Abstract
Ukraine holds a pivotal position geographically, historically and politically alongside Europe and Russia. It is experiencing first-hand how the remnants of communist policies on energy use influence current practices, and how inefficient energy use at the residential and industrial levels threatens economic growth and financial security. This article aims to address the challenge of energy insecurity, encouraging a pan-European attitude to practical policy formation and implementation. In outlining the issues, the challenges posed by the Russian and Eastern European psyche and the will of Western Europe, a case is presented for a meaningful project with the potential for the emerging democracies to play an essential role in ensuring the future energy stability of Europe.
With oil and gas selling at record prices, and because there is a growing belief that energy-exporting countries are now, as in the 1970s, prepared to use energy exports as a diplomatic weapon, energy security has risen to the top of Europe's agenda. But whether or not energy is used as a diplomatic tool, Europe's lack of a coherent energy policy to diversify its suppliers is not only misguided, it is dangerous.
In the 1970s, Europe responded to the OPEC embargo with bold moves to increase energy efficiency and diversify its supplies. That same boldness is needed now. All the countries of Europe, with the European Union taking the lead in forging a collective effort, must begin to take concrete steps to neutralise the threat posed by both politically motivated energy embargoes and a dependence on too few suppliers.
Of course, energy embargoes as a long-term strategy have always proven futile to the nations that use this weapon. In the Middle East, Saudi Arabia saw its share of world oil exports drop sharply in the 12 years after the 1973-1974 embargo. The politically imposed price increases of the 1970s were unsustainable because they drove governments, consumers and multinational oil companies to protect themselves with energy taxes, conservation and a big expansion in oil production outside of the OPEC countries that had launched the embargo.
Increasing energy security in Europe today will, as in the 1970s, ultimately depend on governments responding with the same mix of tax incentives, conservation and expanding energy production from new countries and sources. Variety—relying on all sources of energy rather than on natural gas and oil alone—will certainly play a key role. But greater energy security for Europe will also depend on the recognition that due to the inevitably linked nature of our energy supply and transmission systems, we Europeans must depend on each other. This is where what I like to think of as an ‘energy alliance’ could be useful, with every country in Europe helping to guarantee the energy supplies of others in an emergency—whether that emergency is accidental or deliberately imposed.
It is the absolute duty of leaders to tell their people what they believe is necessary for an energy–secure future. Any leader can make his or her life easier by not putting tough choices to the public. But then, when the inevitable crisis occurs, such leaders lose not only credibility but also legitimacy. Now is a moment of decision for Europe's energy future.
Europe's energy goals
The European Energy Charter currently emphasises market access and transparency. While these are certainly laudable goals they do not address those moments of crisis when markets, invariably, perform at their worst. The three main EU goals for energy policy should be price reduction and price consistency across the EU, improving the security of supply and combating climate change. Energy prices are high and vary by as much as 100% between Member States. With today's policies, the EU's dependence on imported energy is set to rise from 50% of total consumption today to 65% in 2030. Emissions of carbon dioxide will increase by around 5% by 2030.
The EU at present seems divided over energy, between those who want to liberalise the market and enable producers and distributors to compete freely within and across national borders, and those who argue with growing confidence against the further deregulating of the market. In their view, long-term security and stable prices can best be preserved by managed national markets that are dominated by strong quasi-monopolistic companies that can withstand bullying producers and sudden shifts in demand and supply. It may be no coincidence that many of continental Europe's biggest energy groups support this argument—after all, the less competition there is, the higher prices can remain.
Playing on fears of insecurity, suppliers try their best to tie customers into long-term contracts—sometimes lasting 10 or 15 years. This harms the development of transparent spot prices, further hindering the growth of competition. A freer market in energy promises to reduce prices down to something like a Europe-wide clearing level.
Energy must become an integral part of all EU external relations. The Energy Community Treaty, now ratified by the EU and western Balkan states, should include other neighbours. We in Ukraine wish to take part and are able to shoulder our part of the collective burden of energy security. As part of this effort, European countries need to band together to improve relations with Russia, which has so far refused to sign the treaty so as to protect its energy companies from foreign competition. Europe should also develop an energy alliance with Algeria, talk more to the OPEC oil cartel and start discussions with Central Asian producers to ensure that supplies can be secured without the use of economically inefficient and politically dangerous intermediaries. But to make this effort work, Europe will have to commit to pipeline construction—both the Nabucco and White Stream pipelines in particular will be needed.
Which way to security?
Europe's failure to liberalise has several causes. First, there is deliberate state interference, motivated by a desire to build strong national competitors. Second, and directly related to the first cause, it has not been in the interests of the big companies to improve the infrastructure in ways that would allow more competition. Third, although enforcers at the EU Commission have some teeth, they cannot counter a lack of effective local regulation. Each of these will have to be overcome if a genuine market in energy is to be possible.
Because energy is so important, it has long been seen as a proper area for government policy. Although entrenched monopolies have lost a little of their strength over the past few years, they remain dominant in France, Italy and Spain. German utilities have reinforced their position since the merger of E.ON and Ruhrgas in 2003; Gasunie dominates the wholesale market for gas in the Netherlands and France's Suez controls the gas and electricity market in Belgium through its local subsidiaries.
The irony here is that perhaps the biggest beneficiary of pan-European liberalisation has been EDF. It is now the second-largest energy company in Britain, the second-largest electricity firm and the third-largest gas company in Italy, as well as the overall number three in Germany.
The second factor hampering integration is practical: how to transport gas and electricity efficiently across Europe's dispersed markets. The engineering challenge is far more tractable than the collective will of big companies to undertake it. Interconnections between national electricity grids do not have enough capacity to allow prices to equalise across the continent. The EU has prescribed that interconnections should be able to carry at least 10% of national consumption, but few states have that great a capacity.
The third problem in European energy markets compounds the first two. Europe remains a patchwork of national energy policies and regulation. The power of the EU Commission to intervene is limited. Although the Commission can fine individual companies, it depends on national governments to push through liberalisation.
Ukraine's energy future
Europe needs some one trillion euros of investment in energy over the next 25 years to be able to meet increased demand. That figure neatly encapsulates the stakes in the debate between the merits of a functioning free market and the solidity, but higher prices, of an essentially fixed one.
Underinvestment has certainly been a problem in Ukraine. We are a country rich in natural resources, but over the years we have systematically underinvested in the production of those resources, most of which are vital to our independence and national security. My government has pledged to do the following:
Pursue a new strategy of increased domestic production of onshore and offshore oil and gas via incentive programmes for direct foreign investment.
Adopt the international standard of cost-sharing production agreements that last 10-20 years.
Work with Ukraine's foreign suppliers, consumers and industrial end-users to develop a structured transition to market prices.
Seek diversification of energy supplies through continued development of coal and nuclear resources, and by encouraging the construction of new pipelines to deliver Central Asian gas to Ukraine and Europe.
Engage in public–private partnerships to develop investment in energy efficiency programmes and energy–saving technologies.
One of the benefits of the higher energy prices that have been imposed on Ukraine in recent years is that our industry has learned that energy efficiency matters. The impact of such energy inefficiency on Ukraine's economy has been enormous. At the micro level, the competitiveness of individual companies is endangered, both in the domestic and foreign market. Traditionally, Ukraine's industrial companies enjoyed a strong competitive advantage because of heavily subsidised energy supplies. But today, even with domestic energy prices still relatively low compared to those in Europe, it is not uncommon for a company's energy costs to account for up to 50% of total manufacturing costs.
At the macro level, inefficient energy use—not just in industry but also among residential end-users—threatens our ability to sustain economic growth. Ukraine's energy sector is already hard pressed to meet the increasing consumption that accompanies the ongoing growth of GDP; soon, peak electricity demand may equal total generation capacity. Today, as much as 30% of heat generated in Ukraine continues to be lost during transportation and distribution, largely owing to leakages from, and the poor insulation of, the extensive pipelines that carry heat directly to buildings.
A no less significant factor is the condition of the buildings to which heat is delivered. Much of Ukraine's population continues to live in apartment buildings that date back to the Soviet era, particularly outside cities with one million or more residents. More than half are in urgent need of renovation, and many have undergone no repairs whatsoever for 40-50 years. A similar state of disrepair is evident at many industrial premises throughout the country. This, combined with poor design and low-quality construction materials, results in enormous heat loss from buildings.
Still more energy is squandered in industrial production processes. As in the case of our infrastructure, much of the equipment and technologies used by industry at the time of the Soviet Union's collapse had already been superseded in Western industrial countries by more energy–efficient equipment and technologies. Today, use of obsolete manufacturing equipment continues to be widespread: almost 40% of production assets date back to the post-World War II period, while over 50% were installed more than 20 years ago. Similarly, around half of the industrial energy equipment (boilers, ventilators, compressors and so forth) was installed before 1991.
Equally important, the attitude towards energy use engendered by the Soviet planned economy contributes mightily to energy inefficiency in today's Ukraine. A key feature of that economy was the absence of incentives to save energy and/or to minimise costs. Industrial enterprises received energy supplies at heavily subsidised prices in an era when supplies of oil and gas were still plentiful.
Among residential end-users, too, wasteful practices became commonplace. During the Soviet era, a utilities payment system was put in place whereby households did not pay for consumption according to how much energy they used; rather, they paid a fixed monthly sum based on the amount of living space, the number of registered inhabitants and the type of appliances installed (for example, stove and water heater). Thus there was little motivation to seal windows (particularly since the inability to control the level of heat delivered by district heating systems made it necessary to open windows on warmer days in winter) or turn off lights when leaving the apartment.
Throughout the post-Soviet period, end-users have been able to carry on wasting energy with virtually no economic consequences, because energy supplies have remained relatively cheap. This has been the case especially for residential users. Under the (Soviet-era) system of cross-subsidies, households have paid even less for energy than has industry—at the latter's expense.
My government is determined that this situation will change. Domestic gas prices are gradually being increased towards market levels. Moreover, not only gas bills are being increased. Wholesale electricity prices are being deregulated incrementally as well. I am determined, indeed, that all electricity produced in Ukraine will be traded freely—and hence its price will be determined by the market. Not least because gas-fired power plants account for around 57% of electricity generated, electricity prices are likely to increase at a rate similar to those for gas.
Ukraine's industry is already responding to the prospect of rising energy costs, which the government has been signalling since our Orange Revolution. Almost 90% of companies have begun taking measures to improve their energy efficiency. Most of these measures are low cost with quick returns, allowing smaller companies to finance energy efficiency projects without incurring borrowing costs. By far the most popular is the installation of meters: more than half of the companies surveyed had taken or were planning to take this measure. Other relatively inexpensive energy-saving measures (so-called good practices in energy savings) being implemented include improving building insulation, switching to energy-saving light bulbs (where health and safety regulations allow their use) and installing automatic light controls (in communal spaces such as corridors and outside passages).
Upgrading manufacturing equipment and heating systems is the top priority of the bigger-spending companies; 50-75% of industry's total spending on energy saving is directed towards such projects. Many companies are still using boilers with a capacity that far exceeds their current needs. And many are keen to ensure independence from local utilities services by installing small-scale combined heat and power generators.
The other main high-cost measure is installing new compressors (which are among the most intensive users of energy in any manufacturing plant). Specifically, mobile compressors are increasingly being deployed in Ukraine's leading (and highly energy-intensive) industries such as metallurgy, where they can be used precisely when and where they are needed. Although compressors require a significant initial outlay, the amortisation period is estimated at no more than two years.
Last, but not least, my government has already drafted the necessary legislative amendments within the strategic framework of our plans to increase energy efficiency.
By pursuing such a proactive policy and by opening its energy sector to foreign investors, Ukraine can do its part in forging an energy policy that will help all of Europe.
Russia
Ukraine's need for Russian energy mirrors that of most of Europe. Here, too, our policies are designed with the greater good of Europe in mind.
We recognise that Ukraine and Russia are destined by geography, history and kinship to be not only neighbours, but also partners. I can state unequivocally that so long as I am Ukraine's Prime Minister, Russia's fundamental interests in becoming a reliable energy supplier to Europe will not suffer. On the contrary, a democratic Ukraine governed by the rule of law will provide many new opportunities for cooperation in the energy sector. Indeed, Ukraine's recent membership in the World Trade Organization can serve as a boon to Russia because we will now apply WTO rules to the energy sector.
Indeed, the WTO's way of doing things—reliance on greater transparency—is what I wish to bring to Ukrainian–Russian energy relations. Lack of transparency has been a particular nightmare for both of our countries in the field of energy, where a shadowy intermediary company called RosUkrEnergo mysteriously gained monopolistic control of gas supplies to Ukraine. No one really knew who owned this company; no one knew who benefited from its revenues; indeed, no one knew what its revenues were and what they were used for. Ukraine was kept in the dark about this, and the result is that many Europeans rightly feared that they would be left in the dark because of an interruption in gas supplies.
This lack of transparency was and is intolerable, and my government, frankly, has refused to tolerate it. In negotiations with Russia, I have consistently sought to create a transparent system of energy supply—a system that European energy consumers can have faith in. What I seek is a direct gas supply agreement between Gazprom and Ukraine's state energy group, Naftogaz. Those responsible for supplies will be known to all and held to account by my government for their actions. The days when Ukraine and, as a result, Europe, are held hostage over energy must be ended.
Here I am pleased to say that Russia's President-elect, Dmitry Medvedev, has publicly said that Russia is ready to do away with these shadowy intermediaries. I believe Mr. Medvedev not only because he has stated this publicly, but because it is in Russia's national interests to clean up the gas transit sector. So it is my hope that my government's energy transparency initiative will find favour with our Russian partners.
Beyond increasing transparency, however, few ideas for how the EU should deal with its chief energy supplier exist. Russia and Germany have teamed up to build a gas pipeline under the Baltic Sea, bypassing Ukraine and Poland. Gerhard Schröder, the former German Chancellor recruited by President Putin to preside over this Nord Stream pipeline, claims that it will make Europe safer. But a study by Sweden's Defence Research Agency concludes that it will divide the EU and increase dependence on Russia.
The fear being expressed in Sweden and elsewhere is that the Baltic pipeline will allow the suspension of gas supplies to Ukraine, Poland and Belarus without affecting ‘more important’ customers. Understandably, Poland is anxious. The pipeline will increase the flow of gas to Germany and connect countries that do not yet consume much Russian gas, including the Netherlands and Britain. Given the depth of these fears, and their presence in so many EU member countries, more needs to be done to provide greater guarantees that energy insecurity will not be increased by the pipeline's completion.
In the south, Russia has a pipeline across the Black Sea that supplies gas to Turkey. Now Russia wants to extend this Blue Stream pipeline to Hungary. This will compete directly with Europe's plan to build the Nabucco pipeline from Turkey to Austria. Nabucco has been one of the EU's few concerted responses to Russia's dominant market position in terms of its gas supplies: it would carry gas from Central Asia and thus bypass Russia altogether. At the moment, this pipeline, too, seems to be creating more friction than unity.
As well as controlling pipelines, Gazprom has been buying other pieces of Europe's gas infrastructure. It owns 35% of Wingas, a German distribution company, and also has stakes in the Baltic countries’ distributors. It has 10% of the interconnector pipeline between Belgium and Britain and wants a similar share of a British–Dutch link. It is also moving into the markets for electricity, oil and liquefied natural gas (LNG) projects.
European governments are right not to want to alienate Russia. As long as Gazprom plays by the rules, it should be allowed to invest in their markets. Belgium recently said it had no problems with Gazprom owning parts of its infrastructure. But rules should be applied equally and, at the moment, Russia has big problems with allowing foreign companies to own, let alone control, any of its natural resources. It forced Royal Dutch Shell to cede control of the Sakhalin-2 project and blocked BP's plan to develop a gas field in eastern Siberia. Russia has also ruled out ratifying the EU's energy charter, which would require it to open up its gas pipelines to other countries and other suppliers.
Of course, energy dependence cuts two ways. Europe may depend on Russia for half its gas imports, but Russia is dependent on Europe for the bulk of its export revenues. Repeated threats to divert Russian gas to China mean little without pipelines that would take many years to build. Switching off gas to Europe will never make commercial sense for Gazprom. Still, the fear in some EU countries is that commercial interests may one day become secondary to political ones. Of 55 supply interruptions, explicit threats or coercive price actions by Russia since 1991, only 11 had no political underpinnings, according to the Swedish defence study cited earlier.
If all this is not worrying enough, there is another, more immediate source of concern for the EU: that Russia may be physically unable to produce enough gas to satisfy demand. Indeed, the output of Gazprom's three super-giant fields, which account for three-quarters of its production, is declining at a rate of some 6-7% a year. Output from a new gas field brought on stream in 2001 has already peaked. Last year, Gazprom decided to develop a massive field in the Yamal peninsula—frozen and barren Arctic land—but that will take years. Meanwhile, Russia's domestic demand for gas is growing by more than 2% a year. Russia's domestic shortage of gas is already affecting its electricity-generation capacity. This does not reflect any lack of reserves—Russia has the world's largest—but rather a longstanding lack of investment in their development.
Instead of investing in new fields, Gazprom has been spending lavishly on pipelines and downstream assets. This has a certain monopolistic logic. Collecting the middleman's profits from exports is easier and more lucrative than investing billions in developing new fields for a domestic market that although it consumes two-thirds of Gazprom's production, generates hardly any profits, as regulated Russian gas prices are much lower than prices in most of Europe.
Meanwhile, Gazprom relies on Central Asia, especially Turkmenistan, to fill the gap in gas supplies. A study by Union Bank of Switzerland concluded, however, that Turkmenistan may have signed contracts to supply twice as much gas after 2009 as it can actually produce.
What can Europe do?
Trying to persuade Russia to break up Gazprom's monopoly is a hopeless task and so talk of doing so should be abandoned. Besides, the best way to increase the EU's energy security would be for the Union to liberalise its own markets and begin the process of unbundling its national utilities. This would encourage European network operators to invest in the interconnectors between electricity grids and pipeline networks that are so essential if Europe is to be able to protect all of its nations from any interruption in supply.
The European Commission has rightly urged EU members to break up their vertically integrated energy companies. Europe is also talking of building more LNG terminals that can be stocked by other suppliers. Increasing the EU's imports of LNG should be encouraged. The International Energy Agency (IEA) estimates that European imports of gas from Africa to the Middle East, mainly in the form of LNG, will quadruple by 2030.
Getting direct access to Central Asian and Caspian gas is also vital to European energy security. The Russians are well aware of this, as are the Americans, who have been active in the region and have brokered the deal to build the twin oil and gas pipelines that now run from Azerbaijan to Turkey via Georgia. The Americans would like this gas to be carried on from Turkey to Central Europe via the Nabucco pipeline rather than through the extension of Blue Stream. But Azerbaijan's resources are not enough to make a material difference to European energy security. So the big strategic struggle now will be over gas-rich Central Asia. The Americans have revived their old plans to build a trans-Caspian pipeline and are actively courting the region's politicians. A change of government in Turkmenistan has given these efforts new impetus.
Ultimately, energy security depends on the existence of global energy markets free from political interference, plus maximum diversity of supply. Indeed, greater diversity in energy supplies and increased transparency in all of Europe's energy contracts and policies is the only way that Europe can begin to end this age of energy insecurity. The way to deal with the complexity of Europe's energy insecurity is to think clearly and act decisively. That is what Ukraine is prepared to do so that we can feel confident enough to play our proper role with our neighbour Russia and in Europe.
Footnotes