By Pawel Jakubowski
Former CEO, Polskie LNG S.A.
Anna Mikulska, Ph.D.
Nonresident Fellow in Energy Studies, Baker Institute
A new proposal to clarify and expand U.S. sanctions on the Nord Stream 2 pipeline has been just introduced in the U.S. Senate. Spearheaded by Senators Ted Cruz (R) and Jeanne Shaheen (D) the bill has a rare bipartisan support. If expanded, the sanctions would impact all pipeline laying activities as well as companies that provide insurance, port facilities, or tethering services for pipeline laying vessels.
But the proposal is only one from a series of difficulties the NS2 pipeline has been currently facing. In December 2019 the pipeline’s construction stopped to a screeching halt only 100 miles (6%) away from being completed due to the first set of U.S. sanctions that targeted pipeline-laying vessels. And earlier that year the EU introduced a regulation that would make it difficult for Gazprom to own and operate the pipeline within the EU internal gas market.
What are Russia’s options in the face of the strong headwinds that NS2 currently faces?
The U.S. sanctions stopped the pipeline construction causing an almost immediate exit of Allseas, the company contracted to lay the pipeline. In response, Russia began preparing its own ship – the Akademik Czersky – to perform the task. By deploying its own vessel, Gazprom hopes to avoid the worst of potential effects of the U.S. sanctions, i.e. abandoning the project. Even President Putin himself ensured the public that the pipeline will be completed without international assistance, albeit with a “several months” delay.
But since Gazprom partially owns the vessel, a switch to Akademik Czersky could expose the company to U.S. sanctions, both current and proposed. There is of course the option to sell the ship to other Russian company, preferably with a domestic focus to minimize impact of any potential sanctions. Possibly in preparation for this move, Akademik Czerski’s ownership has already been transferred from Gazprom Fleet LLC to the Samar Thermal Energy Property Fund (STIF). The latter is still part of Gazprom group of companies but, given its legal status, could quickly change owner if needed be.
However, all this will take time, efforts, and a lot of additional resources delaying the pipeline completion possibly beyond the one year that Gazprom has initially expected and increasing the pipeline’s already significant cost.
And even if Gazprom completes the pipeline, the company will have to face legal obstacles related to its operation within the EU internal market.
In April of 2019, the EU extended its internal gas market regulations (Directive 2009/73/EC, better known as the Third Energy Package or TEP) to pipelines to and from non-EU countries (Directive (EU) 2019/692). Under the newly amended law, on the territory of the EU, the NS2 pipeline needs to adhere to third party access (TPA) and tariff regulation to pipelines entering EU member territory as well as to the principle of unbundling, i.e. the transmission and gas ownership need to be separate from each other. This is a direct hit to Gazprom’s vertically integrated structure and will need significant adjustment.
Gazprom could avoid the new EU rules if it is awarded an exemption by the energy market regulator of the EU member where the pipeline enters the EU. In the case of NS2 this agency is the German Bundesnetzagentur (BnetzA). Such exemption, however, has been denied just last month. Gazprom can and most likely will appeal the decision in court (Stockholm arbitrage tribunal) but prospects are not encouraging. Especially that Gazprom has suffered another defeat: on may 20th, the Court of Justice of the European Union rejected applications filed by pipeline owners: Nord Stream 1 AGand Nord Stream 2 AG for annulment of the Directive (EU) 2019/692.
What application of the new EU Directive can mean for Gazprom?
To begin, if Gazprom needs to adjust to the EU gas market requirements of third-party access, it may have to settle for access to partial pipeline capacity; similar to the 50 percent limitation on the Opal pipeline that transfers natural gas flows from Nord Stream 1. The situation deteriorates even further if, consistent with the unbundling principle, Gazprom has to give up operatorship and ownership of the pipeline.
In that case, Gazprom would have to apply to the German regulator (BNetz) to assign another entity to perform the role of transmission system operator. One can imagine a scenario under which NS2 would be divided into two parts depending on whether it is located on international or Germany’s territorial waters. EU law applies only to the latter – much shorter (4% of total length) part, which would have to be operated by an entity other than Gazprom.
Several potential candidates could perform the role of a transmission system operator for NS2. WIGA company, a joint venture of Wintershall and Gazprom is an umbrella for three subsidiaries: GASCADE Gastransport GmbH, OPAL Gastransport GmbH & Co. KG and NEL Gastransport GmbH. Those three subsidiaries are transmission system operators on the OPAL, NEL and EUGAL pipelines; all related to the NS1 and NS2 projects. OPAL and NEL pipelines take over transmission of Russian gas from the already existing Nord Stream 1 pipelines. EUGAL is supposed to do the same with respect to NS2.
Meanwhile, ownership of the part of NS2 part that runs under German territorial waters could be transferred to companies that have been collaborating on both Nord Stream projects, including Austrian OMV, German BASF-Wintershall and Uniper, French Engie, or British-Dutch Royal Shell. All of those companies jointly own the NS1 pipelines. All of them are also involved in financing the NS2 project after they were prohibited from jointly owning NS2 on the basis of competition and market concerns.
Hence, Gazprom has options that would allow for NS2 to operate, if successfully completed.
However, just like the U.S. sanctions, any of those solutions would make the operation of the pipeline more complicated and less profitable. Profits could be seriously hurt by potential capacity access limitations and the need to divide the spoils between; 1) Gazprom as gas owner; 2) a pipeline owner; and 3) an operator. In addition, Gazprom would also have to accept gas tariffs as set by a German operator, which would not necessarily reflect Gazprom’s own profit calculus.
This will add to other potential costs NS2 currently faces. The company is involved in antitrust proceeding initiated in 2018 by Poland’s Office of Competition and Consumer Protection (UOKiK) against Gazprom and all companies involved in NS2 financing. Irrespective of the result of the proceedings Gazprom also faces a fine for lack of cooperation during the anti-trust investigation. In 2019 Engie has paid €50 million fine for similar behavior in that proceeding.
The implications of new EU laws go beyond profits.
Lack of influence on tariffs would mean that Gazprom would not be able to execute the market power it would otherwise have. The company would also have to commit to transparency levels. Recent changes on the Yamal gas pipeline that runs from Russia via Bialorus and Poland to Germany illustrate the issue. In May the long-term contract to transit gas via Poland to Germany expired and, according to the EU regulations, all pipeline capacity (up to 32 bcm annually) has to be offered in a transparent bidding process by Polish transmission system operator. Hence, Gazprom is forced to bid in a capacity allocation procedure, just like any other market player interested to use the pipeline. Even though Gazprom has been active on the Petersburg Gas Exchange, the level of transparency that is required now on the Polish section of the Yamal gas pipeline is significantly higher.
Also, long delays in the pipeline construction work against Russia’s ability to extract geopolitical power as a dominant gas supplier to Central and Eastern Europe (CEE). The region is currently in the process of significant infrastructure buildup to achieve gas supply diversification away from Russia. This includes expansion of LNG Terminal in Poland, construction of a new pipeline (Baltic Pipe) to bring gas from Norway and better market integration through constructions of multiple pipeline interconnectors. If significant progress on those projects is achieved before NS2 is completed, the gas that flows via NS2 is likely to face a much stronger competition. This means lower prices but also loss of strong bargaining position that Russia has often used to influence the region geopolitically. In this sense, the pipeline will indeed be able to serve the EU energy security, which is consistent with Russia’s official justification for NS2 construction.
All in all, NS2 could be completed even despite current difficulties. However, U.S. sanctions and EU regulatory requirements will significantly delay the pipeline’s completion and could cut deep into the profits Gazprom and Russia, may have hoped for. The delay is also likely to help any competing infrastructure projects currently under construction in the CEE to gain ground. The need to compete for a consumer will make Russian gas prices depend on market forces rather than reflecting Russia’s dominant supplier position in the region. It can also reduce geopolitical power Russia has derived from that position.
This post originally appeared in the Forbes blog on June 6, 2020.