The Russian Rock: Re-landscaping CEE energy (in)Dependence

The recent ‘war of independence’ against Western European owned utilities in Central Eastern Europe (CEE) and South East Europe (SEE) sets the stage for re-integration into Russia’s energy sphere – and dependence. A war against electricity, gas and water prices has been raging in Hungary since 2012 while SEE countries have a longer history. The firm rejection throughout the region of privately owned utilities managed by independent regulatory institutions limits capital inflow to upgrade and diversify the region’s energy infrastructure.

Omul de tinichea transfagarashan

Benefiting from the ‘war’ against Western capital is Russia. State owned Gazprom remains the dominant and stable supplier of gas to the region’s state owned firms and centralized energy systems. The CEE (including Poland) and SEE regions reject complex market structures with competition and diversified generation technologies pushed by the EU. Full independence from Russia is no longer sought, rather a ‘safety’ margin to weather a Russian gas storm provides a low cost diversification option. Three historical periods are discussed, with the third marking the re-integration into the Russian fold.

  • Stage one, fully dependent on Russian resources and technology;
  • Stage two, building an energy system semi-independent of Russia;
  • Stage three, ‘(in)Dependence’ on Russia’s energy wealth, the recognition of benefits gained from dependence coinciding with diversification of energy sources.

The CEE and the SEE regions see energy dependence as strategic while allowing for new infrastructure, such as gas interconnectors, shale gas and LNG terminals to rebalance the energy landscape and provide space for energy independence, rebalancing the historical Russian dependence. The term, ‘(in)Dependence’ provides a encapsulating expression of how Russia remains firmly positioned in the CEE/SEE regions’ energy landscape. It is the rock in the region that despite the best efforts of multiple countries, governments and international organizations, Russia remains firmly positioned in the CEE/SEE energy landscape.

Dependence

The Central Eastern European Region, including the Southeast of Europe, is heavily dependent on Russia’s energy resources. This includes gas, oil and nuclear technology. The ability to cement through physical infrastructure and human capital during Communist period established a robust connected system of resources and expertise between the region’s countries and Russia. The headlines hold that gas security is the most contentious issue. But finding a solution to this dependency requires a complex and stable energy investment climate. Since the fall of the Berlin Wall and 2004 and 2007 eastward expansion of the EU, diversification away from Russia for CEE countries was the overall most important headline issue. Despite concerted efforts the region has failed to find alternative sources for Russian gas and remained wedded to Russia. The era of Russian energy dependence can be seen to have evolved over decades under the technical capabilities of the Soviet Union.

We see the impact that this uncoordinated, but regional consistent energy strategy has on the CEE region: Complete reliance on Russian gas and oil imports. After the political winds shifted in 1998 and the region shifted towards Western Europe for political and economic integration these energy links were viewed as high risk entrapping the region into an almost single sided relationship where the terms are dictated from Moscow. The region may have gotten democracy and removed overt economic and political control but the energy infrastructure is a strong reminder that continues the previous political-economic relationship.

Independence

The launching of the energy independence period, away from Russia, began in the mid-1990s.  Privatization of energy assets and the establishment of energy regulators brought private capital into the energy system, transforming the role of the state. Market considerations would help guide and fund development of the national energy system. Technocratic independent regulatory institutions would oversee the region’s energy system.

Privatizations of energy companies, mainly electricity and distributions companies were never very popular, but the politicians making these decisions were aware the state was incapable of funding a renewed energy system able to operate efficiently. Bloated inefficient companies, were typical and unable – or unwilling due to political pressure, to collect from large and small consumers. In Macedonia at the time of privatization there were 500,000 individual court cases filed over fee collection. Large state owned factories paid little or nothing. Other countries mirrored this systemic inefficiency resulting in underfunded and crumbling energy systems. The entire CEE and SEE region made the hard decision to bring in mainly Western European energy companies to fund the renewal of power generation and electricity and gas distribution systems. These important energy assets were privatized, in some countries more than others, but each country, usually with strong encouragement from international organizations, did privatize. Enough to place the energy sector on a market footing.

By the mid-2000s sufficiently robust national and regional markets in electricity and gas were well under development in the CEE and SEE region. Strong market and regulatory elements were integrated into the system. Authority of the energy system typically, on a technical level, transferred from an energy minister to an ‘independent’ energy regulator, who set prices and technical standards. This technocratic system was established to ensure the long-term commitment and investments by private energy companies were secured and the system as a whole was managed to ensure its continual long-term development.

Since the onset of the 2008 financial crisis already strained relations between private energy companies and governments escalated. The underlining truth to the ‘Utility Rebellion’ of the CEE and SEE region is politicians had a hard time letting go.  From price setting, control or influence over cross-border electricity and gas interconnectors politicians have a hard time coming to terms with allowing the energy sector to operate like an open, but regulated, market. Repeated attempts to establish a transparent and unified electricity system in the Southeast of Europe has failed, despite consistent support (and pressure) from international organizations and institutions. In 2013, the tension has spilled over into outright social and political rebellion against private owners. This includes (but not limited to) some headline cases:

  • Albania: In January 2013 the energy regulator took away the license of Czech power company preventing it from operating in the country.
  • Macedonia: Disputes between Austria’s EVN and the Macedonia government over debts and investments are on-going since privatization in 2006.
  • Bulgaria: After years of building tensions, including court cases, between private investors (CEZ, EON, EVN), the spring of 2013 saw public street protests erupt over electricity and gas prices resulting in new elections, along with investigations and regulatory changes in Bulgaria’s energy sector. Although the fury is equally directed at state owned companies as well as privately owned ones.
  • Hungary: What was once a success story of privatization and equal risk levels to Western Europe, changed after the 2010 elections with the new Fidesz government.  Extra taxes on energy companies were introduced after which the energy regulator was sidelined and forced legislated price cuts above 20% in 2013, compounded by a proposed law to be passed before the 2014 elections of utilities becoming non-profit entities. Many privately owned utilities are making losses since 2011 and have slashed investments.

 

Markets and independence

The focus on market transformation contributed to two false assumptions: First, from a Western European perspective, overall EU gas supplies were not significantly exposed to Russian gas interruptions – if they were to occur at all. Russia was a stable supplier not willing to use gas as a political weapon and the governments of the CEE and SEE regions could diversify themselves; second, over time alternative sources could be secured from Europe’s ‘near abroad’. During this age of attempted energy independence, the pro-market perspective and activity created an assumption that the market would induce greater supply security, investments by Western European firms would contribute to greater energy security. However, these assumptions came to a head at the start of 2009.

Supply disruptions, between Russia and the Ukraine, were already regular seasonal events, but in 2009 the crisis cascaded into disruption to EU Member States. This disruption showed, what was already known in the region, diversification away from Russia was important for the energy security and security of supply for the region. It was not the overall EU level of dependence that matter, but the regional dependence. EU institutions woke up, but not until after they coordinated a technical response of sending gas to dried up systems in Bulgaria, Hungary and Serbia. Afterwards, the EU threw greater effort and coordination into helping the region diversify and open up alternative routes of supply for the region. These include interconnectors, expanding gas storage, ensuring reverse flow in pipelines and instituting new procedures and guidelines to ensure a timely coordinated action in case of emergencies. However, much of this diversification is funded by national governments. Key diversification projects include:

  • Polish LNG
  • Poland’s push into shale gas
  • Hungary’s oil and gas group MOL upgraded an oil pipeline to the Adriatic, tying the region into global oil supplies.
  • Bulgaria signed an agreement to import gas from Azerbaijan starting in 2019, completely avoiding Russia by transporting the gas through Turkey and Greece.
  • Bulgaria will build interconnectors with Turkey and Greece.
  • Upgrading gas interconnectors between Hungary and neighboring countries, particularly a new Hungary-Slovak interconnector that begins to establish a north-south gas corridor to Poland.
  • Gas storage investments in Hungary and Austria
  • Western interconnectors to Austria and Germany with reverse flow capability are being built or upgraded.

Missing from these ongoing or completed projects, is the most symbolic project of all, Nabucco. The failed bid to transport Azeri gas to the SEE and CEE regions may turn out to be more politically significant than functionally significant. Existing Soviet era transport pipelines to Russia remain the only large supply route of gas into the region. Regardless of boosted interconnectors, regional LNG access or gas storage, Russia will remain the dominate gas supplier to the entire region, all the additional projects provide a boosted level of energy security and improve security of supply in times of emergency. Nonetheless, if the goal is to ensure operations through a cold winter when the gas is cut off from Russia then the region can weather a Russian storm.

The failure of Nabucco to launch prevents the region from adding the significant alternative capacity, which combined with on-going diversification projects, could reduce further Russian reliance. Nabucco, backed by a consortium of CEE, SEE and Western European companies represented the most symbolic effort for energy independence. It was the battle between competing gas pipelines through Europe’s southern gas corridor: Russia supported South Stream vs. Nabucco. The EU backed Nabucco, had the political-economic edge to deliver more gas while increasing energy security. In the end, the pure commercial decision was taken by the upstream consortium to deliver gas into the Italian market through a competitor private pipeline to Nabucco. The downstream activities in the CEE and SEE region prove themselves just as important as the upstream transit routing decisions, which together influence large scale investments into the region.

Building the Nabucco pipeline through the CEE/SEE region would require decades of commitments from all upstream extraction parties tying them into downstream distribution partners. As outlined above, past relations between the region’s governments and foreign energy investors is turbulent. If Nabucco went ahead the upstream suppliers, extracting in Azerbaijan, would be tied to the political whims in the CEE and SEE region. If the original point is to play Nabucco against the Russians, then the tables could be turned to threaten the extra capacity from the older Russian pipelines to drive prices lower once Nabucco pipes are in the ground. Fixed assets and fixed prices are only as fixed as the political winds.

Current actions of governments throughout the CEE and SEE region demonstrate independent energy regulators are used for window dressing to meet EU requirements. Energy regulators were meant to ensure the long-term investments by energy companies were protected. This has turned out to be false. Under current conditions, the forced price reductions, revoking – or the threat of revoking – licenses and continued disputes over the prices of electricity and gas creates a significant challenge to maintain necessary investment levels, upgrade or prevent a company from financial losses. It is hard to imagine the political rhetoric and actions stopping for upstream suppliers physically locked into the region and with alternative sources of gas for governments to buy.

The original energy newcomers to the region, described above, are now withdrawing – or literally being squeezed out, like in Hungary. In short, the energy investment environment has turned negative, price pressures dominate, and political along with social demands result in an unpredictable market. Despite gas being a global commodity, politically mandated cuts in electricity and gas prices force losses onto distribution companies. Building a multi-billion Euro pipeline through the region begins to weaken under the current domestic and regional conditions energy providers are met with.

The loss of Nabucco should send a clear message, and the politicians of the CEE/SEE should hear it: Market fundamentals, are the basis for investments, not political considerations. Politicians can fight downstream electricity and gas companies for lower prices, argue with Russia over contracted prices, but unless governments are prepared to pay a market price for commodities – thus subsidizing their consumers, energy companies will go elsewhere. Private capital doesn’t finance displays of populism and energy independence that in the long-term undermine both security of supply and energy security.

 (in)Dependence

Today, 2013, we have a new era, of energy (in)Dependence. It represents the limits of infrastructure development, alternative import routes and politically induced market risks. Constant political warfare with private energy companies, in most of the CEE and SEE countries, has resulted in depressed incentives for infrastructure upgrades and price instability. Building a non-Russian transit pipeline into a region of significant market instability requires incentives outweighing these negatives. Each country in the region is proclaiming energy independence, which then (laughably) increases their reliance on Russian gas and increases security of supply risks. Resiliency within national systems is less than in regionally integrated systems. Faltering now on regional integration or preventing foreign capital from entering only underfunds alternative energy solutions which displace Russian gas.

The region’s largest gas projects moving ahead mainly rely on government efforts and financing. Gas storage in Hungary, network interconnectors, Polish LNG terminal and shale gas. While these efforts are able to move the ball down the court towards greater energy security, they do not provide substantial regional upstream diversification. The original intent of privatization of energy companies was to infuse capital into the regions’ energy systems to modernize the infrastructure, governments lacked the money to redevelop the basis of their economies. The question must be asked, does this trend continue, or has energy capital taken flight?

CEE and SEE governments cannot finance a new energy system that excludes market based elements and players. EU institutions are pushing for great market transparency, elimination of state aid, stronger energy regulators, stability in prices for private energy investors, and the interlinking of national and regional markets, thus reducing the room for political interference in energy markets.

There are now a number of attraction for CEE/SEE governments to deal with Russia and maintain its dominate position in the region, and in fact, moving away from Russia now appears more dangerous as the original – and justifiable reasons for energy independence fade. Russia remains a single supplier who is ‘simple’ to deal with. The terms of gas supply are clear, ‘You buy it we deliver it.’ Not the Brussels motto of, ‘If you buy it then here are the competitive conditions that have to be fulfilled, here is the transparency that is expected, and we expect the energy regulator to make well-reasoned opinions based on professional decision making process.’ Politically, that EU garbage only works in Western Europe.

Politically for CEE countries, Moscow can now act as a counterweight against Brussels. Whether this is just symbolic or not, the political elite in the CEE region is learning to balance energy relations between the old foe and the new foe. Finding a common cooperative topic with Russia is also beneficial for on-going relations, if not energy than what? Agriculture or software? There’s nothing that says a serious relationship than building long-term energy ties with Russia. Satisfying the strong neighbor, financially and commercially on energy issues distracts them from other issues.

A cooperative relation also demonstrates that CEE countries can stand by themselves with Russia. The rules of the energy sector may be dominated by Brussels and Western European companies, but the national governments of the CEE region still have an important role to play in their national gas markets and pricing. Bilateral relations are fostered and maintained with energy. While Russian gas, in the age of independence, was viewed as a necessity, in the age of (in)dependence, negotiations demonstrate politicians are in control of their country’s energy assets and a solid relationship exists between old foes/friends. This is contrasted against the assumed friendly relations with Brussels and the EU’s demands for an independent and transparent energy sector with complex rules and limited room for political grandstanding and influence. Russia and Gazprom are more than happy to lend to the showmanship, with the price of gas possibly linked to the temperature of relations between countries. Energy (in)Dependence provides security, simplicity, political capital and limits the need for a more complex energy market to replace Russian sourced gas.

The intertwined concepts of finance and market complexity, for alternatives to Russian gas, provide another reason for energy dependence on Russia. Despite alternative gas supplies, like LNG and shale gas, becoming more available, they will only make a small dent into the domestic or regional gas market. Any alternative to Russian gas requires considerable investments into developing a functioning gas market, including a nationwide network with gas power plants. Failure to incentivize private companies to invest in alternatives to Russian sourced gas (such as shale gas) ensures continued Russian dominance, for example in Poland’s gas market. Poland values energy independence, but not even concerted investments into LNG, shale gas and interconnectors can reduce its heavy reliance on Gazprom. The same applies to all the other countries in the CEE and SEE regions.

Conclusion

The political and economic hurdles for energy independence are too high for the CEE and SEE regions: Building a new energy system, funded by private capital, requires competition and complex market structures with limited political involvement.  Extending dependence on Russia energy resources provides the opportunity to maintain centralized energy systems and using Russia as a counter weight to Brussels non-political energy market schemes.

The collapse of Nabucco represented the failure of an energy independence strategy. A high priced, visionary project that was politically supported but without the political or economic stability required for its long term success. The debate over Nabucco overshadowed the on-the-ground work of building and expanding interconnector capacities, LNG terminals, domestic gas deposits and an overall beefing up of security of supply components. Enough so that supply disruptions, from Russia or transit countries, would have a limited impact. Energy independence can be gained by small hedges against Russian agitation and action. Therefore, (in)Dependence provides a lower cost, economically and politically hedged energy strategy that balances the local politics of the CEE/SEE region and the competing demands of Brussels and Moscow. A classic Central European strategy.