The Commercial Logic of Nord Stream 2?

15. 3. 2017

The economic factors underlying Nord Stream 2 are even more interesting than the legal hurdles and, surprisingly enough, less often taken into consideration.

Much ink has been spilt as of late both against and in favor of Nord Stream 2, a natural gas pipeline proposal intended to bring Russian gas to Europe. The project was proposed last year by a consortium made up of Russian natural gas giant Gazprom and five European companies: German E.ON and BASF/Wintershall, Austrian OMV, French Engie and Anglo-Dutch Royal Dutch Shell. Gazprom is to own a 50% stake in the pipeline, while its partners will make up for the remaining half with a 10% stake each.

The project aims to expand on the existing northern route, Nord Stream 1, which connects Russia directly to Germany through the Baltic Sea. Nord Stream 2 is planned to add two new pipelines to the existing two which make up Nord Stream 1. This would effectively double the route’s capacity from a maximum of 55 bcm/y now, to 110 bcm/y if the new pipeline is built, sometime by the end of the decade.

The controversy over the proposal revolves around whether it is a geopolitical (or at least political) weapon employed by Russia or whether it is in fact an inherently commercial project as claimed by the pipeline consortium and supported by the German government.

The view that Nord Stream 2’s goals are geopolitical in nature is largely shared among Central and Eastern European governments, nine of which addressed the issue in a letter to European Commission President Jean-Claude Juncker in March this year, citing their own security of supply risk to arise from the pipeline’s construction. The fact that Nord Stream 2 would dislodge significant gas volumes from the current Ukrainian route is also a problem often cited, mainly with reference to its financial implications on both Ukraine and Slovakia which could stand to lose transit fees currently in place.

Moreover, the project’s mere existence has already exacerbated existing rifts within the EU, pitting Germany against Central and Eastern European governments on the one hand and against South Europe (Italy and Greece especially) on the other, since competing proposals to bring Russian gas through a Southern route (the now suspended South and Turkish Streams) have collapsed at their expense. It seems to also be opening a new fracture in Germany-US relations since the latter is a fervent defender of keeping the Ukraine route—both because it makes commercial sense to everyone involved and because it sends a strong signal of support to a Kiev weakened by the covert Russian war waged against it.

Considering these developments, if Nord Stream 2’s goal was to “divide and conquer,” then at least the divide part is mostly done, even though—if its supporters’ assertions are to be taken at face value—this was not the aim. The aim is purely commercial, something that the EU, which takes such pride in its economic and legislative value, should come to recognize fairly quickly: European companies see a good business case in the pipeline, no money is asked of the taxpayers, and the pipeline will even cut emissions by an already calculated 8.9m tons of carbon dioxide equivalent compared to Ukraine transit, as the EU has recently learned from Gazprom’s CEO Alexey Miller at the Sankt Petersburg Economic Forum.

So why the hesitation? To answer this question, both the legislative and economic dimensions should come to the forefront of the discussion, rather than the political ones.

The legal argument was rightfully made in mid-June by Juncker himself, in a belated reply to the abovementioned March letter. “If built,” Juncker finally conceded, “Nord Stream 2 would have to fully comply […] with applicable EU law, including on energy and the environment. This is also the case for off-shore infrastructure under the jurisdiction of Member States, including their exclusive economic zones. The construction of such an important infrastructure cannot happen in a legal void, or only according to Russian law.”

The offshore reference is the crux of the legal debate. Bizarrely, just like with failed South Stream before it, Gazprom is now pushing its own interpretation of European legislation as applying to Nord Stream 2. The Third Energy Package (TEP), according to Gazprom, only applies on Member States’ territory, not their territorial waters and exclusive economic zones. In this logic, it deems Nord Stream 2 an “import pipeline” and cites precedents of pipelines in the Mediterranean and even its own Nord Stream 1, which did not have to comply with the unbundling and third party access rules that make up the bulk of the TEP—disregarding, however, the fact that the legislation was not yet in force at the time the construction of the pipelines in question began.

Under the TEP, Member States must ensure that network ownership is separated from production and distribution activity (ownership unbundling) and that implementation of a system of third party access to the transmission and distribution system is applied objectively and without discrimination between system users. The controlling stake of Gazprom in the pipeline precludes it from complying with these two legal requirements.

Even if the TEP is somehow interpreted as not applying to Nord Stream 2, Gazprom would still have to indirectly comply with the legislation, as is shown by present day’s Nord Stream 1’s case. Nord Stream 1 makes a landfall near Greifswald in Germany and from there onwards its gas is carried through two German pipelines: Nel and Opal. The latter is the export pipeline to the Czech Republic with a 36 bcm/y capacity that, however, can be used only partially in light of the TEP’s application.

The situation would be similar for Eugal, a 51 bcm/y pipeline parallel to Opal set to be built in order to serve Nord Stream 2. Eugal would need an exemption from TEP rules if it is to be used at full capacity. Opal, however, which long stood in a legislative limbo before obtaining a temporary partial exemption, stands as evidence of the hurdles to come for Eugal as well, which will have to prove that it enhances not just gas supply security, but also gas supply competition, and that the investment undertaken has had such high risk that it can only be made if the exemption is granted.

If German and European authorities do find a way to bypass the Third Energy Package, then there would be no doubt that Nord Stream 2 is indeed a political project and not a commercial one. In particular, they would have to explain why the same concessions could not be made for South Stream a couple of years ago, even though it can also be argued that South Stream was cancelled by the Russian side before any such talk could even be opened.

The economic factors underlying Nord Stream 2 are even more interesting than the legal hurdles and, surprisingly enough, less often taken into consideration. The pipeline’s construction would cost an estimated €9 bn, an investment well worth taking in a favorable market environment. However, if one is to take a long-term view and factor in all variables, the EU gas market may not look quite so favorable after all.

Gazprom insists that Nord Stream 2 will replace dwindling North Sea supply at affordable costs, often citing the troubles at the Groningen field as a sign of what could become of the EU’s own gas production. But this argument leaves out other possible domestic natural gas sources such as Romania’s and Bulgaria’s Black Sea offshore fields or even the elusive shale gas projects in Britain especially.

In terms of imports, however, Gazprom seems to have fully grasped the threat of liquefied natural gas competition and, seen from this perspective, its attempts to secure a long-term market share are indeed a very rational commercial choice. Abundant LNG supply especially from the United States, Qatar, and Australia is expected to drive prices down even further as technology advances to improve costs, possibly even to levels competitive with piped gas. This would add to LNG’s existing advantages such as market liquidity, diversified suppliers, and the fact that its price is set by market factors preponderantly. Europe’s existing LNG import capacity is already significant at around 43% of demand in 2015 and several additional facilities are in planning or construction phase already.

What makes little sense from a purely commercial point of view, however, is building new, expensive infrastructure in order to lock in market share instead of using the infrastructure already in place which suffices to supply even the most optimistic of European gas demand prospects. The fears claimed over Ukraine transit can be mitigated with EU mediation or even bilateral negotiation while old infrastructure can be modernized at lower costs than building new one instead of letting it go to waste. It makes even less sense if the new infrastructure is not used at fully capacity so as to comply with the legislation mentioned above.

A diligent investor should also look over towards the post-2020 European energy market as a whole and, more specifically, at what role gas is still expected to have. A premise widely believed a few years ago (that gas will play the role of transit fuel towards a clean economy) now looks less likely to stand true. International Energy Agency (IEA) figures released this June show that global natural gas demand has increased by just 1% a year in the past four years, as opposed to the 2% annual growths predicted in 2011. Even with the significantly low current gas prices, the IEA predicts only a 1.5% annual growth over the next years. The sluggish rise of natural gas demand is owed both in Europe and worldwide to an abundance of cheap coal available on the market and to strong support policy towards renewables.

The 2% annual gas demand growth was supposed to usher in the Golden Age of Gas, expected to last well into the 2030s. It was predicated on the North American shale gas revolution, the post-economic crisis demand growth, the increased availability of LNG supply, and the climate change mitigation policies which seemed to favor gas thanks to its lower carbon footprint. Still, even this pro-gas climate-related argument rings less true today when efforts to curtail methane emissions are gaining momentum alongside those for carbon dioxide emissions reduction.

It is unclear at this time whether the shift in the position of gas is structural or just temporary, but it’s still an important variable to factor in when building a large infrastructure pipeline like Nord Stream 2.

Furthermore, another recent report makes an even more compelling argument against the Golden Age of Gas scenario. Bloomberg New Energy Finance announced in June in its New Energy Outlook 2016 an expected fundamental transformation in the global electricity sector, as wind and solar power costs are expected to fall sharply over the next 25 years. Bloomberg expects renewable energy to overtake fossil fuels in electricity generation worldwide by 2040. Despite last years’ fatigue in terms of adopting new and costly climate policies, Europe seems set to remain at the forefront of such shifts with Bloomberg expecting renewables to generate up to 70% of Europe’s electricity in 2040 (compared to 32% in 2015).

To conclude, factoring in all these trends, future European gas demand seems set to stagnate at best. Considering also supply-side opportunities, including but not limited to LNG, the Energy Union’s push for small interconnectors makes for a far more commercially-adequate approach than new large infrastructure projects. It is therefore difficult to see the business case for new and costly infrastructure at a time when demand for the product it carries is hardly certain in the long term, and when infrastructure is already in place to satisfy the demand which is certain.

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