political allies to sow dissension withinEurope. It also intereres with long-term energy security, contributingto the perpetual delays and problems aficting Russian plans to build

new pipelines. Pipeline projects, which typically cost several billion dol-lars, have been a prime mechanism or large-scale embezzlement. Suchcorruption can prevent, or at least signicantly delay, construction othe pipelines, as appears to have happened already with the Far EasternOil Pipeline, now years behind schedule.21

This kind o corruption also reaches into Russias post-Soviet neigh-borsabove all, Ukraine. Shady intermediaries such as RosUkrEn-ergo have been a principal conduit or payos and embezzlement, a

source o political instability in Ukraine, and a contributing actor tothe repeated conficts between Moscow and Kiev over gas. Until 2008,Gazprom purchased Turkmen gas or around $130/tcm prior to sell-ing it to Ukraine or more than double that amount, with much o thedierence vanishing as payos to various Russian ocials, partiallyin exchange or continuing to obstruct Western companies seekingaccess to Russian gas.22 Meanwhile, the dierence between the priceRosUkrEnergo paid to buy gas rom Gazprom and the end-user price

paid by consumers was a major source o revenue or Ukrainian poli-ticians. Much o Ukraines political maneuvering is based on securingthe prots o the energy trade or one bureaucratic clan or another. Theresulting political uncertainty in Kiev has compounded the problem orelying on Ukraine as a transit state and strengthens the case or diver-sication. The decision to pay Central Asian producers Europeanprices or their gas and the January 2009 agreement between Moscowand Kiev to cut RosUkrEnergo out o the gas trade are positive steps,but greater transparency is still required.

The solution to corruption in the Russian energy industry is not toexclude or limit Russian participation in the European market but todevelop clear and enorceable EU rules regulating transit and ownership.


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The presence o Russian rms inside the EU subjects their operationsto both regulatory and judicial oversightindeed, Gazprom may soonnd itsel acing lawsuits in Europe over its decision to cut o suppliesto European customers as part o its conrontation with Kievbut theEU needs greater clarity about the rules o the game, and a nondiscrimi-natory regulatory regime. Here too, greater intra-EU coordination isimportant, a process that targeted U.S. intervention can help promote.


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19

Washington and its EU allies dier sharply about Russias role in Euro-pean energy security. Many EU states are eager to get as much gas as

they can rom whatever source is available. This stance requently putsthem at odds with the United States, whose approach has ocused onreducing Europes dependence on Russia as a supplier, rather thanoverall supply maximization.

Washingtons strategy centers on establishing an east-west energycorridor rom the Caspian to Europe, bypassing both Russia and Iran.The EU also backs what it calls the Southern Gas Corridor as one ele-ment in its campaign to diversiy supplies. The Baku-Tbilisi-Ceyhan

(BTC) oil pipeline, which came online in 2006 and was ollowed shortlyby the Baku-Tbilisi-Erzurum (BTE, or South Caucasus) gas pipeline,was a critical and very successul piece o this strategy. Eventuallyencompassing Kazakhstan, Azerbaijan, Georgia, and Turkey, as well asthe United States, BTC established a channel to bring 1 million bbl/d ocrude rom Azerbaijan and Kazakhstan to Turkey, rom which it can beshipped by tanker to the EU. The roughly parallel BTE brings 8.8 bcmper year o Kazakh and Azeri gas to Turkey.

Washington would like to greatly expand the amount o Caspiangas making its way to Europe and has ambitious plans to get new sup-plies o gas rom Azerbaijan and Central Asia, primarily Kazakhstanand Turkmenistan, and transport it to Turkey through a new pipelinebeneath the Caspian Sea (dubbed the Trans-Caspian pipeline, or TCP).Once the gas has reached Turkey, it would be sent on to Europe throughanother newly built pipeline known as Nabucco. Designed to run romErzurum in Turkey (the terminus o BTE) through Bulgaria, Romania,and Hungary beore terminating in Baumgarten, Austria, Nabucco ibuilt will ultimately carry 31 bcm o gas per year to the European market.Unortunately, even ater the crisis o January 2009, Nabucco is notpractical in the near or medium termit is too expensive and politically

Connecting Europe and Asia


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complex. Most important, no one has yet determined the source o thegas it is meant to supply.

Unlike its attempts to derail BTC in the 1990s, Russia has developedin advance its own project to counter the appeal o Nabucco to potentialcustomers and transit states: South Stream. With a projected volumeo 30 bcm, approximately the same as Nabuccos, South Stream will beconstructed by Gazprom and the Italian energy rm Eni, and will runrom Russias terminal at Novorossiysk under the Black Sea to Bulgaria,where it will split into a southern branch, through Greece to Italy, and anorthern branch, through Serbia, Hungary, and Slovenia to Austria.

Nabucco and South Stream are in some ways competing projects,

not least in that they are designed to provide essentially the same gasto the same markets, though some analysts do point out that the twoprojects could prove complementaryand could help keep end-useprices lower by ostering competition. South Stream is certain to bemore expensive to build, possibly twice as expensive. Because it reliesheavily on the Kremlin or nancing, immediate protability is less oan impediment, though the ongoing economic crisis means that theprojects nancing is in jeopardy. Nord Stream, which is urther along

and more likely to turn a prot, is in better shape.The hurdles Nabucco aces are even higher, however. For now, a per-ception o high political and economic risk ollowing the summer 2008war in Georgia has given many rms second thoughts about participat-ing.23 More broadly, the war ed the impression that Western infuencealong Russias periphery remains weak, making the leaders o manyCaspian states reluctant to commit to the project.

The most serious problem Nabucco aces is locating and locking up

gas. At various times, countries including Kazakhstan, Turkmenistan,Azerbaijan, Egypt, and Iraq have been suggested as possible sourceso gas or Nabucco. Yet none o these states, apart rom Azerbaijan,has shown any sustained interest in committing large volumes o gas toEuropean markets. The Bush administration believed that Azerbaijan,with a little help rom Iraq, could provide enough gas to ll the pipe-line.24 Many geologists and energy executives are less sanguine, andpotential consumers worry about overreliance on a troubled heredi-tary dictatorship like Azerbaijan. And though Baku is strongly behindNabucco, its leadership is also against the idea o relying entirely on oneexport route and has been negotiating with Russia, as well as with out-side powers like Turkey, Iran, and Israel, on additional possibilities.25


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21Connecting Europe and Asia

Russia has also been lobbying Baku hard to export more o its gas viaRussian pipelines.

Consequently, securing gas rom Central Asia or, less likely, the ArabMiddle East appears critical to Nabuccos success. Three Central AsianstatesKazakhstan, Turkmenistan, and Uzbekistanhave substan-tial gas reserves that could be used to provide the volumes necessaryto ll Nabucco, but only i they receive a high enough price and viable,well-nanced pipeline projects. The challenge lies in convincing themto participate, and in moving their gas across or around the Caspian Seato Turkey. U.S. attempts to enroll Kazakhstan and Turkmenistan in theNabucco/TCP project have so ar not been successul.

Apart rom a small Turkmenistan-Iran pipeline, all Central Asian gasis currently exported through Russia, and Moscow has moved aggres-sively to maintain its position. In May 2007, Gazprom reached a dealwith Ashgabat and Astana to construct a pre-Caspian (prkaspsk)pipeline along the seas coast. More recently, Gazprom agreed to payEuropean prices or Central Asian gas (around $340/bcm), which bothpreempts Western companies rom gaining a oothold and limits theability o countries like Ukraine to continue demanding price subsidies.

The Wests inability to protect Georgia rom Russia during the summer2008 war also deepened Central Asian leaders wariness about relyingon Western support against Russia.

I Nabucco cannot secure gas rom Central Asia, the obvious alter-native is Iran, which controls the worlds third-largest supply o naturalgas, ater Russia and Qatar. Yet Iran remains anathema to the UnitedStates because o its nuclear program and role in ostering instability inthe Middle East. Some European leaders have suggested that opening

Nabucco to Iranian gas is the only way to make the project viable.Absent a undamental breakthrough in relations between Washing-ton and Tehran, Iranian participation would represent a major deeator U.S. oreign policy, and Washington might well preer not buildingthe pipeline in the rst place.26 Nabuccos managers are courting notonly Iran but also Russia as a supplier. Indeed, Russia has sought to jointhe Nabucco project in various capacities, even while continuing tobuild political support or South Stream. Gazprom chairman AlekseiMiller has hinted that the company would be interested in becominga partner in the Nabucco consortium, a prospect that some Europeananalysts have welcomed but that could atally undermine support orthe project in Washington.27


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A nal problem with Nabucco is Turkey. Although Turkey does notproduce its own gas, it is a crucial part o the transit corridor or boththe Nabucco project and BTC/BTE, and is a stakeholder in Nabuccothrough its state-run energy company Botas, which holds a 16.7 per-cent share in the consortium. But Turkey continues to block progresson negotiations or a common legal ramework that would allow thepipeline to move orward. Meanwhile, many southeastern Europeanstates are wary o Ankaras pivotal role. In essence, their complaintsabout Turkey echo those o Ukraine and Belarus about Russia: theirlarger neighbor has been willing to cut energy supplies to extractpolitical concessions. Countries like Greece, Bulgaria, and Hungary

ear increasing their reliance on Turkey and see South Stream, whichwould run beneath the Black Sea beore coming ashore at Varna, Bul-garia, as a way o diversiying ther gas supplies by reducing depen-dence on Ankara.

Although Nabucco could contribute to European energy security,its utility as a tool o U.S. oreign policy is more limited by doubtsabout its viability without Russian or Iranian gas and by the seeminglyincompatible goals o Washington and the Nabucco consortium, not

to mention an uncertain time rame. For all these reasons, Nabuccois not a realistic solution to Europes energy security concerns in thenext decade-plus, even ater the Russia-Ukraine gas crisis impartednew urgency to Europes quest or new sources o gas. Rather, a single-minded ocus on Nabucco has diverted attention rom other, morereadily easible options.

t H E c as P ian REgion

The Caspian region is central to any discussion o diversiying Europesenergy supplies. The Caspian littoral states apart rom Russia andIranAzerbaijan, Kazakhstan, and Turkmenistanare importantas the most promising non-Russian source o oil and gas or Europe.Unortunately, the Western states have had little success in the region,apart rom Azerbaijan, largely because they have been unable to puttogether projects that the regions leaders see as benecial. Much o theproblem is simple geography. Russia is closer, and because the regionsexisting pipeline inrastructure dates mostly rom the Soviet period,it is much easier or Turkmenistan and Kazakhstan to export their


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23Connecting Europe and Asia

hydrocarbons through Russia. Western governments and Westerncompanies need a more concerted eort to access upstream resources,particularly in Turkmenistan.

Azerbaijan is a major oil producer, with output o 860,000 bbl/din 2007, and an increasingly important source o natural gas thanks todeposits o its coast in the Caspian Sea.28 With the construction o theBTC and BTE pipelines earlier this decade, Baku has broken out o itseconomic and strategic dependence on Russia. Azerbaijan is alreadyexporting gas to Georgia and Turkey, and with the urther developmento the giant Shah Deniz eld and the construction in the medium-termuture o planned pipeline connectors to Greece and Italy, Azeri gas

will enter EU markets in the next decade.With output o about 1.4 million bbl/d, Kazakhstan is the largest oil

producer in the Caspian region, and the countrys economy dependsheavily on the sale o its oil abroad. It also produces a substantialamount o natural gas (though little is currently exported), principallyrom the oshore Tengiz and Karachaganak elds, which are oper-ated by international consortia.29 The United States has long soughtto recruit Kazakhstan as a supplier or the BTC pipeline and contin-

ues to discuss ways o bringing Kazakhstan into the Nabucco project,though Astana remains noncommittal.30 Kazakhstans participationin Nabucco would likely require the construction o the dubious trans-Caspian gas pipeline connecting Kazakhstans oshore gas elds to theexisting export terminus at Baku.

Turkmenistan has less oil but more gas (72.3 bcm in 2007), and ormuch o the past decade it has been something o a wild card because othe erratic governance o ormer president-or-lie Saparmurat Niyazov

and Russias success in bottling up Turkmenistans gas in Russian-con-trolled pipelines.31 Thanks to its control o export routes out o Turk-menistan, Russia was long able to buy Turkmen gas at a discount, whichit could then sell abroad or a substantial prot. With Niyazovs deathin December 2006, Turkmenistan again became a critical actor in Cas-pian energy diplomacy, as the new regime in Ashgabat has sought toemulate the Kazakhs in balancing between Russia and outside powers.

New president Gurbanguly Berdymukhammedov appears ambiv-alent about Russias dominant position in Turkmenistan. Thoughnancing remains problematic, he is exploring new pipelines toIran, South Asia, and China. In April 2008, the Turkmen presidenttold a high-level EU delegation that he was committed to developing


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a mechanism or sending Turkmen gas directly to Europe, and heoered to supply 10 bcm as early as 2009.32 Privately, many ocialsare skeptical that either the volumes or the political commitment willmaterialize in such a short time.

Despite his attempts at courting Europe, the new Turkmen leader hasalso recognized that or economic as well as political reasons Turkmen-istan will continue to need Russia. In May 2007, Berdymukhammedovsigned an agreement with Putin and Kazakh president Nursultan Naz-arbaev to build the new pre-Caspian pipeline around the northernshore o the Caspian Sea, bringing an additional 30 bcm per year oTurkmen gas to Russia (and thence to Europe) by way o Kazakhstan.

Although Berdymukhammedov insists that he remains open to the ideao participating in Nabucco and an east-west gas corridor, the shorterlead time and proximity o the Russian market appear to have made thepre-Caspian pipeline a higher priority. Most analysts also doubt thatTurkmenistan can produce enough gas in the near uture to accommo-date both the pre-Caspian route and TCP/Nabucco.

The agreement to build the pre-Caspian pipeline and Ashgabatshesitancy on Nabucco refect the Wests inability to provide Turk-

menistan with attractive alternatives. In particular, doubts about theviability o TCP and Nabucco have made Ashgabat wary o allowingWestern rms into the countrys upstream. I the West is to gain unet-tered access to Turkmen gas, it will have to provide a credible proposalor moving the gas to markets, as well as guaranteed nancing to ensurethat the pipelines will be built. The dicult nancial climate obviouslylimits the availability o investment capital, but its eects on Russia areeven more severe. Doubts about Russias ability to move quickly on the

pre-Caspian pipeline potentially create a window o opportunity orWestern governments to promote their alternatives in Ashgabat.


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25

Conclusions and Recommendations

For the West, Russias emergence as a dominant orce in Eurasianenergy politics is both a challenge and an opportunity. Although Russia

is in many ways a problematic partner, it could contribute to improv-ing energy security both or Washingtons European allies and, morespeculatively, or the post-Soviet states o the Caucasus and CentralAsia. Given the growing political instability in the Middle East, theUnited States would do well to think about ways o leveraging Russiasvast holdings o oil and gas to expand the supply o available energy.Doing so will require establishing a ramework or Russia to be a con-structive participant in European oil and gas markets, and insulating

against the danger that Russian supply will all short, or either politi-cal or technical reasons.The West should consequently adopt a two-pronged strategy based

on the principles o integration and diversication. Adopted in tandem,these principles can be mutually reinorcing: integration will lessendiversications impact on relations with Russia, and diversicationwill ensure that integrating Russia does not thereby increase Europeandependence on it. Diversication, which will require new inrastructure

such as pipelines, liquied natural gas (LNG) terminals, and nuclearpower plants, will take more time. A credible, realistic plan or diversi-cation can, however, decrease the potential short-term diculties ourther integrating Russia into European markets, a process whose rststage merely requires changing the rules o the game, and the obstaclesto which are more political than physical.

The starting point or integration is or European governments torecognize, one, that energy security is a common concern that can beaddressed adequately only at the EU level (the recent gas crisis has donemuch to strengthen the case or common action) and, two, that or theoreseeable uture interdependence with Russia is an inescapable reality.In cooperation with European governments, Brussels should promote


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the creation o a pan-European regulatory ramework and an integratednetwork o interconnector gas pipelines. Brussels is already moving in theright direction but needs more cooperation rom EU member states, espe-cially the big western European powers, and better nancial incentivesor building interconnectors. Europe also needs to ocus on integratingRussia into European energy markets by establishing a set o consistentand enorceable rules governing Russias market participation.

Creating a new east-west energy corridor should be part o a diver-sication strategy, but not all o it. Although Washington and Brusselsare right to continue pressing or Nabucco in the long term, especiallyi they can secure the gas rom North Arica and the Middle East (TCP

appears increasingly chimerical), they need to take additional steps inthe short to medium term to lessen the possible negative consequenceso competing Russian initiatives such as Nord and South Stream. Inparticular, that means pursuing integration in the near term while thetechnically more dicult process o diversication moves orward.

O course, Russian energy is o less immediate importance to theUnited States than to Europe, which limits opportunities or direct U.S.engagement with Russia on energy issues. Moscow has shown little

interest in sustaining a dialogue with Washington, because Washing-ton has little to oer it. Nonetheless, the United States can work moreclosely with Europe to promote coordination in dealing with Russia.It can also improve the chances o getting pipelines such as Nabuccobuilt by lobbying countries along the pipeline route to cooperate and byhelping companies assemble attractive project proposals that can helpthem gain a oothold in the non-Russian Caspian states.

in t EgRat ion

Integration must work on two levels: creating a common Europeanramework or energy, especially in the gas sector, while binding theRussian energy sector more closely to Europe. Integrating Russia suc-cessully demands above all that Europe address the structural actorsthat allow dependence on Russia to be not just an economic challengebut also a strategic liability. Central to European strategic vulnerabilityis that EU members levels o exposure to Russia dier radically andthat, to a great extent, national governments rather than Brussels setenergy policy. This ragmentation means that dierent governments


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27Conclusions and Recommendations

view the Russian challenge dierently, and pursue national strategiesthat are at best uncoordinated and at worst mutually exclusive. Build-ing a single market or gas is imperative i the EU is to urther integrateRussia. Without a single market, Russia will remain able to pursue adivide-and-rule strategy inside Europe. A unied European marketwould help equalize dependence between Russia and Europe and alignthe interests o the European states at the same time.

For the past decade, several larger states that enjoy close relationswith MoscowGermany, France, and Italy, in particularhaveblocked steps toward real integration. Yet circumstances are converg-ing in 2009 in a way that makes concerted action an increasingly realis-

tic possibility. The Czech government, which holds the EU presidencyduring the rst hal o 2009, avors greater gas market integration andsupports plans to build a network o gas interconnectors to overcomeEuropes uneven dependence on Russia. A short-term all in demandresulting rom the onset o a severe recession in 2008 also works inEuropes avor, because it creates a buyers market or gas and weakensGazproms market position. Even i Gazprom aces long-run produc-tion constraints, its immediate problem is excess supply in the ace o

alling demand. The allout rom the crisis between Russia and Ukrainein January 2009 also appears to have changed the political landscape,with EU leaders insisting on a common response and even the Germangovernment indicating it would be open to greater intra-EU coordina-tion.33 This avorable convergence o circumstances will not last or-ever; it is vital, thereore, that the EU and its members take advantage othe opportunity while it exists.

Support an Integrated gaS Market In europe

To eectively integrate Russia into a European energy market, theEU rst must construct an integrated market or natural gas, an enor-mously complicated undertaking and one it has pursued or close toteen years. Lack o coordination within Europe is especially problem-atic in the gas sector, where individual countries oten compete againstone another to seek avorable deals with Russia. This ragmentation ointerests will only be exacerbated in the event that the Nord and SouthStream pipelinesstrongly supported by countries such as Germanyand Italyare built and current transit states such as Poland are iso-lated rom the fow o Russian gas to Europe.


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For now, Brussels approach to energy prioritizes competition oversecurity, which allows countries opposed to the idea o market integra-tion to continue throwing up barriers. Some European governments(particularly but not exclusively France and Germany) have resistedgiving up control over gas market regulation, unbundling, and estab-lishing an integrated supply grid. The problem, as all acknowledge, ispoliticalgaining French and German support or unbundling andpan-European regulation.34 Treating market integration as primar-ily a security issuestrengthening the connection at the EU levelbetween the competition and oreign policy bureaucracieswouldhelp lay the groundwork or a more proactive approach that includes

the ve main policy objectives outlined below.

Create a CoMMon regulatory FraMework

Perpetuating national regulatory approaches inhibits the ability toinsulate countries that depend heavily on Russia rom supply shocks.A common regulatory ramework would allow coordination at the EUlevel and create a more liquid market to enable gas supplies to be moved

and swapped between member states. Establishing the European Net-work o Transmission System Operators or Gas (ENTSOG) and theAgency or the Cooperation o Energy Regulators (ACER) are steps inthe right direction, but their roles remain too vague. ENTSOG requiresvoluntary assent rom national operators, many o which opposemarket integration, to implement its rules, and it has no authority toaddress legal, as opposed to regulatory, inconsistencies.

These weaknesses can be addressed only by the European Com-

mission, which shouldin the context o its heightened ocus on secu-rity o supply issueswork with ENTSOG and the various nationalauthorities to develop and monitor the implementation o new rules.The ocus should be on security o supply, rather than on growth or sus-tainability. ENTSOG, which is charged with coordinating investmenton the part o operators, should prioritize investment in interconnec-tor pipelines in vulnerable parts o the continent. ACER, meanwhile,ought to be given a strengthened mandate to establish gas market regu-lations, including the power to overrule national regulators on issuesconnected with security o supply and the operation o cross-bordertransmission systems.


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ConStruCt a network oF gaS InterConneCtor

pIpelIneS, StartIng In SoutheaStern europe

Insulating countries that depend heavily on the existing Russian-Belarusian-Ukrainian corridor rom supply disruptions requiresbeing able to move gas quickly and eciently among the Europeanstates, which in turn requires interconnector pipelines that can beactivated in times o crisis. Gazprom has already conceded on one othe major impediments, namely, the existence o restrictive destina-tion clauses in its delivery contracts, which allows or the resale o itsgas inside Europe.35 Once the pipelines are in place, the gas itsel can

move reely.Yet because the construction o such pipelines is expensive and

politically dicult, Brussels will have to throw its political and nancialsupport behind them. One important example is a Hungarian initiativeknown as the New European Transmission System, or NETS, to set upa regional network in southeastern Europe. I NETS succeeds, Brussels(and Budapest) can use it as a ramework or urther expansion.36

NETS would create a single operator or pipelines covering most o

southeastern Europe. This entity would enhance the bargaining powero states in the region in their negotiations with Gazprom (especiallyover the construction o South Stream) and create a larger regionalmarket more eective at attracting investment capital than the existing,smaller national markets. So ar, Hungary, Romania, and Croatia haveagreed to participate in NETS, and Bosnia-Herzegovina, Bulgaria, Slo-venia, and Serbia have indicated interestthough Austria has ruled outparticipation or the time being.

The European Commission already supports NETS but needs todo more both to smooth the legal and regulatory barriers and to securenancing or the initial stages o pipeline construction. As the regula-tory and nancial hurdles to NETS have become apparent, the targetdate or its completion has been repeatedly moved back. Leadershiprom Brussels is needed to deal with these obstacles. The EuropeanCommission could start by exempting it, and similar regional integra-tion schemes, rom unbundling schemes imposed on national-leveloperators. It should then begin working with regional authoritiesand ENTSOG to develop a timeline to complete the various stageso implementing NETS, and conduct regular consultations with the


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regional operators to ensure that deadlines are met. Furthermore, itshould appoint a single ocial responsible or NETS with a triplemandate that

establishes legal and regulatory harmony among the participatingstates, including non-EU member Serbia;

conducts an intensive dialogue with the Yugoslav successor states,whose mutual distrust continues to limit their appetite or coopera-tion; and

seeks to overcome Austrian, German, and Greek opposition to par-

ticipation in the project (Greece has an LNG re-gasication termi-nal that could be used to supply NETS).

Financially, the EU needs to derive insurance mechanisms to ensurethat pipelines designed to operate only in the event o supply disrup-tions remain protable when supplies are normal. It should promotecoordination among the regional operators to plan investment deci-sions. With credit increasingly tight, the EU itsel should also be will-

ing to help with loan guarantees and other kinds o nancial assistancethrough the European Bank or Reconstruction and Development(EBRD). The EU summit scheduled or March 2009 will press membergovernments or nancial commitments to build pipeline interconnec-tors. With the memory o January 2009 still resh, European leadersneed to nally answer the call.

purSue Full ownerShIp unbundlIng

I the rst phase o an EU integration strategy must ocus on intra-EU harmonization and the creation o transnational inrastructure,the second phase should ocus on Russias role in European energymarkets. Although the EU and the United States support greaterdiversication away rom Russia, the reality is that or the oresee-able uture Russia (and Gazprom) will be indispensable to the Euro-pean economy. Consequently, Brussels should seek ways o bindingMoscow more rmly to the EU legal and regulatory ramework, aboveall in the gas sector. Treating Moscow as a special case by imposingspecial regulations on Russia (the Gazprom clause) is less eective


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than having an agreed set o rules that applies equally to Russia and toEU member states.

Real competition means ensuring that Gazprom does not operatewith an unair advantage based on its monopolistic structure. For thisreason, the EU must adopt a clear and consistent position in avor ocompetition, above all by insisting that Gazproms operations in theEU are unbundled. However, as long as Brussels seeks to impose thisby the special Gazprom clause rather than as part o a comprehensivepackage o energy market reorm applying equally to EU utilities, it willhave little leverage in Moscow. The European Commission thereoreneeds to overcome the opposition rom French, German, and other

energy monopolies and impose across-the-board unbundling, ratherthan ocusing on the Gazprom clause as a compromise position.

The EUs Third Gas Directive, tabled in September 2007, initiallycalled or complete ownership unbundling. In the ace o oppositionrom France, Germany, and a handul o smaller states, the EuropeanCommission was orced to all back on the creation o independentsystem operators (ISOs), which allow the big European energy rmsto maintain ownership o transmission inrastructure but leave man-

agement decisions to the ISOs.37

At the national level, the ISO optionis suboptimal rom the point o view o encouraging competition, butmore important, it does nothing to address the security challengesposed by Russian participation in the European market. As part o theEUs increased ocus on security, it should continue to insist on thenecessity o ull ownership unbundling, apart rom new transnationaloperators such as the one to be set up in the context o NETS.

adopt and adhere to FIxed ruleS

For tr anSparenCy

The EU can ensure transparency only as part o a collective eort, and itwill need to adopt and enorce the necessary rules at the European Com-mission. In terms o Russia, the temporarily postponed negotiations toenter the World Trade Organization (WTO) and to secure a new part-nership and cooperation agreement with the EU are important levers.The EU should make transparency a central issue in these negotiations.With regard to Ukraine and other transit states, the EU should welcomethe gradual transition to market prices agreed to as part o the deal to


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end the January 2009 dispute, and hold orth the prospect o eventuallyintegrating Ukraine into a common EU energy market to mitigate theconsequences o uture clashes with Russiabut only i Kiev can cleanup the gas-linked corruption aficting its political system.

Additionally, the EU should keep alive negotiations with Moscow onthe Energy Charter Treaty (ECT), which Russia signed in 1994 but didnot ratiy. Russian objections stem rom Gazproms unwillingness toaccept the treatys Transit Protocol, which would establish and denethe principle o reedom o transit, threatening Gazproms revenuesrom its pipeline monopoly.38 The ECT and the protocol require adher-ents both to practice transparency and nondiscrimination, and to pro-

vide a mechanism or settling interstate disputes. Russian objectionsstem rom a variety o sources, including opposition to allowing oreignaccess to its pipelines and a denition o transit that diers rom theEUs. Although Moscow has given conficting signals about its willing-ness to sign an amended version o the ECT, especially while oil pricesremained above $100/bbl, it is worthwhile to keep the process going,especially given that oil prices are now lower. Even i agreement provesimpossible, continuing negotiations gives Russia a reason to continue

abiding by many ECT principles in the breach, and potentially subjectsit to legal consequences or violations.

oFFICIally aFFIrM european wIllIngneSS

to enter Into long-terM ContraCtS For gaS

Russias interest in buying European inrastructure has much to dowith uncertainty regarding the EUs appetite or long-term supply con-

tracts, an additional component o the security o demand on whichMoscow insists. Such contracts, which ensure suppliers a guaran-teed price on the principle o take-or-pay, give suppliers an incentiveto invest in pipelines and other elements o expensive inrastructurethat take many years to turn a prot. In the ace o pressure to abandonlong-term contracts as well as its export pipeline monopoly, Gazpromsought to hedge against price volatility in Europe by buying up distribu-tion inrastructure, which gives it the ability to secure a greater percent-age o the end-user price.

Part o the EUs strategy or gas market liberalization has involvedattempts at creating a spot market based on short-term contractsdesigned to give end-users greater choice, but at the expense o


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guaranteed returns to suppliers. For this reason, Gazprom and EU gasutilities have opposed much o the EUs liberalization agendaeventhough spot markets and liberalization more generally are not incom-patible with long-term contracts. Given concerns about productionshortalls, long-term contracts also benet Europe in that they makeit more dicult or Russian companies to shit sales to the domesticmarket, should supplies tighten. To address these concerns, the EUwill have to both enorce clear rules on investment and signal unam-biguously its acceptance o long-term supply contracts as a way toreduce risk or Russian companies.

divERs if ic at ion

Regardless o Russias geopolitical aims, that Europe derives so mucho its energy rom a single source is problematic. I only because oEuropes real concerns about Russias ability to meet its contractedobligations, the continent needs to diversiy its energy supplies bothgeographically and by type. At the same time, Europenot to mention

the United Statesneeds to reduce its overall energy demand to containthe eects o climate change and to minimize the potential problemsassociated with overdependence on a single source. No magic bulletwill rescue Europe rom its dependence on Russia or the oreseeableuture. For that reason, diversication must be a long-term strategyinvolving several components: boosting Russian output; building newpipelines; increasing supplies rom Scandinavia, North Arica, and theMiddle East; developing new types o energy; and improving eorts

at conservation. Diversication will not be an immediate x; it is notpracticable in the near or medium term or both political and technicalreasons. Despite this caveat, a credible commitment to diversicationsignals to Russia that the EU is serious about reducing its dependence,thereby giving Moscow an incentive to act responsibly.

booSt ruSSIan output

An eective strategy o diversication should consider what role Russiacan play. The danger that long-term Russian production will not keepup with demand is real, and as principal consumers, the Europeansshould actively promote increased production o Russian oil and gas.


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The solution lies in getting Russia to allow greater competition, espe-cially on the production side, which would allow or increased invest-ment and eciency without having to take the money rom governmentrevenues. Gazprom and the Kremlin both recognize the potential oruture shortalls and the potentially disastrous consequences theycould have.39 Allowing independent producers to increase their marketshare within Russia would benet Gazprom too, because it would reeup more o Gazproms output or sale to non-CIS customers, who payhigher prices.

A concerted eort by the Western states or access to gas productionrom the Caspian, which would be benecial or other reasons as well,

could also contribute to boosting output inside Russia. A successulcampaign to promote European-American investment in the Caspianwould lessen the percentage o the regions gas being sold to Russia.Access to Central Asian gas remains a major impediment to greaterdomestic investment and production inside Russia, because it is morecost eective or Gazprom to resell large volumes o gas rom Turk-menistan and Kazakhstan than to invest in new production at home.Deprived o its dominant position in much o Central Asia, Russia

would have a real incentive to allow more competition in the domesticupstream to meet its contracted obligations.

obtaIn energy FroM new SourCeS

Even with increased Russian production and eorts at conservationinside the EU, it will remain necessary in the long term or Europe tohave access to greater amounts o non-Russian gasthough Russia

will remain Europes major source o energy or the next decade-plus,no matter what. Obtaining signicant amounts o gas rom alternativesuppliers will require both locating the necessary gas and moving it toEuropean markets. As it has been since the 1990s, the Wests strategyor promoting energy security is ocused on the construction o newpipelines, like Nabucco, that skirt Russian and Iranian territory. Thechanging geopolitics o Eurasia, however, have made this strategy moreproblematic than it was ten or teen years ago.

Consequently, the EU needs a more broadly based approach todiversication that ocuses on more immediately realistic gas suppli-ers, such as Norway, Qatar, Iraq, and Egypt. Even the United States is apossible source o additional gas, given that it has a substantial number


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o LNG storage acilities that remain underused because o too littledomestic demand and that could conceivably serve as the basis oa strategic reserve.40 The EU and its member states will also have tomake a concerted push or new inrastructure construction, ocusingon assets such as storage acilities, LNG terminals, and nuclear plantsin countries where politically possible. Financing rom the EuropeanBank or Reconstruction and Development or the U.S. OverseasPrivate Investment Corporation could be directed to projects insideEurope that would promote conservation and diversication, such asbuilding gas storage acilities and laying intra-EU pipelines rom Scan-dinavia to Poland and other east European countries that depend heav-

ily on Russia.41Additionally, the EU should ocus on a variety o solutions to the

issue o transit. Alongside Nabucco, one more immediately viablepossibility in the gas sphere is the 10-bcm-per-year Turkey-Greece-Italy (TGI) pipeline that would mostly use existing pipeline inra-structure and gas rom Azerbaijan. LNG can also be part o the mix,though in an increasingly global market, LNG rom Qatar and othermajor producers may not normally be competitive on a commercial

basis with gas piped rom Russia. NETS in particular could benetrom having a secure supply o LNG, which Greek participation inthe project would bring.

Pursuing these steps would require Brussels and, particularly, Wash-ington to pursue a variety o options at once. Successully diversiyingEuropes energy supplies would require a much more concerted eorton the part o European governments and companies, especially inCentral Asia, where they have been continually outmaneuvered by not

only Russia but also China or access to oil and gas. Especially i it canbe supplied with non-Caspian gas, Nabucco should be one piece o thatstrategy, but not at the expense o other projects that, given sucientattention, have a higher probability o success and shorter time rames.

O course, the EU also needs to make a bigger push or conservationand the development o alternative energy. Although the large-scale useo wind, solar, and other renewables is many years in the uture, the EUwould benet rom a program to reduce its overall dependence on ossiluels. Part o a conservation strategy could also ocus on moving romgas to electricity or powering actories and other industrial operations,especially given that a third or more o Europes gas consumption is orpower generation, where using other types o uel is already possible.


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proMote weStern InveStMent In Central aSI a

Although Russia and Russian companies have gotten something o ahead start in the race or Central Asias resources, continued U.S. andEuropean investment remains crucial to the regions development.Regardless o whether (or when) Nabucco proves viable, upstreamopportunities will exist or Western companies in Kazakhstan, Turk-menistan, and potentially Uzbekistan that Washington and Brusselsshould promote. The EUs 2007 Central Asia Strategy laid the ounda-tion or an enhanced energy dialogue with the Central Asian states.42However, concrete proposalsand moneyare still lacking.

Western companies have consistently ailed to gain a oothold inthese countries, most notably Turkmenistan, which is at the centero the current scramble or Caspian energy. Much o the problem hasto do with the inability o Western rms to match their Russian (andChinese) competitors, whose close state connections allow them tomove in with complex, expensive projects with guaranteed nancing.Even though investment by Western rms creates a variety o socialand economic benets or Central Asian states (such as job training or

local employees), Central Asian leaders have been reluctant to approveWestern-led deals because U.S. and European rms have not been ableto propose investment schemes that combine both production andtransit; without guarantees that pipelines to world markets will be built,new production is worthless.

For that reason, getting Western rms into Turkmenistan willrequire Western governments to be clear about their commitment togetting their companies, which are oten reluctant to take on the associ-

ated nancial risk, to invest in the region. Specically, Western govern-ments will need to step up with concrete backing in the orm o loanguarantees, political risk insurance, and other kinds o support orprojects that promote their broader energy security aimsspecically,projects that combine investment in production and pipelines. Suchsupport will be especially important in the atermath o the autumn2008 nancial crisis and the associated withering o priv

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