KSE’s plan for Ukraine to fight back against Russia’s weaponisation of gas

KSE’s plan for Ukraine to fight back against Russia’s weaponisation of gas
Russian gas should be allowed to continue to flow to Europe via Ukraine, but the volumes should be reduced and Ukraine incorporated into the European gas storage infrastructure, argues the Kyiv School of Economics. / bne IntelliNews
By Ben Aris in Berlin May 11, 2023

Russia's attempt to use its gas supply as a political tool against its neighbours and the European Union has backfired, tarnishing its reputation as a reliable supplier and causing energy prices around the world to spike. Moscow's strategy involved under-delivering gas in 2021 to put pressure on Europe into accepting its annexation of Ukraine, subsequently squeezing Europe's supply by demanding payment in rubles, cutting off several countries and unilaterally closing the Yamal and Nord Stream pipelines.

Borys Dodonov, head of the Centre for Energy and Climate Studies at the Kyiv School of Economics (KSE), and his team published an outline of a plan to defang Russia’s control of gas that will not only constrain Russia’s leverage in the energy market, but also ensure that Europe gets the energy it needs.

Russia’s weaponisation of gas has had significant and immediate consequences, with gas prices soaring ten-fold from the normal price levels, causing inflation, reduced incomes and profits, and slowing down economic growth across Europe. In countries like Germany, heavily dependent on Russian gas as an input, there has been some serious de-industrialisation as things like chemical and fertiliser factors become loss-making due to the high cost of gas and energy. On the flip side, Russia’s budget enjoyed record gas revenues, even as export volumes fell, which increased by 55.7% in 2022, as natural gas exports to Europe dropped by 56.1%, KSE reports.

“The Kremlin’s attempt to weaponise gas led to an extraordinary adjustment. Pipeline supply fell by 85% from pre-invasion levels, while the supply of ship-borne liquefied natural gas (LNG) increased. Europe’s gas-storage level ultimately hit a record high,” Dodonov wrote. “This success resulted in gas prices falling to less than twice pre-invasion average levels. The International Energy Agency (IEA) suggests that Europe’s efforts to reduce gas demand should be sufficient to cover a complete cut-off of Russian gas next winter, even in a stress scenario.”

With gas supplies partly restored thanks to booming LNG imports the question now is to restructure the gas market in Europe for the long term.

Currently Europe's gas storage levels are at record highs for this time of the year that have led gas prices to fall to less than twice pre-invasion average levels, although they remain elevated from the five-year average. (chart)

On April 6, the gas withdrawal season from European underground storage facilities came to an end. A mild winter greatly aided Europe's heating season.

In early May, the pace of gas injection into underground storage (UGS) facilities in Europe was 29% lower than the figures for 2022. At the same time, the occupancy of storage facilities exceeded 62%, which is 19.37 percentage points higher than the five-year average for the date.

LNG supplies in the EU are at an all-time high, and gas is trading at the early July 2021 level at around $400 per 1,000 cubic metres.

According to Gas Infrastructure Europe (GIE), gas withdrawals from UGS facilities in EU countries totalled 30mn cubic metres on May 8. At the same time, the injection volume reached 337 mcm.

LNG imports from terminals into Europe's gas transmission system reached an all-time high of 12.07bn cubic metres in April, according to data from the European Union. In May, Europe continues to see record LNG flows.

“Russia tried and failed to use its gas weapon to compel Europe. Now that Russia has lost its leverage, Europe has an excellent opportunity to retaliate. By doing so, it can support Ukraine and minimise the threat to Europe’s energy security. Specifically, we propose four steps,” says Dodonov.

First, to bolster Europe's gas resilience and independence from Russia, the EU should raise its gas storage target to 100% from the current 90% by November 1, counting EU-owned gas stored in Ukraine towards the target. Ukraine can offer at least 15 bcm of capacity to store additional volumes of European gas and has the largest gas storage tanks in Europe. “A joint purchasing mechanism should be used to finance this additional storage,” Dodonov says, which is what the EU says it intends to do.

Secondly, the EU should halt all purchases of Russian pipeline gas except via Ukraine, ending current flows of around 10 bcm a year through Turkey, KSE proposes. Amazingly, some of the key gas pipelines from Russia to Europe run through the middle of the war zone and are still carrying gas to market. Some 25 bcm of Russian gas should transit Ukraine this year to European markets and Russia’s state-owned gas behemoth Gazprom is still scrupulously sticking to the terms of the 2019 gas transit deal with Ukraine’s Naftogaz and paying hundreds of millions of dollars to Kyiv in transit fees – a crucial source of income for the cash-strapped government in Kyiv.

“To achieve this, stricter enforcement of European rules on “unbundling” ownership and distribution could be implemented. Currently, the Ukrainian gas transmission system can accommodate more than three times the volume of Russia’s gas supply to Europe,” Dodonov says. “We propose to cap the allowable volume of Russian gas that can flow through Ukraine at 40 bcm a year, a level that was set in the current Russia-Ukraine gas agreement for 2021-24. Making the Ukrainian gas transmission system Russia’s sole channel of gas supply to Europe would facilitate a levy on all Russian gas sales to Europe to finance Ukraine’s reconstruction and compensation.”

As bne IntelliNews has reported, the problem for Europe is not the need to buy Russian gas per se, but the amount it bought. With Russia’s share in the European gas imports running at 35%-40% pre-war, that was too much gas for Europe to be able to switch suppliers in case of a crisis. However, if the amount were reduced to around 15% of the total, then existing LNG facilities would allow the EU to switch from Russian piped gas imports to LNG supplied by the US or Qatar.

And this seems to be the plan; the EU does not intend to cut off cheap Russian gas entirely and will continue to import it via Ukraine and Turkey, but the volumes will be reduced to the point where Russia’s energy leverage over Europe is diminished to manageable levels.

Thirdly, KSE proposes that the wider EU should follow the UK and Germany in ending the purchase of Russian LNG, which has ballooned in the last year. According to the IEA, Europe would be able to outbid others for gas in a stress scenario, as LNG trade volume is projected to increase by 4.3% in 2023, KSE reports.

Fourthly, KSE recommends cracking down on Russian energy companies with more sanctions. In order to keep the gas flowing several companies and banks have been exempted from the sanctions.

“With Europe no longer dependent on Russian gas, it’s time to impose sanctions on key Russian gas companies involved in last year’s conspiracy to squeeze Europe, including Gazprom and Gazprombank, as well as personal sanctions on their boards and management,” Dodonov says.

“Russia lost its status as a leading gas supplier to Europe. Its share of total EU imports declined to just 8% in the early months of 2023. At the same time, European gas storage is at a record high, and prices have fallen sharply since their peak in the third quarter of last year. However, 2022’s high-energy prices caused welfare losses for consumers. Therefore, sanctions are necessary to prevent similar behaviour from anybody else in the future,” Dodonov adds.

These measures would reduce Russia's export earnings by $8bn over the next year, according to KSE, helping to constrain its invasion of Ukraine. At the same time, they would maintain a useful supplementary revenue stream for the government in Kyiv.

This plan shifts the balance of power from Europe being dependent on Russian gas to Russia being dependent on Ukraine for access to the European market, KSE argues. It also paves the way to impose a levy on Russian gas flows to finance Ukraine's reconstruction as the price of future Russian access to the European market.