The Question of an Annual $3 Billion: Why Ukraine Needs a Contract With Russia on Gas Transit

Three-ways talks will be held in Brussels on September 19 between Ukraine, Russia, and the European Union regarding the formation of a new gas transit contract for Russian gas transiting to Europe via Ukraine. The current contract expires on December 31 of this year, and without the establishment of a new one, Ukraine stands to lose its status as a transit country, losing all economic privileges associated with that status.

In the lead up to the negotiations, Hromadske explains why Ukraine needs this transit, what should be included in the new contract, and what are Ukraine’s chances of coming to a successful agreement.

The European Union imports about 400 billion cubic meters of gas annually, with 40% of that volume supplied by Russia. Currently, the Ukrainian gas transit system is the main system of transiting gas to the European Union. But when Ukraine began to make overtures to establish closer relations with the E.U. under ex-President Viktor Yuschenko, Russia began to build a gas transit pipeline that would bypass Ukraine. This was "Nordstream 1".

Now, Russia is continuing construction on "Nordstream-2" and "Turkstream" pipelines, which, when completed, will give it the capability of bypassing the Ukrainian gas transit system entirely.

Why Does Ukraine Transit Russian Gas?

Gas transit is the biggest source of export income for the Ukrainian government. It provides $3 billion to Ukraine annually, which amounts to 2.3% of its GDP.

For comparison, the government has allocated approximately the same amount for road construction and repair in the 2020 budget. Without the income from gas transit, these funds would be lost for at least a year.

READ MORE: The Zelenskyy Government Priorities: Debts and Defense

Aside from the income, gas transit also lowers maintenance costs for Ukrainian pipelines. These pipelines are a complex system that requires a certain level of pressure to be present inside, as well as constant care. Without actively transiting gas, the pipelines turn from rather profitable enterprises to unprofitable ones that suck millions of hryvnias from the government budget for no appreciable use.

The lost of gas transit is the loss of a source of Ukrainian funding, which can be used for education (for example, the equivalent of two years of education funding per the 2020 budget), or road repairs. But for the average citizen, the loss of gas transit would be most keenly felt in a rapid rise in the price of gas.

Most of the gas purchased by Ukraine at the moment lies on its eastern border. While technically this gas belongs to Poland, Slovakia, or Hungary, in practical terms, the gas is still sourced from Russia. As a result, one reason gas prices would rise without gas transit is that Ukraine will have to pay more to transit it from those countries (by paying those governments transit fees.)

Ukraine and Russia’s Negotiating Positions

As stated earlier, the current contract on gas transit ends on December 31, 2019, and a new contract has not yet been formalized. And tense relations between Ukraine and Russia, aggravated by the victory of Ukraine’s national gas company Naftogaz at the Stockholm Arbitration Tribunal against Russian state-owned Gazprom, have drawn the two sides to call in the European Commission as a representative of the gas Ukraine wants to transit.

For Ukraine, an ideal contract would be a 10-year agreement with precisely fixed conditions and transport volumes. Ukraine wants to set this deal according to European rules, to minimize Russian political pressure and to make settling disputes with Gazprom less painful.

Ukraine’s position is mostly supported by the European Commission. The European Commission (EC) is mostly concerned with ensuring stable gas supplies, which is why the EC is also interested in a long-term contract. The Commission also supports the expansion of its rules and directives to transit contracts between Ukraine and Russia.

Russia, for its part, wants either the extension of the current gas transit contract or a short-term contract, as it expects to complete construction of pipelines that will bypass Ukraine.

However, Ukraine cannot extend the current contract as it has already re-litigated its provisions at the Stockholm Arbitration Tribunal, and wants to maintain its victory over Gazprom. Russia has used the provisions of the current contract and the “gas question” as geopolitical leverage over Ukraine in previous years.

Ukraine’s Negotiating Strengths

“Nordstream-2”

The Russian “Nordstream-2” pipeline is projected to be completed on January 1. 2020, the first day immediately following the cessation of the current gas transit contract between Ukraine and Russia. However, Russia has encountered numerous setbacks and difficulties during construction. One of the biggest obstacles is the decision by Denmark to not permit pipeline construction in Danish waters. Aside from Denmark, “Nordstream-2” crosses through the territorial waters of Russia, Finland, Sweden, and Germany. Construction work has nearly finished in all those countries, but the delay in the launch of “Nordstream-2” plays into Ukraine’s hands, as without this pipeline Russia will remain reliant on Ukrainian gas transit.

Gas Directives for Russian Pipelines

In the spring of 2019, the European Union decided to apply its own rules for gas transit in all pipelines that enter the E.U. This means that “Nordstream-2” is subject to those directives.

Briefly put, the European rules state that a single company cannot both supply and transport energy resources, that is it cannot both sell gas and own a pipeline because this would give the company a monopoly.

As these rules apply to the pipelines that bypass Ukraine, they require Gazprom – the only Russian company that has the right to export gas – to transfer ownership of “Nordstream-2” to a different company and allow other companies to supply gas through that pipeline. However, since there are no other companies in Russia that only transit gas, Gazprom may be required to lower its volume of gas through Ukraine-bypassing pipelines by a factor of two, thus "reserving" pipeline capacity for other participants.

The OPAL Case

Ukraine received a welcome surprise thanks to an E.U. court case involving German pipeline OPAL, an aboveground extension to the original “Nordstream-1”. The court’s decision vacated a previous decision by the European Commission to allow Gazprom nearly singular transit rights through OPAL. This allowed Gazprom to use “Nordstream-1” at full capacity, and deliver gas to Czechia and Austria, as well as Germany.

The Russian gas monopoly was forced to lower gas volumes through “Nordstream-1” by a factor of two after the court’s decision on OPAL.

Analogous norms may exist for the JAGAL pipeline, which is an aboveground extension to “Nordstream-2” that is still under construction.

America’s War for Europe

The United States wants to turn into one of the biggest players in the international gas market. But in order to do that, they’ll need access to the European market, the largest gas market in the world. The U.S. already provides Europe with record volumes of liquified natural gas, but more Russian and offshore pipelines can prove to be an obstacle. This is one of the reasons that the U.S. is actively working to apply sanctions because of “Nordstream-2”. These sanctions would apply to a number of contracting companies, most of which are European. Some of those companies own unique technologies relating to laying offshore and underwater pipelines, so excluding them from Russian pipeline construction may very well freeze those projects indefinitely.

A $14 Billion Lawsuit

Another reason for Russia to finalize a gas transit contract with Ukraine is a new lawsuit, prepared by Naftogaz, at the Stockholm Arbitration Tribunal, to the tune of $11-14 billion. The basis for the suit are provisions of the current contract which fail to consider the fact that the end of the contract removes the very reason for the Ukrainian gas transit system. That gives Naftogaz the right to demand a review of gas transit fees, so that they take into account the accelerating obsolescence of the current system.

In other words, Naftogaz will be trying to win compensation from Gazprom for the cost of Ukrainian pipelines, since Russia did not warn Ukraine that it was building bypassing pipelines in order to stop using the Ukrainian system.

Naftogaz is offering to withdraw the suit if Russian agrees to sign a long-term gas transit agreement.

Strengths of the Russian Side

Bypassing Ukraine

Russia still has the opportunity to put “Nordstream-2” and “Turkstream” into service, even considering the current difficulties. The potential volume of these pipelines could allow Russia to entirely reject the Ukrainian gas transit system. And “Nordstream-2” may be ready as early as July of 2020, according to updated projects by Gazprom, though it did admit that the pipeline would not be ready by the original date of January 1.

Even if the new pipelines are forced to carry less gas due to European gas transit regulations, and even if Gazprom loses control over the OPAL and JAGAL pipelines, they will still lower the amount of gas sent through the Ukrainian gas transit system, thus improving Russia’s position during negotiations.

A Gas War

The traditional Russian approach is to utilize its dominant position in the gas market for political pressure. Russia can choose to prolong negotiations from October to November, once the heating season starts and the need for Russian gas grows. Additionally, gas supplies from Russia can completely cease in order to provoke a crisis and force Europe to take Russia’s side over Ukraine’s. The E.U. will be able to put political pressure on the Ukrainian authorities, who would then be incentivized to agree to Russian terms.

Pressure on Ukraine

Russian can also apply direct pressure to Ukraine without using the E.U. This was the case, for example, during previous gas transit negotiations in 2009, when Russia completely shut off gas supplies to Ukraine. However, Ukraine is now prepared for this situation, but Russia has a new pressure point on Ukraine – the conflict in Donbas. If Ukraine does not agree to Russian terms regarding gas transit, then Russia has the option of creating a situation that will force the Ukrainian authorities to compromise.

Unbundling

The only formal reason for Russia’s current refusal to sign a new contract regarding Ukrainian gas transit is the fact that Naftogaz has not been unbundled. In other words, Gazprom is accusing Naftogaz for violating European regulations for being both a supplier and transporter of gas, in which case Ukraine would have to give up control of its gas transit system to a different company, disconnected from Naftogaz (just as Russia would have to transfer ownership of its pipeline to companies not connected to Gazprom.)

Ukraine has not fulfilled this requirement, despite the fact that the E.U. has also set this condition. But unbundling Naftogaz, as its called, carries its own risks for Ukraine and its standing in current arbitration: the unbundling of Naftogaz could lead to the loss of Ukraine’s ability to continue its $11-14 billion lawsuit against Gazprom, which would weaken Ukraine’s negotiating position significantly. However, if Naftogaz is not unbundled, then the E.U. may withdraw its support from Ukraine and give it to Russia.

Trust in Victory, but Prepare for Loss

Ukraine will be going into negotiations in Brussels prepared. The Naftogaz administration has accepted a series of measures with the goal of minimizing potential losses that could be incurred if Russia ceases gas transit through Ukraine.

Most importantly, these measures relate to Ukraine’s gas reserves. Naftogaz typically pumps 19 billion cubic meters of gas into underground storage for the winter season. Normally, this would be enough to last for a heating season and provide Ukrainians with warmth for the winter.

But for the winter of 2020, these reserves have been increased. Ukraine is currently storing 19.5 billion cubic meters of gas, with another 0.5 billion reserved to buy from Western sources. These 20 billion cubic meters, according to Naftogaz predictions, should be enough to last a heating season even with a full loss of Russian gas. This will help keep the right pressure levels in Ukraine’s gas transit systems and provide enough reserves to heat Ukrainian homes.

Ukraine is already preparing a plan on how to use the gas transit system in the case that transit stops entirely. It’s being tested to see how well it functions in reverse. If enabled, it would be sending gas not from east to west, but from west to east. This would help Ukraine import gas from Europe instead of turning the entire system into scrap metal in 2020.

Another use for the system could be the provision of gas storage for European energy companies. Aside from its own pipes, Ukraine has a large underground storage, with capacities enough to both store gas for necessary Ukrainian uses but also to store gas that it doesn’t own. This service is in demand among European companies – they’ve pumped 1.4 billion cubic meters of gas into Ukrainian storage already.

Ukraine is also offering the use of its transit system to Moldova, as that country plans to terminate its agreements with Gazprom. It plans to receive gas from Europe via the Ukrainian gas transit system.

The Ukrainian government is also actively working on the question of unbundling Naftogaz. The Minister of Energy and the Environment of Ukraine, Oleksiy Orzhel has stated that the government needs to confirm a new unbundling model, which will allow Ukraine to continue pursuing its lawsuits with Gazprom, before negotiations continue on 19 September.

Ukraine’s current negotiating position is stronger than ever. It has its own ace-in-the-holes to play, and its prepared to counter Russian ones.

All of this gives hope for a successful end to negotiations with Moscow – successful enough to not only resolve the gas question, but also the war in Donbas.

“But now we need to do everything possible in order to gain the maximum out of the favorable situation shaping up around the question of gas transit. Perhaps it’s not worth limiting [ourselves] to economic questions. Maybe, [we’ll] have the ability to win concessions on Donbas from Russia. And we must take advantage of that,” said National Bank of Ukraine chief Bohdan Danylyshyn.

/By Yaroslav Vinokurov

/Translated by Romeo Kokriatski