Pázmány Péter Katolikus Egyetem Bölcsészet-és Társadalomtudományi Kar Nemzetközi és Politikatudományi Intézet

The Third Energy Package and its Effect on the Energy Relations of Russia and the Baltic States

Rácz András egyetemi adjunktus

Árok Norbert László Nemzetközi tanulmányok MA

Budapest, 2014.

I.

INTRODUCTION

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II. THE EUROPENISATION OF THE ENERGY POLICY OF THE EUROPEAN UNION

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II.1 The starting point - the consequences of 2006 and 2009 Ukrainian-Russian gas crises

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II.2

The disintegration of bilateral relations

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II.3

The antitrust case against Gazprom

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II.4 The liberalisation of the energy market II.4.1 The content of internal energy market II.4.2 The Third Energy Package II.4.3 Debated points and controversial issues II.4.4 Creating infrastructure: the BEMIP

14 14 17 19 21

III. THE BALTIC STATE’S VISION

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III.1 Setting the scene – current status of the gas energy market of the Baltic States 25 III.2 BEMIP: a feasible solution? III.2.1 Gas storage facility III.2.2 GIPL, LNG market

34 34 35

III.3 Price setting III.3.1 Gazprom’s new contractual portfolio

39 40

III.4 The Baltic State’s strategy in practice

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IV. CONCLUSION

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V. SOURCES

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I. INTRODUCTION The contemporary EU energy policy has been under a formative period in the previous decade. The most determining changes emerged in the gas sector of Europe. As a result of this process an increased Europeanization emerged where the emphasis in the agent – principle relationship moved towards the European Commission (COM) as the principle. Consecutively the Baltic States has been undertaking a more active and proactive stance towards their energy policy. The most basic assumption of this very thesis is that the Baltic States might enhance their position in these new coordinates of the European energy policy. As a natural consequence of the unique conditions characterising the energy attributes of the Baltic States we will situate the behaviour of Russia and Gazprom in these coordinates. In this thesis we undertake a unique approach to the Europeanization through the lenses of the Baltic States. In the corresponding literature various aspects of the Europeanization has been elaborated. One broad field brings under the scope of investigation the Europeanization as the process of norm internalisation. By definition represented by the other set of scholarly literature the Europeanization is being assessed as the Member State’s (Ms) proactive agenda setting behaviour so that the EU norms serve the objective of their national energy policy. This approach involves such concepts as ‘solidarity building’. The approach that is of our pledged interest is the agent-principle relationship where the Commission undertakes a proactive stance. By further elaborating this broad concept we aim at a new assessment: How a state can use indirectly the means of Europeanization in order to fulfil short-and medium term objectives other than the most profound aim of these legislations. The end-time of our investigation was the end of February, 2014. Our hypothesis being tested in this very thesis is that in a disadvantageous position can advocate in an enhanced way certain policy objectives. In line with these, disadvantageous position is being conceptualised as a high dependency rate on a foreign supplier at the same time being isolated from other markets. In order to reach the testing of this hypothesis a broad set of questions needs answer to: 1) The broadest question is what are the elements of the modified agent-principle relationship? What kind of policy changes and dynamics prevail in the landscape? 2) How does it affect the position of Gazprom and in an interrelated way Russia? 3) How can we assess the position of the Baltic States in this regard? 4) Based on the assessment which options are available from the broad set of tools of Europeanization? 5) As a vector of the previous questions which objectives might be fulfilled? 4

6) What kind of strategy the Baltic States have undertaken in this process? Did they engage in unified actions or choose different path on the contrary? The scholarly literature of our analysis is of profound importance. To the greatest extent the periodicals of the leading energy policy research institutions are elaborated in the thesis. These include the Oxford Institute for Energy Studies or the Oil, Gas and Energy Law Intelligence (OGEL). While periodicals are used to the greatest extent for certain economic concepts we assess the findings of the profound energy economics and energy law textbooks. In line with these we aim at comparing and contrasting assumptions of opposing experts on certain issues. In order to reconstruct certain chain of actions we elaborate the corresponding news from EU and national, English and Russian language portals with critical stance. The basis of our investigation are the primary sources. These include EU legislative sources, strategies and assessment reports. Parallel, where available we assess agreements and proposals. The other set of primary sources are the various data on investment and energy flows. This said it has to be highlighted that certain limitations are imposed on the availability of the datasets and legislative sources respectively. While data on energy flows constitute a fairly public set of information, investment sums, contractual obligations and draft proposals are not made available for the public. In spite of these difficulties we aim at providing the assessment to the possibly most accurate extent. The thesis elaborates the gas energy market developments; as a result no reference is made to the electricity market of the EU and related developments. We take as precondition the concept of mutual dependency concerning the EU-Russia energy relations. In line with these we do not intend to provide with an EU28 elaboration of the topic alongside with broad assessment of EU-Russia energy dialogue and the partnership in general. This said methodological limitations are posed upon the analysis of EU energy policy respectively. Such policy developments as Renewable Energy Resources promotion, proposed Emission Trading Scheme or the Energy 2020 impact on the national energy mix are beyond the scope of our investigation. The geographical scope is limited to the Baltic States that are composed of Estonia, Latvia and Lithuania. However, where it is required we make brief reference to the broader Baltic Sea Region. From a methodological point of view we do not conceptualize the issue of energy security as a separate entity but rather elaborate it as the starting point for certain assumptions.

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II. THE EUROPENISATION OF THE ENERGY POLICY OF THE EUROPEAN UNION II.1 The starting point - the consequences of 2006 and 2009 Ukrainian-Russian gas crises In this section of the paper we evolve the first part of our basic argumentation for understanding the environment of action for the Baltic States. We support the view that the 2006 and later the 2009 gas crises triggered the increased securitization and parallel politicization of energy relations between Russia and EU. Consecutively we encountered a gradual disintegration of existing framework for institutionalised cooperation. Considering this as a basis point we will come to the conclusion that the EU COM has undertaken a new path with regard to the relations with Russia and consecutively the Gazprom. We describe this new path as extending the internal dimension of energy market to external relations. The concept involves on the one hand the means of the competition policy on the other hand the means of liberalisation of the energy market. From the dissolution of the Soviet Union the Russian Federation pursued a foreign policy that assessed the rest of Europe as being a partner sharing the similar values. While the inherited, historically developed energy relations and settings were recognised the two parties scrutinized a cooperative approach.1 The developments of 2006 and 2009 marked a turning point in the EU-Russia energy relations. The Russian issue became the most complex and important factor of the EU’s external energy policy.2 The two crises triggered several considerations to be revised in the EU. First and foremost the very obvious consequence gained fundament; the Russian state is willing to exercise leverage upon the Gazprom to comply with foreign policy goals. By the means of the Gazprom Russia has not avoided cutting supplies to Europe. Consecutively Russia has ceased to exist as a reliable partner. In line with these the vulnerability of Europe was highlighted. Gazprom is the leading supplier of Europe. In this regard the interruption of gas supplies was threatening. From a technical point of view the lost capacity did not pose immediate threat the size matters. Due to alternative supply in Western Europe and the available storage capacity the interruption did not have immediate consequences. However the perception of it multiplied the effect. From this point of view the new era marked by 2006 and later reinforced by 2009 paved the way for

1 2

Belyi, 2009:121 Belyi, 2009:122

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increased securitization, and as complementary phenomena, and politicisation of energy relations. This was marked outstandingly by the formalization of the issue into the CFSP.3 In 2006 was issued the strategic document of the EU by the COM. The Green Paper entitled “A European Strategy for Sustainable, Competitive and Secure Energy” marked the new energy policy of the EU. Sustainable, competitive and secure energy was highlighted as the overall priority of energy policy for the upcoming decades. Clearly the COM advocated a broader perception of energy security. It is not limited exclusively to supply security but it involves as well higher prices. The “outside threat” that brings naturally Russia into focus has gained much reinforced ground. In line with these the Green Paper explicitly refers to interruption in energy supply owed to politically motivated actions. It is clearly outlined by the document that the COM dedicates more emphasised role to the means of the internal energy market and competition rules.4 The two policy areas where the COM exercises strong control and has considerable power. Earlier the marked year the incumbent president of the COM José Manuel Barros highlighted as a sign of determining change in the stresses of principle-agent process: “If I have one message for you today, it is that the external aspects of energy policy must be seen together with the internal aspects...To have a successful external policy, we must have a strong internal policy,”. 5 The new external policy concept was issued by the COM in 2011 and later approved by the Council and the Parliament.6 In principle the document aims at a stronger coordination of the energy policies of the MSs. In line with these we observe the modified agent-principle relationship where the COM takes more initiating power in political moves. It is best reflected in the centric concept of the paper that entails an information exchange between the MSs and the COM. The Communication issued by the COM serves as a basis for the Proposal and later approved legislation.7 The document lists four policy priorities. The first point “building up the external dimension of the EU internal energy market” proposes an information exchange mechanism upon bilateral agreements with third countries that is by definition notification of the COM. In line with these the COM is vested in the right to ex-ante and post-ante asses these agreements while as well might be involved into the negotiation process of the very agreement. There is a wide range of bilateral agreements that might be subject to assessment on the top of which are those that provide (long-term) political and regulatory backing to the

3

Belyi, 2009: 9 European Commission-Green paper, 2006 5 The Parliament, 2006 6 European Commission, 2011 7 European Commission, 2011a 4

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commercial relationship of the energy companies (national champions) involved.8 These contractual structures are predominant attribute of the Russian-Gazprom related agreements. Notably, the finally Decision enacted jointly by the Council and the Parliament enlightened this option by stating that “...Member States should have the option of informing the Commission of negotiations with regard to new intergovernmental agreements or amendments to existing intergovernmental agreements.”9 Moreover the Paragraph (9) of the final decision as well underpins that “this Decision does not create obligations as regards agreements between commercial entities”. Of course in principle it might undermine and liquidate the profound aim of the regime.10 At the same time the logic one might elaborate with it is more illuminating. The Decision on the first place does not specify the scope of the rights of the COM in the process of the negotiation; these are open ended conditions. This might result in an active participation of the COM in the negotiations. The assessment (exante and post-ante) has a wide scope as well: the process is subject to assessment from the prospective of the competition law. We will see that these assumptions are of profound importance of the Baltic States: it is a forceful tool in the hands of the MSs in longer term. Beside these, the string of documents stipulate the broader security concept as well the strengthening of the external dimension With reference to the external relations the concept of the ‘exporting the energy acquis’ prevails. The profound idea of the concept ‘exporting energy acquis’ is to establish a single regulatory space where based on these the directives and the rules of internal energy market the security of supply is guaranteed. This new approach has three profound implications. The first to create a single regulatory space by the means of regime building. The most profound one is the Energy Community launched in 2005. Further one, we will see in the upcoming section is the Energy Charter Treaty as a multilateral forum being in strong relation with the EU-Russia Energy Dialogue. The third tool is the internal application of the Energy Directives where the reciprocity principle applies alongside with other questions related to our basic concept. The last three assumption will be further elaborated in the upcoming sections.

II.2 The disintegration of bilateral relations The most profound manifestation of bilateral energy relations with the EU has been the EURussia Energy Dialogue. From the first half of the 1990’s promising developments prevailed

8

Van Vooren, 2012: 63 European Council, 2012 10 Van Vooren, 2012: 71. 9

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in the EU-Russia bilateral relations resulting in the 1994 Partnership and Cooperation Agreement (PCA). By ratifying the treaty the legal basis had been established for the Energy Dialogue to be launched. In 2001 four working groups were set up with the prime objective to provide the analytical basis for the further enhancement of the dialogue. Later in the same year the EU-Russia Summit in Brussels paved the way for the main guidelines for cooperation in the field of promotion of investment, increased energy security and boosting commercial relations in the energy sector. The end of the first stage was marked by the adoption of the four Common Economic Spaces on the Moscow summit to further increase the cooperation in the field of energy as well. The second stage lasting from 2004 until 2007 envisaged cooperative stance towards the cooperation. In 2005 the first meeting of the high level Energy Permanent Partnership Council was held. However the previously mentioned 2006 Green Paper has marked the new security perception and possible change in the EU external energy policy it still vested in the determining role into the Dialogue in general and the Partnership Council in particular.11 In the dialogue Russia adopted a more active standpoint; President Putin stressed in his opening speech at the G8 Summit in St.Petersburg that international cooperation is of special importance to facilitate energy security.12 During this period the Thematic Groups were reorganised. One group was dedicated to the short-term issues, such as forecast and strategic planning, the second one on the market developments and the third on the energy efficiency. The third period encountered a gradual degradation of the Energy Dialogue. One of the primary and obvious cause underlying was the end of the PCA agreement. However the negotiations have started upon a new PCA the end of the process is far from being in sightdistance. Moreover the PCA itself was a determining obstacle as since the institutional setting did not allow for the adoption of legally binding documents. The output of the Thematic Groups and the high level meetings were solely of political content.13 For the EU it was definitely not satisfactory. The Dialogue, as we saw previously, evolved into three specific areas. In case of the energy efficiency considerable progress was observed mainly because the aims on this field had complementarity in the EU and Russian domestic priorities. However the market making section was hindered by the profoundly divergating perceptions.14 In line

11

Belyi, 2009: 122. g8russia.ru, 2006 13 Van Elsuweg, 2012: 7. 14 Romanova, 2012: 5. 12

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with these we shall not forget that the 2006 and 2009 crises resulted in negative perceptions difficult to repair – it had as well direct influence on the relations.15 The Energy Charter Treaty (ECT) was a subsequent milestone that hindered the further development of bilateral relations. We saw in the previous section that the EU advocated a cooperative and multilateral approach in until the early 2000’s. The ECT acquired a pivotal role in energy governance being a unique example for multilateral regime building. It stemmed from the fact that it provided legally binding provisions accompanied by Dispute Settlement Mechanism. The ECT was signed in 1994 and entered into force in 1998. The founding document established three legally binding pillars. The first and the second pillar cover the field of trade where the GATT norms and provisions, like MFN, are applied to the signatories. The strategic value of the two pillars is the regulations upon the transit. The ECT signatories are obliged as a negative provision not to interrupt the transit flow and at the same time to take the necceserary measures to facilitate the former. The investment pillar just as in the case of the first two is based on the GATT norms. Investments made are covered basically through the entire supply chain where the transparency, non-discriminatory practice and the investment protection against non-commercial risks (i.e.: illegitimate appropriation) is detailed. The other profound strategic value of the ECT system is the Dispute Settlement Mechanism (DSM) that is applied to the transit (state-to-state) and the investment (state-toinvestor) respectively. The EU and the Russian standpoint differed to a great extent regarding the international governance structure embodied in the ECT. It is clear that the Russian government was highly critical about the ECT for a long time. The prime consideration was that on the one hand the ECT and the Transit Protocol can only ratified simultaneously in spite of the EU official’s pressure. On the other hand the Transit Protocol doesn’t take into account the Kremlin’s considerations and priorities. However few of these assumptions are incorrect – or rather perceived wrongly.16 At the same time it is clear as well that the EU expressed it’s modified external energy policy in the negotiation process. The acquis has been extended as a result of the increased and changed Europeanization. This was represented vividly by the Transit Protocol (TP) where for Russia it was the mean to ensure long-term supply chain and in relation with it avoiding unnecessary competitiveness. While for the EU to introduce flexibility in the supply chain, one of the prime aims of the

15 16

Talseth, 2012: 37. Konoplyanik, 2009: 277.

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liberalisation process.17 As we will see later, the 2003 gas directives made the ‘transit of energy’ de jure inapplicable, for this reason the EU represents itself within the ECT as a Regional Economic Integration Organisation.18 From the definition it clearly concludes to the modified Europeanization logic of the EU: the acquis is applicable, therefore the transit provisions are not applicable within the EU. In line with these the EU representatives included the so called ‘REIO-clause’ into the draft Transit Protocol.19 With the wording of the Article 20 (the ‘REIO-clause’) of the draft TP the EU claimed that the transit rules shall not apply to the flows in the market of the EU. However the Russian representatives claimed that the term ‘transit’ has been limited only to the export flows into the EU from a third country. As since the export entry points of Russia with the 2004 enlargement had been re-situated within the borders of the EU these are as well exempted from the binding provisions of the TP.20 However not comprehensively explaining but partly providing a reasoning the EU new energy governance approach has pushed Russia towards to terminate the provisional application of the ECT in 2009. At the same time Russia has lost an overly valuable tool for investment protection.

II.3 The antitrust case against Gazprom In September, 2012 the European Commission “has opened formal proceedings to investigate whether Gazprom, the Russian producer and supplier of natural gas, might be hindering competition in Central and Eastern European gas markets, in breach of EU antitrust rules.”21 This proceeding might be profound in the logic of the COM. On the one hand it fits into the internal energy market creation of the COM having been pursued since the 1990’s. The most profound cases were the prosecution against the alleged activity of European majors like EDF, GDF, E.ON and RWE. This said the Gazprom case represents a further opportunity to be embraced by the COM to foster the steps towards the energy market liberalisation.22 On the other hand, notably this question is of our profound concern, the COM might advocate the main logic: To bring the “game into European (legal) field”. The logic underlying is that the acquis communautaire is might be proved by the COM superior to those international 17

Belyi, 2012: 16 The Regional Economic Integration Organisation (REIO) means according to the Part I, Article 1, paragraph 3 of the ECT “an organization constituted by states to which they have transferred competence over certain matters a number of which are governed by this Treaty, including the authority to take decisions binding on them in respect of those matters.” 19 Notably in the draft of the TP the EU and the Member States (based on the harmonised standpoint) declared several concepts already detailed in either the acquis or related documents, such as ’abuse of dominant position’, the existence of ’internal energy market’ 20 Konoplyanik, 2009: 282. 21 European Commission, 2012 22 Riley, 2012: 6. 18

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commitments. This standpoint is a broadly advocated one especially by representatives of Gazprom.23 The reasoning behind can be captured as the following. The communication states that “first, Gazprom may have divided gas markets by hindering the free flow of gas across Member States. Second, Gazprom may have prevented the diversification of supply of gas. Finally, Gazprom may have imposed unfair prices on its customers by linking the price of gas to oil prices.” The market partitioning claims concern the ‘destination clauses’ of the Long Term Supply Contracts. This is not a new phenomenon. In 2003 the COM has already came to agreement with Gazprom and the Italian ENI on the destination clauses, the same cancellation was reached with OMV in 2005.24 In theory these are non-existing ones. However provisions of such nature might be in the scope of investigation of the COM. The second bunch of claims regard a suspected prevention of diversification of supply through the Third Party Access.25 The claim makes reference to the 1st, 2nd and 3rd Energy Package as being the source of this regime. The past investigations against RWE, ENI, GDF and E.ON has represented a precedent in this regard.26The third claim of unfair pricing includes the LTC with take-or-pay (ToP) clauses that in nature imposed higher cost upon the customers of the EU. Interesting enough, until recently only the German Federal Court of Justice was the only authority to investigate such implications of contractual settings.27 The decision of the COM, being a legal act, can be appealed to the European Court of Justice in annulment proceedings. Notably neither the RWE, nor the E.ON reached this point of debate. Moreover they agreed upon a Commitment Decision meaning that allegations against these firms did not enter the public domain. However as part of the deal was that the firms were obliged to proceed with the unbundling respectively.28 Given the intense response from the Russian Federation the Gazprom is not expected to set this deal. It stems from the fact that the company might attempt to provide a reasoning based on obligations derived from international law. One of the prime examples would be legal arbitration based on the BITs providing some degree of investment protection. Under the obligations of the bilateral agreements the contracting party might imply that because of the TPA the value of its 23

Konoplyanik, 2013:10 Sartori, 2013: 5. 25 In September 2011 the COM had opened an inquiry into the alleged practices of the Gazprom in the CEE . This inquiry serves as the basis for the investigation of the Gazprom’s practices in the 2012 formal proceeding. By definition “the prevention the diversification of supply of gas” was expressed as breach of TPA in the 2011 inquiry. (http://europa.eu/rapid/press-release_MEMO-11-641_en.htm?locale=fr) 26 Sartori, 2013: 6. 27 Sartori, 2013: 7. 28 Riley, 2012: 7. 24

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investment has been decreasing.29 Appeal might be made based on the WTO rules applicable. However due to the high level of fragmentation of sectoral classification system it is of high risk at the same time probable.30 However the verdicts of the ECJ, by main principle, does not necceserary have to be in compliance with the MS’s commitments derived from international agreements. Moreover, as a profound criteria, the MS have by all possible means have to avoid discrepancy between the EU law and their commitments that might result in the termination of that certain agreement.31 Provided this we have come to the ending implication of the previously launched claim: If the Gazprom turns to the ECJ for appeal the former might found itself in a sticky situation. As since the ECJ is not obliged to decide based upon international obligations it might consecutively embrace the opportunity to enhanche the aims of the COM. In practical terms the ECJ might disapprove the Gazprom claims explicitly referring to the superior nature of the acquis. This fear has vocalised by Gazprom officials as well.32 Moreover the pricing will have implications respectively. Having a prohibition decision in place and a probable ECJ decision the other European energy companies might use it as a basis for legal claim before arbitration panels.33 With this step the COM had obviously manoeuvred itself into a position where it can have a considerable leverage upon the Gazprom. Of course it was an unavoidable step to call into the game the Russian state – it symbolises as well the perception of considering the step determining. The Russian Federation, seemingly, tried to put a grip upon the developments by issuing the Presidential Decree No. 1285. The first point of the Decree pointed out three explicit limitations on the companies operating outside the territory of the Russian Federation. Without the consent of the appointed appointed executive offices cannot take action upon request of either foreign states or international organisations. Three main actions are providing information upon activities, perform changes in agreements and perform business activity in assets.34 On the very same day Sergei Kuiyanov, the spokesperson for Gazprom, answering on questions informed that the company have to apply for consent of the federal bodies in case of information request, amendments are entailed in the contract or request upon the sale of assets. Denial might be incurred if it contradicts with the economic interest of the Russian Federation.35

29

Fratini, 2009: 11. Cottier et.al., 2010: 11. 31 Blutman, 2010: 215. 32 Konoplyanik, 2013: 10. 33 Riley, 2012:9. 34 Kremlin.ru, 2012 35 Gazprom, 2012 30

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This said one notable remark has to be given to further underline our argumentation. No explicit explanation was given to the term ‘economic interest’. By definition it does not specify the range of it and the extent to which these federal bodies might intervene. Provided this the Federation might undertake three options. The one is confrontation that might result in a lose-lose situation. Triggering political clash might enhance and increase tensions and would further disintegrate the political relations in the field of energy. This would be accompanied by a harsher response on behalf of the COM.36 This is the least probable outcome. Another trajectory would be to increase pressure within the COM. Based on the collegiality decision making of the Russian Federation might leak the decision through pressure imposed by the MSs on the corresponding Commissioner. The election of the new COM is still ahead but given that the current Commissioner for energy has been delegated by Germany the logical answer would have been that the course of the development of the COM’s energy policy could have been changed course. Neither it is true for Commissioners originating from other strategic partners of Russia and the Gazprom (such as Italy). On the contrary it did not happen.37 In order to provide an even broader approach, political pressure might not apply as it did not happen with such famous cases such as Microsoft when the US was at its highest political and economic power.38 Тhe most probable outcome would be the cooperative approach with the Commission. It can undergo in the existing framework of the Dialogue. At the same time all the outcomes and responses are pursued within the established framework favoured by the COM.

II.4 The liberalisation of the energy market II.4.1 The content of internal energy market The Founding Treaties do not establish explicitly this legal entity but rather a complex set of primary and secondary legal resources establish the system of what we might entitle as internal energy market. In fact the European Commission regularly refers to terms like ’energy market’, ’energy acquis’, ’internal market’ etc. however, the TEU and the TFEU do not refer explicitly to it as the internal energy market. From the point of view of our scope of research the second, third and sixth column is of special importance. In particular the Directive 2009/73/EC on the common rules for the 36

Sartori, 2013: 14. The author is well aware of the fact that in principle the Commissioner is not supposed to represent interest of the sending state. 38 Riley, 2012: 7. 37

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internal market in natural gas, the Regulation (EC) No 715/2009 on conditions for access to the natural gas transmission networks and the Regulation (EC) No 713/2009 on establishing an Agency for the Cooperation of Energy Regulators secondary resources are of highlighted relevance accompanied by the TEN-E provision with special emphasis on the PCI. 1. Figure: Overview of the energy policies of EU

Basic of the EU energy policy Strategy for competitive, sustainable and secure energy • COM(2010) 639 (

Internal market

External policies

Energy Community infrastructure and technologies – TEN-E • Decision 2006/500/EC • TFEU article 170-172 • TFEU Article 194 o Decision No 1364/2006/EC o Decision 96/391/EC Functioning of energy market: CFSP Electricity and gas directives (‘Third Energy Directive) • TFEU Article 47, 55, 95 o Directive 2009/72/EC o Directive 2009/73/EC o Regulation (EC) No 714/2009 o Regulation (EC) No 715/2009 o Regulation (EC) No 713/2009

Security of Supply (SoS) EEAS • TFEU Article 194 • 2004/67/EC Promotion of Renewable Energy Resources and energy efficiency • TFEU Article 191, 194 o Directive 2009/28/EC o COM(2011) 109 ( Energy Efficiency Plan 2011) Oil stocks • Directive 2006/67/EC GTM The natural gas has completely different market attributes compared to the natural gas. Storing natural gas faces many difficulties moreover it is heavily dependent on the infrastructure. The rationale underlying the latter in terms of energy market is that it becomes tradable ones it exits the pipeline. For this reason controlling the entire supply chain is of special importance. In practice it results, on the one hand, in a single supplier, moreover in a vertically integrated energy company that covers the import, the transmission and the 15

distribution (wholesale market) as well. On the other hand these conditions point towards the need for long term contractual settings, rather than capacity market structures.39 The contractual relations include long term supply (LTSC) contracts and long term capacity contracts (LTCC). The liberalisation aims are in strong correlation with the EU’s overall energy policy aims, namely security of supply, sustainability and competitiveness. The 4 February 2011 conclusion of the European Council highlights and summarizes with great effectiveness the milestones and rationale behind energy market liberalisation.40 The liberalisation efforts should include market opening, market coupling (rules, norms, network codes) and company restructuring in order to facilitate increased cross-border movement of natural gas, increase competitiveness, stimulate investment. These actions should be based on solidarity of the member states. The set of directives aim at fulfilling the above scrutinised objectives. At this point we are advised to make some legal notifications on the directives. As we have noted above neither the TEU nor the TFEU makes direct reference to the internal energy market as a result not establishing such. The primary source for any secondary legislation can be derived back to the TFEU Title XXI, Article 194. However it still not refers to the internal energy market, the listed measures should be implemented “In the context of the establishment and functioning of the internal market...”. Article 194 (2) states that “the European Parliament and the Council, acting in accordance with the ordinary legislative procedure, shall establish the measures necessary to achieve the objectives in paragraph 1.” Notably, with important exemptions detailed in Article 194 (2), namely “Such measures shall not affect a Member State's right to determine the conditions for exploiting its energy resources, its choice between different energy sources and the general structure of its energy supply...” Prior to that in Article 4 (2) of the TFEU refers to the energy as shared competence of Member States (MS) and the European Union. These provisions together have several implications. On the one hand there is a clear basis for legally binding secondary legislation, on the other hand provides a basis for the application of other internal market provisions. In line with these, however it is beyond the scope of this study, competition law procedures may apply to certain energy-related issues (i.e: LTSCs, LTCCs) being an exclusive competence of the EU (Commission). This is underlined by various decisions of the European Court of

39 40

Talus, 2011: 261 European Council, 2011

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Justice (ECJ) such as Costa v. Enel 6/64, Campus Oil 72/83, C-393/92 Municipality of Almelo, C-158/94 Commission vs. Italy, referring to the energy as a good.41

II.4.2 The Third Energy Package The Directive 2009/73/EC is a result of a more than a decade development. The Directive had been preceded by two other directives on the natural gas. The first one was enacted in 1998, the second in 2003. There are considerable improvement between Directive 1998/30/EC and 2003/55/EC. The first gas directive in Article 18 (5) indicates a 30% market opening for eligible customers42, however no reciprocity is included. The second gas directive on the one hand includes all customers, including residential consumers, in Article 23 (1) on the other hand indicates full market opening for the eligible customers. For this reason not only the wholesale but also the distribution market is to be opened. Moreover, with reference to the previous paragraphs, the 1998 gas directive established the internal energy market. By 2009, the COM found, based on Sector inquiry (2007), Green Paper and Benchmarking report, in summary, the following aspects hindering the effective functioning of energy internal market has been found: • • • • • • •

Vertical integration Lack of market integration Lack of TSO cooperation Regulatory gap High degree of market concentration Lack of transparency Different powers and competences of national regulators energy regulators43

In response to these, the 2009 directive has three pillars around which the provision emerge; the unbundling, the access to infrastructure and the retail market. On the contrary of the COM’s intent, a much more liquidated unbundling regime was involved into the 2009 directive. Ownership unbundling was codified to be optional, not a mandatory provision. The basic idea behind unbundling is that the transmission and the supply/production are separated in the vertically integrated company.44 In line with these, liberalised access to infrastructure is not possible without unbundling. Without the regime a conflict of interest would occur between the supply/production and the transmission. In economic terms a competition would emerge within the company resulting in a negative impact on the overall return of the

41

Banet, 2010 Defined in Article 18 (1), in general words it aims at the liberalisation of wholesale market. 43 Braz, 2007 44 Vertically integrated energy company is the structure where the supply/production and the transmission/distribution is integrated within the company, under the same managerial and ownership structures. 42

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company.45 Ownership unbundling envisages, according to Article 9, that the vertically integrated company is deprived from its owned assets. The unbundling is legally executed by the designated regulatory authority by certifiying the transmission system operator (TSO) based on Article 10. The Directive allows for two other option in the unbundling regime. On the one hand it facilitates, provided the COM’s consent, the so called independent system operator (ISO). In case of ISO, no deprivation of the assets occurs however, as expressed by Article 14 (4), is managing the TPA, access and congestion charges and maintenance of the transmission system. The independent transmission system operator (ITO) model envisages as well no deprivation of the physical assets. However, in comparison with the ISO model where the TSO legally doesn’t have to be outside the structure of the company, the ITO aims at establishing a legally separate company operating outside the vertically integrated company. The legal independence of TSO is further ensured by such measures as supervisory body or compliance officer. With reference to the distribution (retail market) Article 26 of the Directive indicates unbundling as well, similar to the ITO model. It does not require deprival of the assets by the vertically integrated company, solely managerial separation. The other prevailing cornerstone of the Directive is the third-party access (TPA regime). The Directive provides only the most profound rules with reference to the TPA, the more detailed provisions are submitted in the 715/2009 and other market plans based on the latter legal source. According to the Article 32 requires access by third parties to the transmission and distribution system. It is a regulated TPA as since the tariffs and access methodologies are provided based on the Article 41 by the national regulators in advance. Concerning TPA for the storages, regulated and/or negotiated TPA access shall be selected by the MS. The latter indicates that the national regulatory authority shall establish the requirements and procedures for managing access to the infrastructure. This right is delegated to the national regulatory authorities, the capacity allocation and the congestion management (the procedure to get access to the allocated capacity), by Article 41 (c). The exemption of new infrastructure from TPA regime is a profound provision. According to the Article 36 (1) details of the exemption. There are 5 requirements on the top of which is that the new infrastructure must enhance competition in gas supply and enhance security of supply. Moreover, the precondition must be standing that without the exemption the investment wouldn’t be realised. It is important to note that the owner of the infrastructure has to be, at least legally, independent from the TSO operating in the given area.

45

Talus, 2011: 265

18

The Directive 715/2009/EC provides more detailed provisions on most of all TPA with referring conditions, such as capacity allocation and congestion management, tariffs for entry and exit capacity, network codes. Beside these, the registration of TSO and DSO are made reference to alongside with the establishment of the ENTSOG, the cooperation forum of gas TSOs. According to the Article 14 of the Directive, the TSO are obliged to provide TPA on long – and short term and non-discriminatory basis; the similar rules apply to the LNG facilities. It is important to note that the Directive implies a strong determination to move towards a market-based environment on the top of which is the emergence of spot markets and hub trading (i.e. Article 16 of the respective Directive). The COM in a regulatory commitology procedure accepted on the 24 august 2012 a set of amendment on the congestion management procedures (CMP). This document provides a comprehensive insight into the capacity allocation and CMP rules aimed at by the EU. The capacity allocation is a clear procedure, it basically provides capacity booking on non-discriminatory and transparent basis. The rule underlying the congestion management is that the TSO might monitor the capacity booked by market stakeholders and in case of finding unused capacity, it might utilize two basic CMP: buy-back scheme and use-it-or-lose-it mechanism (UIOLI). In both cases the capacity may be re-allocated on the same rules as initial capacity allocation. The Third Energy Package makes strong reference to the third country investors in the energy infrastructure. The Directive details the regarding provision in section 22 as “Persons from third countries should therefore only be allowed to control a transmission system or a transmission system operator if they comply with the requirements of effective separation that apply inside the Community.” In Article 11 the EU obliges the countries to certify those legal persons intending to acquire assets in the infrastructure that are from third countries. The assessment is exercised by the EU COM that bases it on the requirements of Article 9 of the Directive.

II.4.3 Debated points and controversial issues It is beyond any debate that from the trinity of EU energy policies the security of supply has gained more importance.46 These assumptions are clearly depicted in the liberalisation process. Beside the direct gains from liberalisation (competitive prices for customers, investment attraction etc.) the liberalisation indicates security considerations that fits into the wider perception of SoS. Through the unbundling options and TPA provisions the EU aims at 46

In the Energy2020 the three prevailing priorities of the EU energy policy are: Competitive, sustainable and secure energy.

19

challenging the pillars of the Gazprom’s business model on the market. In a historical perspective the EU has gradually made the provisions stricter. The ownership unbundling is now a feasible option. The TPA has been made obligatory alongside with the relations to third countries controlled by the Directives. The correlation, detailed below, will shed light on the justified bases for this assumption. With reference to the process of liberalisation three profound concerns arise. First, the question of TPA, the quality of unbundling and the so called Gazprom clause. The TPA combined with capacity management establishes a peculiar situation. Under the current setting, as we have learnt in the precedings, the TSO is obliged to grant access to the transmission pipelines for third parties (supply companies). The capacity allocation is realised through congestion management. The Gazprom, rightfully, raised the concern of supplycapacity mismatch. The gas is different from oil to a great extent. On the one natural gas is highly dependent on the infrastructure. Currently the Russian export is entirely tied to the cross-border pipeline infrastructure. However these are historically developed, they are capital intensive with a long, generally 15-25 years, payback period. On the other hand the capital intensive exploitation needs long term security of shipments. It not only speaks for long –term supply but as well capacity contracts.47 We can admit that the short term capacity allocation aims at the increase of competition and market building. At the same time, besides it is important for the security-of-supply, the long term supply contracts are still predominant on the European Union’s energy market.48 The profound explanation underlying the concept of supply-capacity mismatch is that the shipper cannot fulfil the contracted volume. It stems from the fact that it either cannot at all compete for capacity because of the scarcity or does not win the auction for the capacity allocated. However in theory all the suppliers may face the challenge of not gaining access to the existing, to the greatest extent Gazprom faces this challenge.49 Moreover the fact that the Nord Stream 1 and 2 is operational now, it still not reduce the risk for the mismatch.50 Gazprom’s fears are not beyond reasonable assumptions: last year capacity allocation was unsuccessful to the OPAL pipeline essential for deliveries from the North Stream.51 Moreover of course the evolved capacity management is under process the EU COM has already enforced the TPA through the tools of the competition policy. In the past few years two predominant cases were processed by the EU COM. On the

47

Talus, 2011: 261 Talus 2011: 269 49 Yafimava, 2013: 29 50 Yafimava, 2013: 35 51 Reuters, 2013 48

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one hand the Gaz De France case on the cross-border capacity and gas market foreclosure. The other prevailing case was the E.ON case referring to the access to pipelines. The aforementioned provisions for the third countries are widely considered as the “Gazprom clause”. In the past few years, on the one hand, it has been evident that the Gazprom aims at gaining footholds in EU infrastructure assests.52 The Gazprom has already leaned towards this strategic pattern from the 1980’s and by 2010 it had direct stakes accounting for 10% of British and French market – mostly through joint ventures.53 The traditional strategy of Gazprom has been M&A’s. The Commission has explicitly addressed to have tight control over these actions.54The perception that the EU assesses the third party clause is telling and can be evaluated as a strong response to the overall concept of persuasive EU actions. Returning to the section 22, the certification of investors is derived from security of supply concerns. As we have learnt before, the correlation between the unbundling and the third country provision are correlated and points towards the securitization of energy relations with Gazprom. The EU has clearly incorporated the third country clause so that the unbundling provisions can apply on companies operating extra-EU.55 Especially by the deployment of ownership unbundling the monopolies are deprived of their infrastructure assets. As a result the investment is subject to the third party clause by which investment is regulated under EU acquis.56 This obviously affects to the greatest extent the Gazprom.

II.4.4 Creating infrastructure: the BEMIP Infrastructure projects are considered to be of high priority. At the same time represents a prime example for the Europeanization of EU energy policy. The BEMIP identifies the infrastructure priorities for the region to terminate the “energy island” of the East-Baltic states. Тhe BEMIP is based upon the document “An Energy Security and Solidarity Action Plan”, that addresses 6 priority infrastructure plan. It aim at the identification of “the key missing infrastructures necessary for the effective interconnection of the Baltic region with the rest of the EU, establishing a secure and diverse energy supply for the region, and listing necessary actions, including financing, to ensure its realisation.”57 Notably, two separated section discusses the corresponding infrastructural topic on the East and West-Baltic. The final report of the BEMIP, presented by the High Level Group, provides the most profound 52

Locatelli, 2013: 8 Locatelli, 2013: 12 54 EU Energy Law and Policy Yearbook 2012, 2012: 45 55 Fratini, 2009: 2 56 Belyi, 2009: 125 57 European Commission, 2008: 4 53

21

objectives in the region in terms of market integration and the closely related interconnection facilities. The final report suggests that “gas infrastructure development projects in the region are necessary to allow the creation and strengthening of the internal market...”.58 There are four objectives set on the top of which is the termination of the isolation of the East-Baltic States from the EU energy market and the assessment of the LNG infrastructure. 59 In line with these, the BEMIP as well lists the infrastructure priorities essential for the objectives. 2. Figure: Project indicated by BEMIP Project

Short description of the project

GIPL

pipeline connecting Lithuania to Poland via the Yamal-Europe pipeline or national Polish system. (Capacity: at least 3 bcm/year) Off-shore gas pipeline connecting Finland and Estonia (Capacity: at least 2 bcm/year) An increase in the capacity of existing systems by establishing new meter stations and upgrade of pipeline capacity capacity-3 bcm/year

BalticConnector

Estonia-Latvia; Latvia – Lithuania upgrade of cross border capacity and internal systems Finngulf LNG, new LNG terminal in Estonia, Latvia or Lithuania Access options for gas storage in Latvia or Lithuania

One of the following options: a) Expansion of Inčukalns storage (from 2,3bcm to 3,2 bcm) b) New strategic storage in Lithuania – Syderiai (0.5 bcm) c) New storage in Latvia – Dobele UGS (6 bcm active gas) (feasibility study 20092010)

Dependency on other project (Reverse flow on Yamal-Europe)

Responsible body GazSystem, Lietuvos Dujos

Gasum Oy

Lietuvos Dujos, Latvijas Gaze, Eesti Gaze Gasum Oy, Eesti Gaas a) Latvijas Gaze b) Ministry of Energy of Lithuania c) Ministry of Economy of Latvia

Source: BEMIP

3. Figure: Projects indicated by BEMIP

58 59

High Level Group, 2009: 17 High Level Group, 2009: 17

22

Source: BEMIP

The founding of the projects involved under the aegis of the BEMIP are entitled to community founding from TEN-E and EEPR. The decision 1364/2006/EC, amending the 1229/2003/EC, establishes the guidelines for TEN-E networks including natural gas and electricity interconnection infrastructure. With reference to natural gas, the scope of highlighted infrastructure is limited to, as stated by Article 2, high-pressure gas pipelines, excluding those of distribution networks, UGS, reception, storage and re-gasification facilities for LNG and complementary installations needed for the formerly mentioned infrastructures. The TEN-Es are divided into three different groups and are ranked accordingly. Projects of common interest (Article 6.) are those projects that fall within the categories listed preceding; accompanied by the objectives listed in Article 3. It indicates that the PCI encourages the effective operation and development of the internal market, facilitates the development and reduces the isolation of the less-favoured and island regions of the European Union, as well reinforces the security of energy supplies. Of course, these requirements are further detailed in Annex II of the Decision. The PCI shall be granted limited Community founding based on the provisions of (EC) No 2236/95. Member States shall take any measures they consider necessary to facilitate and speed up the PCI alongside the respect of Community legal provisions. Priority projects are those that shall have priority in Community founding. These projects are selected from the PCI. Priority project that are of cross-border nature or which have significant impact on cross-border transmission capacity are declared to be of European interest accompanied by overall priority for EU founding. Currently the following project fall under the provisions of TEN-E from the point of view of our paper: 23

4. Figure: TEN-E project in the East-Baltic region

PCI Gas pipeline from Russia to Germany, via Latvia, Lithuania and Poland, including developing underground gas storage facilities in Latvia (Amber project) Gas pipeline Finland — Estonia Priority projects Projects of European interest LNG terminal Świnoujście (Poland) capacity increase of USG in the Baltic Sea Region Source: European Commission

Besides TEN-E and as part of the TEN-E the European Energy Programme for Recovery (EEPR) has been established by the Regulation (EC) No 663/2009 and later amended by the Regulation (EC) No 1233/2010. The EEPR is a financial instrument gas and electricity infrastructures, offshore wind energy and carbon capture and storage. The budget is, according to Article 3 of 2009 Regulation is EUR 3,98 billion out of which gas and electricity infrastructure projects account for EUR 2,365 billion. With reference to the East-Baltic states, a number of projects are involved in the EEPR (that are of special importance from the point of view of our investigation), namely: 5. Figure: Project founded by EEPR

Baltic-Poland interconnection

leads to the Świnoujście LNG station and connects to the Polish transmission system

Swinoujscie LNG terminal Latvia - Lithuania - reverse flow (RF LV- This project aims at improving the LT) infrastructure and equipment for bidirectional gas flow between Lithuania and Latvia. The project will eliminate bottlenecks and will safeguard required capacities in both directions. It consists of the reconstruction of 15 wells in the Incukalns gas storage complex, the reconstruction of the Daugava river underwater pass in Latvia, and the modernisation of the Panevezys gas compressor station in Lithuania. Source: European Commission

However these are ambitious projects, the community founding accounts for only a fraction of the investment cost. According to the legislation of the TEN-E the founding might be devoted up to 10%. The EEPR in general provides the founding 1/3rd of the total costs.

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III. THE BALTIC STATE’S VISION III.1 Setting the scene – current status of the gas energy market of the Baltic States The three Baltic States and Finland share numerous attributes of their natural gas market at the same time differ to a great extent.60 All four states face 100% dependency from one single supplier, Russia and in particular the Gazprom. In line with these, each of the countries face a historically developed complete isolation in terms of connection to the rest of the EU’s energy market. The ownership structure of their TSOs, dominated by Gazprom and E.ON, is as well a shared attribute accompanied by the same outnumbering presence of the former two companies. In terms of the quantity of the shipped natural gas the 4 countries are small players for Gazprom as the sole supplier. On the contrary the Baltic States and Finland have a different TPEC setting alongside with different total energy consumption pattern. 6. Figure: TPEC of the East-Baltic States (as % of total energy consumption in Mtoe)

Estonia

Latvia Oil

Oil

Natural Gas 31%

Coal 52%

0% 0% 5%

Natural Gas 31%

Nuclear Energy

0% Hydro electric

12%

Coal

0% 2%

53% 14%

Hydro electric

Renew- ables

0%

2%

Renew- ables

Finland

Lithuania

3% 2%

Oil

10%

Oil Natural Gas

Natural Gas 43% 50%

Nuclear Energy

Coal Nuclear Energy Hydro electric Renew- ables

10%

36%

20%

Coal Nuclear Energy

13% 11%

Hydro electric Renew- ables

Source: Eurostat

The Total primary energy consumption of the East-Baltic states differ to a considerable extent. Nuclear energy, since the closure of the two blocks of the Ignalina power plant in

60

We use the data on Finland solely a point for visual comparison. From a methodological point of view Finland is not subject to investigation.

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Lithuania is totally absent, and the similar pattern applies for the other two Baltic States. 61 On the contrary in Finland nuclear energy plays a determining role accounting for 20% of the consumption. Energy produced from renewable energy resources (RES) has a minor share in Lithuania in comparison with the other three, where RES, including hydro energy production and biomass, have a pivotal role.62 Provided the increased road – and sea transportation, stemming from the underdeveloped railway infrastructure and geographical attributes, the oil consumption is visibly great. The oil shale exploitation in Estonia boosts to a great extent the share of oil within the TPEC. 7. Figure: Electricity generation of the East-Baltic states (as % of TWh)

Estonia

Lithuania

Latvia

Finland

Source: European Commission

The direct usage of natural gas accounts for 11% to 14% in Finland, Latvia and Estonia as such being a relatively low figure in comparison with Lithuania’s 52%. However, taking the 61

Lithuania undertook the obligation as part of the accession agreement with the European Union to phase out and close down the two blocks of the Ignalina Nuclear Power Plants by 2010. As a result Lithuania has become increasingly dependent on electricity import. Currently the country is considering the construction of a new Nuclear Power Plant in Visaginas. 62 For Latvia, biomass export to the West-Baltic states, especially to Sweden, is of special importance.

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electricity production into the scope of the investigation, the picture becomes more modulated. In Finland the proportion of natural gas approximately equals to the share within consumption. Accounting for almost 15%, the natural gas has an underlying position in electricity generation.63 It is clearly visible, that for Lithuania and Latvia natural gas is inevitable and essential in this regard; increase case of the former the data indicates 52% in case of the latter 45%. However Estonia enjoys the advantage of domestic supply in oil shale located in the North-Eastern part of the country. The data suggesting a considerable position of natural gas in Finland and for Latvia and Lithuania is clearly visible. 8. Figure: Heat generation in the Baltic States and Finland

Source: EU COM -Energy DG

Heat generation has a pivotal effect on the energy policy considerations and actions of the states, these considerations have a crucial place within these structures due to the Nordic climate. The former attribute is accompanied by the low energy efficiency of the residual buildings. In case of all the countries the natural gas is in a determining position, with special emphasis on the three Baltic States where natural gas usage in heat production is well beyond 50%. In line with these, the sustainable, secure and competitive natural gas supply is in the centre of the energy policy settings of the Baltic States and Finland. 63

In my point of view, this position can be considered as solid – especially with reference to coal. Coal is an advantageous source of energy because of the competitive (low) price, established world market and geographic distribution. On the other hand it is not a complementary product to the natural gas stemming from the obligations on 202020 objectives.

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9. Figure: Natural gas import of the East-Baltic States

Year / Billion cubic metres Estonia Latvia Lithuania Finland TOTAL

2008

2009

2010

2011

2012

0,92 1,3 3,2 4,0 9,476046

0,62 1,7 2,7 3,6 8,598224

0,67 1,1 3,1 3,9 8,814459

0,6 1,7 3,4 3,4 9,133529

0,65 1,5 3,3 3,1 8,554342

Source: BP, Eurostat

The quantity of the East Baltic States accounts for roughly 10 bcm.64 It is clearly noticeable that Finland has the greatest import qualities and natural gas market – we will later on make the necessarily statements on it with reference to internal market considerations. However it is clear that without including Finnish market into the system we cannot reach the proper market size to attract infrastructural investment and diversified supply with alternative shippers. The three Baltic States account for 1% of the entire export quantity of the Gazprom, together with Finland the data doubles65 – they are far from being “big fish” on quantitative terms. However, as we will highlight in the upcoming chapters, they can be in a negotiation-position in unbundling, TPA issues, and most probably capacity market and price arbitrage. In Estonia, gas is imported only from Gazprom accompanied by the sole wholesaler (importer) Eesti Gaas. The import price of gas is calculated by a price formula that considers nine months heavy and light fuel oil average prices in USD/ton preceding to the accounting month, taking into account the USD/EUR exchange rate.66 Latvijas Gaze acts as the importer of natural gas in Latvia from the Gazprom, accompanied by the licenses for the storage (Inčukalns UGS), transmission, distribution and trade of natural gas.67 The Inčukalns is the only UGS facility in the Baltic States with roughly 50% of winter withdrawals allocated for Latvia, 25% for Estonia, and 25% for northwest Russia (Lithuania now only rarely draws on the UGS). Gazprom enjoys operational control over Inčukalns through Latvias Gaze, which it has the right to manage through 2017.68 In Lithuania the participants of the natural gas import market are Lietuvos Dujos AB (39,6%), Dujotekana UAB (14,9%), Achema AB (38,0%), Kaunas Combined Heat and Power Plant (Kaunas CHP), Haupas UAB (7,0%). Market shares of all other market players decreased accordingly: the share of Lietuvos Dujos, AB decreased by 10.8 percent from 50.4 percent to 39.6 percent, the share of Dujotekana, UAB – by 2.3 percent from 17.2 percent to 14.9 percent, market share of Kauno Termofikacijos Elektrinė 64

The data is complicated to access. In this regard i was obliged to use diverse resources. The professional literature, facing the same problem usually quotes 10 bcm/year. 65 Gazprom, 2011 66 Konkurentsiamet, 2012, 12 67 Sabiedrisko pakalpojumu regulçðanas komisija, 2011 68 Bryza, 2012

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decreased from 8.8 percent to 7.0. Market share of Haupas, UAB changed very little - down from 0.5 percent to 0.4 percent. Notably, the Lietuvos Dujos rules the retail market accounting for 70%.69 As it was highlighted by the European Council and the European Commission, the East-Baltic states are considered to be ‘energy islands’. The term ‘energy islands’ means that these countries are solely connected to Russia as an external partner while they are completely isolated from the rest of the European Union’s energy market. The two institutions highlighted that eliminating the ‘energy islands’ is essential to the completion of the internal energy market. 70 As we can see from the Figure 12., the interconnection is historically developed, between Estonia and Latvia, in case of Latvia and Lithuania interconnectivity is established respectively. In case of the former the Karski in case of the latter the Kiemenaj pipeline provides interconnectivity with bi-directional flow capability. In addition to, the three Baltic States are solely connected to Russia and Belarus. TSO’s of these capacities on the Russian entry point section is the Gazprom, on the other way around companies with Gazprom shareholder domination. E-ON Ruhrgas and Gazprom posses the absolute majority in the TSO’s of the three Baltic state’s company. In fact, E.ON Ruhrgas possesses in Latvijas Gaze and Lietuvos Dujos more shares in comparison with Gazprom. However the companies are explicit strategic partners, leading to no doubts about joint and harmonized action in the decision making procedure.71 The decision-making prevalence of Gazprom in Vörguteenus TSO is assured by different system in comparison. The company capital is made up of A-type shares and B –type shares. A – shares nominal value is 10 Euro, B-shares represent 0,10 Euro. In line with these the A-type shares represent more vote in the general meeting of the shareholders. Possessing more than 50% of the A-type shares72, Gazprom exercises bigger leverage in comparison with the other shareholders.73 The constellation is more moderated in the Finnish Gasum Oy, as since Fortum Heat and Gas Oy might out-rule if the corresponding two companies act on their own. Currently the pipeline network, interconnections and import transmission pipelines, do not constitute a physical hub, such as the one in Baumgarten, Austria. In addition to this arise the quality and the need for investment in reconstruction considerations. However the technical 69

Valstybinė kainų ir energetikos kontrolės komisija, 2011 European Council 2011; European Commission, 2011 71 At 03.07.2012 in the renewed Long term supply contract (LTC), stated, that, „…Gazprom and E.ON have shown once more that, as long-term strategic partners, they are able to arrive jointly at viable solutions. By signing today's agreements we are strengthening our long-standing, success-full partnership…” 72 There are 721843 A-type shares, Gazprom possesses 367268 of them in comparison with E.ON’s 254,598. 73 Eesti gas, 2012 70

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capacity is capable of transmitting the required quantity for the three Baltic States, the reliability stemming from the outdated technical features of the system. 10. Figure: Shareholders of the energy companies in the East-Baltic States

Estonia: Vörguteenus 37.03% 33.66% 9.99% 17.72%

Gazprom E.ON Ruhrgas Itera Latvija Fortum Heat and Gas OY Respective Ministry/state other 1,60% shareholders/small shareholders

Latvia: Latvijas Gaze 34,00% 47,23% 16,00%

Lithuania: Lietuvos Dujos 37,1% 38,9%

Finland: Gasum Oy 25% 20% 31%

17,7% 2,77%

24%

6,3%

Source: Vörguteenus, Latvijas Gaze, Lietuvos Dujos, Gasum Oy

The degree of liberalization of the supply and retail market of East-Baltic states can be best captured by the employment of HHI.74 In case of the supply market of Estonia, Latvia and Finland, we can talk about very high market concentration as since there is solely a single supplier and a single import company (HHI=1 / 10 000). The retail market is equally highly concentrated in Estonia and Latvia, stemming from the fact that however there are more distributing companies available, in practice these two represent a 90% (Eesti Energia AS) and a 100% (Latvijas Gaze) share. We can talk about in Finland as well about a high concentrated market. Notably, the vast majority (around 95%) is sold directly to big users (enterprises, district heating producing plants), the retail market only accounts for 5%.75 and In case of Lithuania, the normalized HHI equals to 0,1025 (1025) that represents a moderate market concentrations. The retail market is very high concentrated, as since the HHI equals to 0,5902 (5902). However, while making these highlights we have to keep in mind a crucial factor; it is clear that there is still a single supplier still.

74

The Herfindahl–Hirschman-index is widely used to measure market concentration as a result, the degree of

liberalisation. The . where . The normalised HHI can be expressed with a value between 0 and 1 or in percentage, where the outcome can be placed between 0 and 10 000. The latter is a more picturesque solution as since three categories can be established. Between 750 and 1800 we can talk about moderate concentration, high concentration is indicated between 1800 and 5000. Above 5000 there is a very high market concentration. 75 Energiamarkkinavirasto, 2013

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11.. Figure: Natural gas retail prices in the East East-Baltic States

Source: Eurostat

One of the prime concerns of the three Baltic States is the price level.. As the above detailed graph indicates, the end-customer customer price has been rocketing between first half of 2010 and second half of 2012; in Estonia, Latvia and Lithuania respectively. It is clearly recognisable that for Lithuania the natural gas is available on the highest price.. As since Gazprom is the single supplier it has as vast influence on the end end-customer prices.

31

12. Figure: Cross-border capacity in the Baltic Sea Region

Locati on

Karksi Karksi Kieme nai Kieme nai Imatra Kornet i Kotlov ka Värska Narva

System Operator 1

Vörguteenus Latvijas Gaze Latvijas Gaze Lietuvos Dujos Gazprom Gazprom Gazprom Transgaz Belarus Gazprom Gazprom

C C

B Z

E E L V L V L T R U R U B Y R U R U

System C Operator 2 C

Latvijas > Gaze Vörguteen > us Lietuvos > Dujos Latvijas > Gaze

B Z

L V E E L T L V

Techni cal Technic physic Available al flow al physical capacit directions capacity y bcm GWh/d TS O1

TS O2

N

B

B

N

Rema rks

7 7 70,0 5,2 55,0

B 5,2

55,0

B 6

> Gasum Oy Latvijas > Gaze Lietuvos > Dujos Vörguteen > us Vörguteen > us

FI L V L T E E E E

249,0

-

N

-

B

6 200,0 27-31 323,0

N 4

41,0

-

N

-

N

0,5-4 31,2

Source: , ENTSOG, EEGA,Pakalkaite, 2012: 7.

Тhe first question that needs a reply is why the Europeanization is the best tool in the hands of the Baltic States. By contrasting this question we might get a more illuminating answer. Notably we have to highlight the fact that the effects are to be considered in medium-and short term – the current EU policies aim at embracing this distance in time. Long term decision characterise the infrastructure decisions in the field of energy policy. At the same time short-and medium term changes are to be met in this regard. In the previous section we elaborated numerous characteristics of the Baltic States that we will use a basis for the further assessment. •

From the point of view of gas deliveries we can underpin the elaborated concept of “energy island” with reference to Estonia, Latvia and Lithuania. There is no connecting infrastructure available to rest of Europe.

•

The rate of exposure to the Russian deliveries are the highest in Europe, accounting for 100%. In relative terms the Baltic markets are smaller.

•

The three Baltic States are highly dependent on natural gas in their domestic and industrial consumption. The structure of energy majors are dominated by Gazprom. 32

•

It is clear that the transition to hub based pricing is not feasible in the near future. For this reason changes in the incumbent contractual structure is possible.

As a consequence we can assess the position of the Baltic States relatively weak in comparison with the Central-European and especially with Western MSs. The three profound reason underlying are the small market size, the complete isolation from the rest of Europe, dependency on a single supplier. In line with these we argue that in the absence of a strong position in national capabilities it is a natural consequence to embrace the opportunities represented by the means of the Europeanised energy policy. 13. Figure Overview of the elements of the Europeanised energy policy

Objectives

‘secure’ - Security of Supply ‘secure’-price • diversification (energy mix, • transparency alternative routes, transport • competitiveness (liberalisation) security) • interconnectivity Tools – internal market – BEMIP • 3rd Energy Package – legal (Gas Security of Supply Directive unbundling, ‘Gazprom-clause’ framework 2004, Regulation 2010) • competition rules external dimension – EU-Russia; Energy Charter Treaty; Energy Community Treaty; information exchange mechanism role of the EUROPENISATION – (subsidiarity) COM • ‘exporting energy acquis’ (EU-Russia) • antitrust-investigation • information exchange • 3rd Energy Package • BEMIP In line with the above mentioned starting points we have to assess the possible means being utilized by the Baltic States. On general terms we can state that to the liberalised energy market and the supply diversification might the COM contribute with added value; according to the Baltic States.76 Consecutively we elaborate the possible gains and losses of a combination of policy tools. Notably not all the objectives might be realised in short-and medium term. In general we can state that the most important policy objectives are the supply diversification as being considered the main element of achieving the reasonable price.

76

Molis, 2011: 79.

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III.2 BEMIP: a feasible solution? The most comprehensive program aiming at the termination of ‘energy island’ status is the Baltic Energy Market Interconnection Plan (BEMIP). However it is a promising program it only provide with a long-term solution. The BEMIP envisages three broad projects that might foster the feasibility of program: the UGS terminal, the GIPL and the LNG terminal.

III.2.1 Gas storage facility The BEMIP indicates three different underground storage facility that shall be implemented within the complex system of infrastructure. The UGS is of special interest because traditionally it plays a pivotal role in providing during increased winter time gas consumption additional capacity in peak load. In a hub-based system, it fosters counterbalancing of supply shortage and price volatility. In line with these, the question arises: which of the three project might be implemented. To start with the analysis, the Net Present Value shall be evaluated in a comparative manner.77 Project Responsible body Cash flow (million EUR) Cost (million EUR Discount rate (%) Time interval (year, basis year 2011) NPV

Inčukalns UGS Latvijas Gaze 59

Syderiai USG

Dobele UGS

Lietuvos Dujos 77

N/A (Latvijas Gaze) 59

140 4,35 5 (expected)

347 4,59 5

230 4,35 10

0,036

0,002

~0

Source: ENTSOG - GIPL, NASDAQ, LAtvijas Gaze, Lietuvos Dujos, EU COM

Based on these accountings, the Inčukalns UGS capacity-extension project has the highest probability to be realised. However, other factors foster the higher possibility to realisation of the project. At the end of June this year, a capacity increase has been completed within the framework of the BEMIP internal and cross border capacity increase by the reconstruction of 17 wells of the UGS78. This aimed at to secure the capacity withdrawal capability of the Inčukalns USG, which is currently 2.3 bcm.79 Moreover, the EU has already allocated 7,5 million EUR on the proposed capacity extension project. This brings the Inčukalns UGS

77

The Net Present Value (NPV) provides a comprehensive measure of net benefits and is widely used for project ( ) ranking and decision-making. Mathematically can be described as the following:
 

. If NPV = 0, ( )

then the investment would neither gain nor lose value for the firm. If NPV0 then the investment would generate additional value for the firm. (Bhattacharyya, 2011: 176) 78 Baltic Course, 2013 79 Latvijas Gaze, 2012: 18

34

closer to realisation and displays stronger commitment on behalf of the EU. Notably, the extension is of special importance, as since the entire capacity is withdrawn by Latvia, Estonia and Russia. Provided that transition to hub-based market pricing is envisaged in longterm by the EU, the extension is prevailing.80 However the leverage of Gazprom over the Inčukalns UGS is determining. Currently the JSC Latvijas Gase is the operator of the UGS in which, as we have learnt before, Gazprom has controlling share, while the facility itself is owned by the Gazprom in 100%.81 Latvijas Gaze posses the operational rights until 2017.82 Provided that the East-Baltic states have derogation from the transposition of the unbundling provisions, the Inčukalns UGS might not contribute to the establishment of market based environment, mainly hub-based pricing. On the contrary, there is no such derogation provided with reference to TPA. It has been explicitly vocalised by the Latvian government that no ownership retention is going to take place. However, re-nationalisation is not, the Latvian government will insist upon granting TPA access to the Inčukalns UGS.83 In line with these, it is clear as well that the UGS is not going to be a market-establishing factor. Much more additional investment would be needed to effectively connect it to Lithuania and Latvia – such infrastructure is not in its place.84

III.2.2 GIPL, LNG market The Gas Interconnector Poland-Lithuania is the cornerstone of the entire matrix envisaged by the BEMIP as since it would connect the East-Baltic states to the rest of the European energy market. According to the plans of the Lietuvos Dujos and Gaz-System, the GIPL would have a 2,3 bcm/year capacity in Stage with the future possibility of extension up to 4,5 bcm/year in Stage II. The expected cost account for 471 million EUR.85 Currently there are many open questions concerning the GIPL stemming from the fact that the final investment decision is to be taken later in 2013.86 One of the most prevailing questions is the source of supply to the pipeline. The two stakeholders in the project in their presentation given on the BEMIP conference in Vilnius listed a number of projects as

80

Bryza, 2012: 7 Gazprom, 2011: 13 82 BNN, 2011 83 Ābele, 2013 84 Belyi, 2013: 3 85 Gaz-System, 2012 86 In May 2013, the feasibility study of the GIPL has been conducted, yet not made open for the public. 81

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prospective sources.87 Notably, all of these resources, technically speaking would provide in long term secure supply, however different level of diversification. 14. Figure: Potential resource base for the GIPL

Project Yamal I LNG PL Brotherhood Baltic Pipe Shale Gas

Russain (RUS)/Non-Russian (nRUS) resource RUS nRUS RUS nRUS nRUS

Source: LSTA

The table indicates that there are various sources available not of Russian origin. It includes Świnoujście LNG terminal, the Baltic Pipe and the indigenous Polish shale gas production. The LNG terminal can host various sources, traditional LNG suppliers such as Algeria or new ones like the US. However, the impact of the US LNG export is beyond the scope of this study. The Baltic Pipe subsea gas pipeline connects the natural gas transmission systems of Denmark and Poland delivers natural gas from Norway. Being a bi-directional flow pipeline it might provide an entry-point for the Świnoujście LNG terminal.88 On the other hand, it is clear, and has been vocalised by the companies at the same conference, the pipeline depends to future infrastructure and investment to a great extent. However, the 5 bcm/year capacity of the Świnoujście LNG is going to be in service of the GIPL, the proportion is still unclear. The objective is in place, explicitly assessed by the Gas System, being the owner of the facility.89 The actual contracted volumes, either in long term contract or hub-based mechanism, will be up to the Polskie LNG, the system operator of the facility. According to the original plans, the facility was expected to be completed by the second half of 2014, and deliveries are beginning in 2015 according to the contractual commitments with Qatar.90 In may previous year, with the additional aid granted by the EU, the status of completion indicated a 60% level. 91 However, in September at least 6 month delay was announced as a result of an investigation on progress.92 The BEMIP, as we have seen, identifies LNG terminal projects in each of the East-Baltic states. The Booz&Co. prepared an analysis for the EU COM on the different scenarios and prospective of feasibility of each of the LNG terminals. It highlighted that the most preferred terminal would be the 87

Gas System, 2012 Gas System 89 lngworldnews, 2012 90 naturalgaseurope.com, 2013 91 .lngworldnews.com, 2013 92 Warsaw Business Journal, 2013 88

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FinGulf LNG project, provided that it could enhance the SoS and supply diversification aims at the same time would be located to the biggest market among the East-Baltic states. However the Estonian project in Paldiski or in Muuga would indicate the same advantages.93 The EU Com recognised the findings of the analysis and as a result established strong commitment towards the funding of the LNG projects. It was made explicit that either of the project will be realised with the political and financial support of the COM.94 Up to date Lithuania is taking the lead on the construction of the LNG terminal in Klaipeda. According to the press releases of the operating company, the terminal itself should be ready by the end of 2014. Consecutively, first agreements on delivery are being negotiated.95 Notably, it wont have considerable effect on the current energy scene of the country. The first deliveries are still the question of the upcoming years and the effective amount largely depends on the prospective of US deliveries. On the contrary of the possible disadvantage of the Russian resource, connection to the already existing Yamal pipeline might be a feasible solution. Provided this, the granting of TPA of special interest, however the last intent on it by the polish TSO was published in 2010.96 Poland in particular nourished great expectations towards the shale gas exploration and extraction in the near future. Based on a comparative approach the maximum production is going to be reached in 5 years time, in 2020, accounting for 28,3 bcm/year. The asset life, with the given marginal cost curve, would be 40 years.97 However, many uncertainties surround the outlook of exploration of the Polish shale gas reserves. The EIA estimated the polish technically recoverable shale gas reserves of Poland 4,43 tcm. That result is lower than the widely referred to 2011 report that indicated 5.6 tcm of technically recoverable sale gas for the Baltic Basin, the Lublin, the Podlasie and the Fore Sudetic basin.98 On the contrary the Polish Geological Institute’s estimations, based on exploration drillings, are considerably lower, accounting for only 768 bcm.99 Until the first half of 2013 concessions for shale and tight gas prospection and exploration have been granted out of 256, while 0 concessions for exploitation or production has been issued.100 It has been widely considered to be alarming that the ExxonMobile abandoned its exploration wells in the Lublin and Podlasie basins in June 2012 accompanied by two other companies. Some established connection with low flow 93

Booz&Co., 2012: 102 thebaltictimes.com, 2012 95 euinfrastructure.com, 2014. 96 Energy Regulatory Office, 2010 97 Geny,2010:82 98 eia, 2013: 1-9 99 Bloomberg, 2012 100 Ministry of Environment, 2013 94

37

rates, however in inadequate tax –and royalty regime has been anticipated the reason underlying the abandonment.101 As the ExxonMobile case might depict, both reasoning can be established. Early indications assume that the exploitation costs might account for 10-15 million USD accompanied by the fact that the wells need additional infrastructure such as connecting pipelines, storages or roads.102 Moreover, the services attached to the drilling activities need to be discussed. Services, on the top of which is the rig service is of special importance. In the US, as the primary player in shale gas development, the inexpensive rig capacity was essential for a feasible exploitation and production.103 According to the various interviews with service companies, the rig rate would be around 20% higher in comparison with the US rig rates. It stems from the fact that the market for rig services is oligolopistic.104 Inexpensive and competitive rig services the marginal cost curve might be more steep in comparison. As for the national regulatory environment the Polish Exploration and Production Industry Organisation (OPPPW), the industry's main lobby group assessed the current and the proposed legislation on shale gas exploitation highly disadvantageous. The OPPPW argued that the concessions for exploitation is inadequate as since the time frame is too short for viable production in economic terms. Moreover, the obligation to provide share in each project for the state-owned company, NOKE, is beyond the interest of the industry.105 Generally speaking, the most profound question is the economic viability of the shale gas exploitation. Provided this, with the projected 28,3 bcm/year it might be a potential source for the GIPL. It is clear that there is a supply base for the GIPL, however with various level of completion deadline and prospective. On the hand, provided that it is the primary facility to terminate the ”energy island” status of the East-Baltic states, the EU COM shall foster the completion of the infrastructure. On the other hand, considerations arise in the current framework of the internal energy market to the GIPL. As we have seen with reference to the secondary legislation of the energy market, exemption for TPA might be provided for new infrastructures. The TPA in practice separated the supply and capacity contracts accompanied by the aim to move towards shorter durations in capacity allocation. On the one hand it shall foster the competition on the capacity markets. On the other hand the operational nature of the natural gas industry shouldn’t be left beyond the scope of considerations. The industry is based on long-term strategic thinking, where the mismatch between long-term supply obligations and short term 101

naturalgaseurope.com, 2012 Grodzki, 2012: 10 103 Asche, 2012: 119 104 Geny,2010:82 105 Economist, 2013 102

38

capacity allocation facilities might decrees participation in the market and might mitigate investment.106 It is beyond any doubts that the East-Baltic market is small in comparison. In live with the former suppliers barely would compete for shipment rights under TPA regime. The international experiences indicate that the shippers and pipeline investors prefer comprehensive agreements (supply and capacity contracts jointly) as a result of the TPA exemption.107 However exemption wouldn’t foster capacity market, spot market developments, it is the inevitable tool for the higher probability for the completion of the project, provided the established market attributes. As we see, however the political aim is in place, the BEMIP does not represent a short-and medium solution. Behind it lies the following reason on general terms: •

Uncertainty in financial terms. Uncertainties surround the entire system envisaged by the BEMIP from the point of view of Community and private financing respectively. On behalf of the EU, the small proportion that the community undertakes as financial contribution. The small market size and the high proportion of community support hinders the process of infrastructure development on general terms.

•

Uncertainty with reference to the sources of supply. It considers as well the most advancing infrastructure project in Lithuania.

•

Uncertainty regarding the relevant EU legislation, such as TPA exemption.

•

Lack of unified actions and cooperative agenda setting on behalf of the political elite of the Baltic States.

Stemming from these assumption, it results in that the only feasible aim the Baltic States might fulfil is the most advantageous price level. Here the Baltic States have a broad set of tools from the Europeanisation’s achievements.

III.3 Price setting In short –and medium term the sole feasible objective that might be fulfilled is the price level. The government officials and experts constantly argue that the Baltic States pay in relative terms higher price in comparison with the neighbours and the EU respectively. The most challenging reaction was presented by Lithuanian officials on the topic firmly adopting the stance that the Baltic states in general but Lithuania in particular pays the highest price in the

106 107

Talus, 2011: 269 Belyi, 2013: 2

39

EU.108 To assess the relative level of price in terms of the EU28 level faces difficulties. The LTC’s content and provisions are not open to the public. The indexation formula may differ from country to country agreed with Gazprom resulting in a different price level. 109 What we can firmly state is the end-customer price. Notably the investigation from an absolute point of view brings us closer to a proper assessment. As we have seen in the previous section there is a price difference among the three Baltic States where Lithuania pays the highest price. Of course complete transition to hub-based pricing does not imply any realistic prospect as it intended by the COM. For this reason a more advantageous price level should be reached.

III.3.1 Gazprom’s new contractual portfolio As we have observed in the previous section in short-and medium term considerable infrastructural developments are not feasible. In line with these steps might be taken in order to realise a more advantageous price setting. To assess these prospective of the Baltic States we have to as initiating step asses the price setting policy of the Gazprom. The reason for that is twofold: On the one hand we can determine if the energy giant is willing to take measures aimed the reduction of the price level. On the other hand we might identify those points that contributed to and underlined the aforementioned steps. In line with these we might as well assess whether these steps might applied to the Baltic States or the tools of the Europeanization might be deployed. On the course of 2010-2012 the Gazprom faced numerous challenges on the European gas market. To counterbalance these negative tendencies, it employed for the first sight remarkably flexible changes to its export portfolio. Тhe Russian contractual portfolio was characterised by numerous, seemingly uncontested, attributes. On the top of these attributes was the so called Take-or-Pay clause (TOP) accounting for 80%-85% of obligatory purchase of the total contracted volume. This minimum pay obligation aimed at ensuring a high utilisation rate of high investment in the pipeline system.110 The other cornerstone of the Long Term Supply Contracts (LTC) was the oil-indexed net back pricing where the price of the commodity was tied to a previously agreed multiplication of crude oil and oil product. The Gazprom had the preference for long term run up periods, in average 20-25 years of

108

http://www.euractiv.com/energy/lithuanian-minister-gazprom-know-news-529127 Grigas, 2012: 11 110 Kopolyanik, 2008: 157 109

40

contractual period. The last attribute ceased to exist in 2002; the destination clause is no more part of the LTC’s of Gazprom.111 From 2008 onwards we see a considerable change on the gas market of the European Union. In principle these are the decrease of natural gas consumption, the surplus of natural gas on the market resulting in increased gas-to-gas competition, and in strong relation to it the widening difference between the oil-linked and the hub-based pricing. 15. Figure: Consumption and import in the EU

Source: EU COM

The above figure clearly indicates a decrease in the total consumption within the European Union. It is a direct result of the 2008 economic and the later transposing European crisis. The overall consumption is one thing. The more determining development is the massive surplus of natural gas on the European market. Furthermore, as it is depicted in the figure 16., the share of LNG import has steadily increased, mostly from Algeria and Qatar. 16. Figure: Developments of EU27 imports and the relative position of LNG

Source: EU COM 111

The destination caluse was by definition the restriction imposed ont he re-export of natural gas delivered to a certain state. The economic rationell underlying the destination clause was that the importing state might gain profit by selling with a considerable profit margin the previously cheaper deliverd Russian natural gas.

41

in the past 10 years the European natural gas market has witnessed an increasing role of the trading hubs.

112

These include the Title Transfer Facility (TTF), the Zeebruge Hub, The

NetConnect Germany, the Gaspool Balancing Service and the Points d’Echange de Gaz. 17. Figure Development of trade volumes on related European hubs

Source: data from ZEE, NGC, GPL, PEG, TTF 18. Figure: Price differentials between contracted and spot volumes

Source: BP

The volume traded on these hubs has increased to a considerable extent – as it is portrayed by the above graph. Moreover, the average price of the on-hub-traded gas has decreased in comparison with the oil-indexed one, mostly as a result of the aforementioned oversupply and 112

Patric Heather, the leading expert on the development of European hubs employes the categorisation of 1) trading hubs 2) transit hubs 3) transition hubs. However this categorisation doesn’t have direct relevance from the point of view of our investigation.

42

the increase in the world oil price. Тhe price difference by 2012 accounted for approximately 14% in average. As a result of the increased share of hub-based trading and consecutively the emergence of gas-to-gas competition the justification of oil-indexed pricing has been put into question. The primary assumption underlying the assumption is that the spot market prices are generally lower than those of oil indexed ones. During 2008 and 2010 it has become looming that on the North-Western European hubs a hybrid pricing emerged, where the customers found themselves in a situation where they had the obligation to buy at least 85% of their contractual commitments. At the same time they were obliged to sell natural gas on the provided spot prices; being in average lower.113 Moreover, the buyers failed to take the contracted TOP volumes in year 2008/2009. The reason behind is that they excessively made purchase of spot gas due to lower prices.114 In line with these, the decoupling of oil indexed and hub-based prices raised wings. As a result of the above scrutinised gas market developments the Gazprom faced two profound challenges, namely the fulfilment of TOP clauses and the average wholesale price developments. Notably these changes have to be observed through critical lenses. As for the price, it is profound to express that the question of price level and price setting, however being correlated are different in time scale. The price setting is a question in long term, not imposing immediate effect on the policy of Gazprom. In stems from the fact that the future relative price developments are unpredictable to a great extent. Currently, however almost all of the hubs fulfil the requirement of anonymity and liquidity, the most determining criteria of the at least 10 churn ratio rate is barely met by the continental hubs.115 This challenge their position for benchmarking gas prices. It has to be highlighted that the question of price setting formula is related to benchmarking, namely to include spot prices into the LTCs. In this regard to opposing standpoints evolved over the course of the past few years. One pole of the debate strongly supports the maintenance of the current oil-indexed setting. Sergey Komlev, Head of Contract Structuring and Pricing Directorate at Gazprom Export expressed his opinion in favour of the current system. He stresses the importance of the risk sharing nature of the oil-indexation (accompanied by TOP clauses).116On the contrary Jonathan Stern argues in favour of spot benchmarking as since he foresees a continuing decouple of oil-indexed prices and spot prices. He supports the assumption that the world price of crude oil will be constantly above 70 USD/bbl. In line with these, with the continuing surplus of natural gas

113

Stern, 2010: 21 Stern and Rogers, 2011: 22 115 Konoplyanik, 2011: 8 116 naturalgaseurope.com, 2013 114

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supply the spot pricing shall result in lower relative price.117 Andrei Konoplyanik, advisor to the CEO of Gazprom, argues in favour of a mixed system where different contractual structures will coexist that will link both to the competing fuels (interfuel competition) and gas-to-gas competition.118 All three of them agree upon the continued existence of indexation. In the short term the price levels faced the necessity to be revised. The Gazprom reduced the prices in two steps. First in 2010 when 15% of the contracted capacity was being indexed to spot prices. During 2012 a further price reduction occurred however surrounded by certain degree of uncertainty whether being owed to indexation to the spot pricing or modification in the oil indexation formula.119 Between the economic-and euro crisis and 2012 we see a gradually evolving set of attributes exposing pressure on the export practices of Gazprom. We are able to advocate the assumption of András Deák’s by admitting that Gazprom pursues a more flexible export startegy as a result of price pressure from European hubs and related developments. However these are only general stipulations. The below table allows for further elaboration of the topic. Here we are predominantly interested in, whether an East-West divine can be detected in the modified export strategies of Gazprom. More precisely

Austria Belgium Bulgaria Czech Republic Finland France Germany Greece Hungary Italy Netherlands Romania Poland Slovakia

Share in Gazprom export % 2,86 4,45 1,52 3,99

Dependency rate on Gazprom (%) 61,9 28,0 100,0 66,2

1,91 4,41 18,19 1,37 2,90 8,27 1,27 1,38 5,45 2,30

100,0 20,8 34,6 78,4 81,3 22,9 14,4 72,8 82,2 92,7

Dependency/correction

Export share/correction

+ + +

+ + +

+ + + + +

+ + + + +

117

Stern, 2011 Konoplyianik, 2013 119 Deák, 2013: 4-5 118

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In the table we aimed at identifying two relevant variables. The correlation between dependency and change in the price level (or TOP modification) and the other one is the share in export in correlation with the price change. We listed western and eastern countries respectively. Firstly we can state that our investigation is proven: in both cases if the country was a major partner of Gazprom and/or had access to different sources and trading hubs a price modification occurred. At the same time in countries where there is a relatively low ranking with reference to export position and/or relative isolation from spot markets accompanied by a high dependency on a single supplier price change emerged.

III.4 The Baltic State’s strategy in practice This said, we can claim that other external factors might gain justified foothold. In this regard we strongly adapt the position that the Baltic States aim at the price re-setting by the tools of the Europeanization. Notably, we have to make a methodological bypass at this point. On the one hand the three Baltic States use these tools in a different manner. To the pattern followed by Estonia and Latvia we refer as passive which is on terms by definition a dispute avoiding behaviour accompanied by a free-raider strategy where two states build upon the achievements of another one. On the contrary to the strategy of Lithuania we refer to as active that entails a gain maximising behaviour. On the other hand we support the idea that all three states use the considerable part of the tools in an indirect way. By definition the indirect usage means an act where a policy tool with a well defined objective is used as a bargaining tool to fulfil other objectives. We have seen through the lenses of our reasoning in the preceding part the prospective and opportunities for a liberalised market setting for the Baltic States is not feasible in short-and medium term. It stems from the small market size resulting in low attractiveness for investors and the development of necceserary infrastructure on a slow pace. However we observed respectively that the Gazprom is willing to ease the terms of the contractual portfolio under certain circumstances. Тhese circumstances might be market-based leverage or other external factors. This said our profound argumentation is that the three Baltic States use the provisions of the Third Energy Directive in an indirect way. One of the profound aim of the Energy Package to create an integrated energy market that will be an essential part in creating SoS. The Directive aims at the liberalisation of the market in order to channel in investment and increase competition. This said it is clear that the aims are reachable over a longer period of time. For this reason the manoeuvring of the Baltic States reflect that the direct elaborative

45

aims are only of secondary nature. While operating along these lines the objective that is on the forefront of the moves are to agree upon a more favourable price setting. As we have referred to it is a complicated task to assess the actual import price differences of the Baltic States. What we can firmly state is that from the dissolution of the Soviet Union until 2004 the Baltic States enjoyed a discount import price. In the period lasting from 2005 until 2008 the accelerated increase resulted in price amounting for the Western European level.120 Based on the content of the interview conducted with Deputy Chairman of Gasport Valery Golubov in 2011 there is a considerable price difference between the Baltic States. As he elaborated, due to “Vilnius’s inadequate behaviour while restructuring the gas sector” Gazprom did not cut the prices by a level accounting for 15% for Lithuania as it happened for Estonia and Latvia.121 From the point of view of the above scrutinized system and in the presence of price difference in absolute terms we can assess the strategies undertaken by the Baltic States. It is widely known that Estonia and Latvia opted for a delayed implementation of the Directive until 2014. It is accompanied by the fact that both of them announced the implementation of the ITO option where the owner of the infrastructure is not deprived from the assets in essential. For this strategic behaviour we refer to as passive strategy. In comparison Lithuania took a more proactive stance towards the price reduction. This first was being manifested in not applying for an exemption under the provisions of the Directive and parallel announced the OU formula for the unbundling requirement. By this pattern we mean active strategic manoeuvring. In the preceding chapters it was clearly shed light on that Lithuania is as well an isolated state in terms of energy infrastructure as the other two Baltic States. However Lithuania has a strategic asset in hands on which Vilnius might put a grip upon. Traditionally, basically until the Package was enacted, Lithuania considered the pipeline supplying Kaliningrad oblast as an important element in shaping the relations vis-á-vis Russia.122 The strategic drawback was imminent; there was no direct control over the pipeline until 2013. As a first step Lithuania choose the option to challenge the Gazprom by the means of the national legislation, more precisely by strict legal means. In the legal process started in 2011 the Lithuania state brought before court the claim of alleged discriminating in price setting and using it as a pressure on the state of Lithuania. The Gazprom turned for arbitrage to the Stockholm’s Arbitration 120

Grigas, 2012: 10. Moskovskye Novosty, 2011 122 Balmaceda, 2013: 222. 121

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Institute to make the Lithuanian state to abandon the cases. At this point Lithuania aimed at directly establish a connection between Gazprom’s practices and the higher price of natural gas imported. From 2012 onwards we see a partial turn in the policy concept of the Lithuanian state in this regard. The question of price setting was gradually attached to the legislation of the unbundling format. In 2012 the Shareholders meeting decided upon the establishment of the Amber Grid as the TSO of Lithuania. Notably, the decision upon the shareholder’s status was postponed.123 On more specific terms Vilnius set a complex strategy: It pushed to the possible furthest extent the unbundling manifesting in OU. Parallel the question of the Kaliningrad pipeline was vested in with centric position. As a vector of these steps the price reduction was set as the ultimate objective. Russia’s strategic position vis-á-vis Lithuania is centred around the pipeline respectively. Kaliningrad oblast is solely accessible through the pipeline running through Lithuania. From a strategic point of view Russia cannot exercise leverage upon Vilnius by for example cutting supplies or reducing the delivered quantity as since it would have immediate effect upon the oblast respectively.124 In line with these however Moscow insist upon supply diversification of Kaliningrad in the framework of an LNG terminal. Notably the earliest point for the operational status is might be no sooner then the course of 2018-2019.125 This in turn allowed Lithuania for a broader space for manoeuvring. Having this broader space, Lithuania could maximise the gains. The OU was given green light when already in 2013 the Russian PM considered the implementation of the Directive as Lithuania’s internal authority.126 This was a landmark as since the Russian Federation allows for a free negotiation between the Lithuanian state, the state energy company and Gazprom. At the 2014 meeting between the Lithuanian PM and the CEO of Gazprom the issue of the implementation of unbundling was considered to be settled and completed. 127 At the same time Vilnius made congestions in this process to proceed towards the ultimate objective of price reduction. The initial Russian position claimed a 10-year long term supply contract guaranteeing uninterrupted supply and under the market price transit tariffs.128 The momentum where Vilnius could embrace the Directive as a negotiating tool was that it did not exclude Gazprom entirely from the system. While Gazprom sold the shares in the Amber Grid TSO on the one hand it could stay as investor in the company. On the other hand it has still 123

thebalticcourse.com, 2013. Grigas, 2012: 56. 125 Sharples, 2013: 7. 126 Lithuanian Tribune, 2013. 127 Lithuanian tribune, 2014. 128 naturalgaseurope.com, 2014. 124

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determining share in the Lietuvos Dujos energy company. These two provide with considerable weight for the company, notably, with limits set. Under the provisions of the TPA the tariffs are determined by the national regulatory authority. However being independent of the government, the prospective of effective lobbying is still in place for Gazprom. The temporary frozen negotiations restarted in 2014. The positions have approaching mutually in two determining senses. At the above mentioned Sochi meeting the Lithuanian side did not keep aloof from a commercial agreement to be negotiated between Amber Grid and Gazprom. In addition, however not being certified openly respectively, the Gazprom’s proposal contained a reduced price accounting for 20% in the new LTC starting from 2015.129 This seemingly marks a success for the Lithuanian strategy. In comparison with Lithuania, Estonia and Latvia employed a passive strategy. It stems from the fact that neither of the countries possess such strategic asset or were not capable of exploiting the potentials vested in. Estonia should be considered to be characterised by the first group of attributes. Notably in case of Estonia there might be a change in the strategy. The legal basis has been already established as since Riigikogu has approved a legislation to deprive the assets from Eesti Gaas with a deadline of 2015.130 At the same time this decision at the same time clearly reflects the wait-and-see passive strategy. On theoretical terms the Incukalns would be a basis for negotiation just as we encountered it in case of Lithuania. On the contrary the Incukalns UGS does not share such strategic attributes. The prevailing contractual structure means a considerable obstacle for effective TPA to the UGS. It is accompanied by, as we referred to in the preceding section, the low capacity and need for modernisation of pipelines.131 This effectively lacks behind because of the slow pace advancement of BEMIP. For this reason Russia could exert leverage upon Riga. Moreover the Latvian government had concluded an agreement with Latvia’s Gaze to possess the exclusive rights of supply in the infrastructure until 2017.132 Latvia has explicitly referred to the price dynamics on which the Gazprom has the ultimate impact. The author of the thesis on an energy policy training was informed by high ranking government officials that they prefer the moderate ITO option due to “strategic reasons” in relationship with the Gazprom. 133 In 2013 uncertified news have roamed in the Baltic media of a 20% reduction for the price of gas in the new supply contract with Gazprom.134 While in time close to these alleged developments 129

bne.eu, 2014. Bloomberg, 2012. 131 Lejins, 2010:75. 132 Grigas, 2012: 15. 133 Lecture given by Gatis Ābele, deputy state secretary of the Ministry of Econom of Latvia 134 eurotopics.net, 2013 130

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the Saeima approved a delayed implementation of the Directive.135 We can assess, based on the information available for the public, that both strategies are proven to be successful. However we can firmly state that on in short- and medium term. The passive strategy does not foster to reach the integration of the gas market of the Baltic States in long term. The other tool from the toolset of Europeanization is the antitrust case filed against Gazprom. Notably, this instrument is of complementary nature to the basic strategy scrutinised above. At the same time it reflects partly the basic strategy of the three Baltic States. We can assess the developments from the point of view activity and passivity alongside whether the investigation implies any effects in short-and medium term. As we have revealed in the preceding section upon the topic the COM proceeds with the investigation in three profound respective in CEE states. It claims that Gazprom may have: 1) hindered the free flow of gas across Member States; 2) prevented the diversification of supply of gas; 3) may have imposed unfair prices on its customers by linking the price of gas to oil prices. The first alleged breach is not of profound interest for the Baltic States. It stems from the already elaborated ‘energy island’ status of the countries. The second field of investigation is only of particular interest in longer terms where the precondition is the successful level of implementation of the infrastructure included in the BEMIP. In case the COM finds satisfying amount and proving-powered evidence, might assess an alleged behaviour of hindering the BEMIP projects, including pipelines and proposed LNG terminals.136 Direct and profound effect is imposed by the third section of investigation. Notably, the effect in terms of time considerations is dual. What might imply short-and medium term considerations is the proof directed at the unfair nature of price. In case of underpinning such practice it might give additional tool of leverage in the hand of the Baltic States. As we have seen the new LTCs are under negotiation currently. To come to terms on a more favourable price level, however, this tool has indirect effect providing additional leverage. We have to highlight that the COM’s aim is different to the latter in comparison: the objective might be assessed to put pressure on the Gazprom to alter its pricing model from oil-linked to hub-based pricing. However this is in long term a feasible scenario and might rather result in a hybrid pricing.137 This assumption 135

The Baltic Times, 2013 Riley, 2012: 9. 137 Grigas, 2012: 13. 136

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is even more underpinned if we contrast it with a transition to an exclusive hub-based pricing. If the BEMIP as being implemented would result in diversification and thus increased liquidity is it put into question, whether the Baltic States would enjoy lower prices in comparison. The standpoint is even widely adopted that such a ‘Baltic Hub’ would provide with, in relative terms, higher prices. It stems from the fact that such a hub established would reflect a relative price to already established Western-European hub resulting in a, for example, ‘NBP plus’ pricing.138 From the point of view of active or passive behaviour, the Baltic States are not unified in this regard. Lithuania clearly adopted an active stance. Various source confirmed that Vilnius has appealed to the COM already on the course of 2011-2012 to initiate an antitrust investigation upon Gazprom.139 With reference to Estonia and Latvia no such activity was reported, their strategy reflects the passive, ‘wait-and-see’ practice. The investigation is did not reveal any proactive stance adopted by the latter two countries, they rather aim react passively on the developments.

IV. CONCLUSION Currently the energy policy of the EU is characterised by an increased Europeanization where in the agent-principal relationship the balance has moved towards the agent, the European Commission. In this dynamic process the COM has established a system where it acquired a strong proactive role. Three broad fields were identified within this system. The ‘export of the internal energy market’. This new concept was the direct result of the changes in the EURussia relations. On the one hand stemming from the consequences of the Russo-Ukrainian gas crises the COM acquired considerable rights through the means of the internal energy market and was delegated competences by individual string of documents. On the other hand the disintegration of the EU-Russia Energy Dialogue the Gazprom lost considerable defence. The third element, the Antitrust Case exercises additional leverage upon the Gazprom. The vector of these attributes the Gazprom and Russia in the backyard was increasingly forced to undertake the ‘rule of the game’ set by the COM. The Third Energy Package is a prime tool for establishing the common energy market. The Package well integrates into the increased Europeanization. On the one hand it delegates considerable authority to the COM at the same time challenges the positions of the Gazprom to a great extent. The BEMIP is considered to be a landmark in fostering the establishment of the internal energy market. Here the COM plays an underlying role in promoting the infrastructure development.

138 139

Belyi, 2013: 2. Konoplyanik, 2013: 3.

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We elaborated in a comprehensive analysis the current status of the energy market of the Baltic States. This said, we could underline the concept of ‘energy island’ that is by definition the complete isolation from the rest of continental Europe. In line with these we described the ownership structure of the energy companies in the Baltic States alongside with already established infrastructure. Consecutively we underlined that based on the status of development of BEMIP the only feasible objective is the reduction of price level in short and medium term. As part of these assumptions it has been shed light on that provisions of the Third Energy Package, with special emphasis on unbundling and TPA, and the antitrust case was being deployed as means of arbitrage. Notably, solely these tools could have been measured, other set of tools might be in service of the Baltic States but these were not objectively assessable at the time of the research was being conducted. Based on the publicly available information and dataset we could firmly state that the ultimate objective of the Baltic States was fulfilled by the indirect use of tools of the Europeanised energy policy. At the same time different strategies were deployed. Estonia and Latvia, as constituting one set of rules, undertook the strategy of ‘passive’ approach while Lithuania was in advocation of the ‘active’ strategy.

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