Russia: Breaking the bear hug

How Europe can end Russia’s grip on gas
April 23, 2014

Russian President Vladimir Putin in 2011 at the opening of the Nord Stream pipeline, which supplied Germany but bypassed Ukraine

© Bloomberg via Getty Images

Russia’s southern and eastern borders have been in a permanent state of flux since Catherine the Great first annexed Crimea in 1783. The latest opportunist annexation is but one more episode in a long history. Joseph Stalin gained almost all the territory Russia coveted in what he regarded as its backyard. Mikhail Gorbachev then lost most of it. The game is now being rejoined in Georgia, Ukraine, Moldova and possibly in the Baltic states too. Europe’s eastern borders have rarely been settled for long, and they are not now.

The Russian strategy has been financed in large measure by oil, and now gas, too. Oil kept the Soviet economy afloat. Having witnessed the collapse of the Russian economy under Boris Yeltsin in the 1990s as oil prices plummeted, Vladimir Putin understood that control of Russia’s mineral resources is essential to rebuilding the country’s standing in the world—and with it redressing what he sees as the greatest political catastrophe of the 20th century: the breakup of the Soviet Union. With a declining population and a sclerotic economy plagued by corruption, it doesn’t have much else. Putin’s graduate thesis on natural resources and strategic planning, which he completed at St Petersburg University in 1996, spelt all this out.

This poses a challenge to Europe, which needs to develop a coherent strategy for reducing its dependency on Russian gas. While European leaders have dithered, Putin has been utterly singleminded in pursuing his agenda. It is true that he has ducked and weaved, as smart politicians do—first when Russia was weak, and the oil price low, back in 2000, and then during the regular crises that have since punctuated global politics (9/11, the US invasion of Iraq, Russia’s incursion into Georgia in 2008, the civil war in Syria and now Ukraine). But his strategy has remained remarkably consistent.

First, Putin reversed the power transfer that occurred when Yeltsin gave the oligarchs shares in key assets in exchange for loans. He warned them to keep out of politics. Locking up Mikhail Khodorkovsky, boss of the Yukos Oil Company, was part of a process of regaining control over the major Russian companies. Second, he turned the gas producer Gazprom into a monopoly, and put two men from his support base in St Petersburg—Alexei Miller and Dmitry Medvedev—in charge. The leadership of Gazprom and the government were effectively merged. Gazprom even took over the independent television station NTV as part of Putin’s bid for control of the media. Third, he restored state control of the oil industry, absorbing Khodorkovsky’s Yukos assets into Rosneft, which was transformed into a national champion. He also tamed TNK-BP, a joint venture between BP and a Russian consortium. Although the venture was vital to BP’s long-term commercial interests, it was marred by sustained in-fighting between the petroleum giant and its Russian partners. BP eventually ended up with a stake in Rosneft itself.

Ukraine became a particular focus for Putin after the Orange Revolution in 2004, which opened up the possibility that Russia’s neighbour might one day join both the EU and Nato. Putin pursued a careful medium-term strategy to bring it back under Russian control. Energy was again the key. To get round the stranglehold Ukraine had over the route for Gazprom’s exports to Europe, Russia developed what has become known as its “bear hug.” It applied pressure directly through Gazprom’s prices and contracts, and indirectly promoted alternative pipelines—first the Nord Stream, which runs beneath the Baltic Sea, and then the South Stream, running under the Black Sea—in order to isolate Ukraine. (Twice, in 2006 and 2009, supplies to Europe were interrupted by the Russians, and in between Russia punished Georgia by invading the breakaway republics of South Ossetia and Abkhazia in 2008, reminding the Ukrainians in the process who had the tanks.

To make his overall strategy stick, Putin needed both luck and friends. Luck came in the form of a continually rising oil price, and, since Russian gas contracts are indexed to the price of crude oil, a rising gas price as well. The dire state of Russia’s finances at the end of the 1990s—it went bust in 1998—began to improve and oil and gas prices rose almost continuously from 2000 onwards. The economic fundamentals for Putin were the exact opposite of those Yeltsin had had to contend with. Without the steady rise in oil prices, Russia would be merely another mid-ranking economy faced with a classic “resource curse,” unable to use its natural assets to boost growth.

Putin’s friends turned out to be a mixture of personalities, corporate interests and political operators—the sort of eclectic network of influence beloved of the KGB, whence Putin and many of his associates came. In Ukraine, oligarchs controlled the pipelines and the contracts. There was no market but, as in Russia, a form of “crony capitalism.” A shadowy company in Switzerland half-owned by Gazprom appeared at one stage to be in control of the pipeline. From the outside no one could really see what has been going on. And that is the way Putin likes it.

In the cases of Nord Stream and South Stream, the game has necessarily been more corporate, as western companies cannot get away with the sort of secrecy that is normal for their Russian counterparts. Both pipelines are aimed at undermining Ukraine, and both involve key European energy companies, some of which are partly state-owned. Nord Stream is 51 per cent owned by Gazprom, with the rest split between German, French and Dutch companies. South Stream was initially shared between Gazprom and Italy’s Eni, with French companies joining later. More generally, almost all the major European energy companies have some “relationship” with the main Russian national champions—and therefore much to lose from offending Putin, and from the possible imposition of sanctions by the EU.

The story of Nord Stream shows how these things work. The facts are very simple: Russia and Germany agreed to build this pipeline around the outside of the Baltic states and Poland. It creates a direct link between the two countries, isolating a number of EU member states (Estonia, Latvia, Lithuania and Poland) in the process. They have to contract directly with Russia for their gas, rather than doing so under the protective umbrella of Germany. This creates dependency and vulnerability. It is a classic Putin tactic.

The pipeline was given German government approval during Gerhard Schröder’s chancellorship (1998-2005), an example of the longstanding special relationship between Germany and Russia which spans the supply of oil to Germany at the outset of the Second World War, the “Ostpolitik” of German chancellors Willy Brandt and Helmut Schmidt in the 1970s and now the deep symbiotic relationship between large corporates in both countries. A few weeks after granting that approval, Schröder emerged as Chairman of the Nord Stream pipeline company.

He subsequently played a key role in many of the biggest Russian energy deals. He chaired high level meetings with Gazprom and other Russian interests, joined boards, became a “trouble-shooter” and has spoken and written extensively in defence of Russia and Putin. Schröder personifies the special energy relationship between Germany and Russia.

When the latest Crimean crisis blew up—or rather when Putin decided to seize the opportunity created by the unexpected Ukrainian revolution earlier this year—almost all of his strategy was in place. Gazprom and Rosneft, which were now under his control, dominated Russian energy production and sales, Nord Stream had been built and South Stream was in development. Relations with European and especially German corporate interests were such as to reduce the chances of meaningful sanctions being imposed. Putin could therefore reason that Crimea might now be safely absorbed and Ukraine’s chances of genuine independence, let alone Nato and EU membership, made all but impossible.

Faced with Putin’s clear and coherent strategy, and the monopoly power of Gazprom and Rosneft controlling the oil and gas monies, what did the Europeans do? The answer is that they largely played into Putin’s hands, even though this was hardly their intention.

For much of the 1990s, the EU treated Russia as if it were a candidate for membership, expecting it to evolve gradually into a western-style democracy, adopting European laws and practices. It would, Europe’s leaders assumed, become just another European democracy.

This played out in the energy sector with the demand that Gazprom should open up its gas networks to third-party access, as required by the European Internal Energy Market networks directives, and that Russia should ratify the Transit Protocol of the Energy Charter Treaty. After Putin’s election in 2000, and with the confidence that rising oil and gas prices brought, the monopolisation of pipeline access by Gazprom proceeded apace, as BP was to discover. The terms of the latter’s gas assets licence meant that it needed access to Gazprom’s pipes. The Russian company did not cooperate, and in the end BP lost its those assets. Meanwhile, another global player, Shell, was squeezed by environmental regulation covering the development of its Sakhalin-2 oil and gas plant. Putin’s strategy of using a combination of Gazprom’s market power and the selective application of Russian law worked. If the Europeans thought they could dictate what Putin did in Russia, they were soon disabused.

The Europeans gradually learnt their lesson and eventually gave up lecturing the Russians on how to run their own affairs, moving instead towards accommodation. Russia was not going to join the European club as long as Putin ruled over it. He regarded Russia as a great power, not a prospective member of the EU. Schröder understood this, whereas Tony Blair and George W Bush, who claimed to have been able to get a “sense of [Putin’s] soul,” had been naive in their dealings with him when in power.

Europe had several options: it could develop alternative pipelines and supplies; it could diversify away from gas; it could develop security measures to support any country exposed to Gazprom; it could enforce competition law, preventing price discrimination; and it could act as a central buyer. In other words, it had considerable room for manoeuvre.

The Europeans’ geopolitical play was the Nabucco pipeline project—to bring gas from the Caspian Sea to Europe through the “Southern Corridor,” which runs across Turkey. The plan for the Southern Corridor, sketched in an EU “Energy Security and Solidarity Action Plan” published in 2008, posed a substantial threat to Gazprom, whose bear hug of Europe depended on getting the Caspian states to send their gas north to Russia, and then via Gazprom to Europe. These former Soviet states were naturally nervous of offending Putin, and they needed the kind of security the US had provided for the earlier Baku–Tbilisi–Ceyhan oil pipeline after it opened in 2005. Europe did not give it, and the EU did not directly invest in the project. Furthermore, the EU never really understood that there was a link between the treatment of Turkey—the key transit country—in its EU accession negotiations and the vital energy corridor the Turks could provide to buttress Europe’s energy security.

Europe’s attempts to diversify away from gas were half-hearted too. Instead of taking the Gazprom bear hug seriously, the Europeans focused largely on “world leadership” of the climate change debate, and adopted the “20-20-20” targets, on the ludicrous assumption that climate change could best be addressed by policy targets which all added up to 20. Decarbonisation for the Europeans meant building lots of very expensive solar panels and wind farms. These had virtually no impact on climate change, added little to security, and their effectiveness was in any event blunted by Germany’s decision to abandon nuclear power. Ironically, the one form of diversification which did make a difference was the dash for coal, notably in Germany and the UK. It is hard to think of anything less green than coal.

Collective security ought to be something Europe is good at. Solidarity has always been a central theme of the European project, after all. But when it comes to gas, it is noticeable largely by its absence. Not only did Germany bypass Poland and the Baltic states, but Europe as a whole failed to develop a mutual support programme and thereby frustrate Gazprom’s divide-and-rule strategy. Gazprom discriminates on the basis of the ability of the customer companies and countries to gain access to alternative supplies. A “band of brothers” approach would have made such discrimination much more difficult. But Europe did little to stand behind its frontline members in the east.

Making solidarity credible requires the ability physically to provide the necessary support. That requires common access to storage and the willingness of allies to provide emergency supplies. Not much of this was evident when Gazprom turned off the tap to Ukraine in 2006 and 2009, and little has been put in place since then. In an energy emergency, the lack of a serious plan was made painfully apparent.

A more formal version of the “band of brothers” approach would be for the Europeans to set up a central buyer agency and negotiate as a single entity with Gazprom. This would stop Gazprom’s discriminatory games—there would be one price for all. It would be a bold move—probably too bold for the Germans and the Italians, and even the French, to countenance.

A similar outcome could be achieved by applying competition law to Gazprom. While the Europeans may not be able to tell Gazprom what to do in Russia, they can decide the rules in Europe. European competition law prohibits price discrimination and the exploitation of market power. Gazprom regularly engages in both. The good news is that the EU’s Directorate-General for Competition has finally steeled itself to launch an investigation. It remains to be seen whether it will act decisively on the evidence it receives.

The annexation of Crimea and the price hikes imposed upon Ukraine by Gazprom are a wake-up call. There can now be little doubt of Putin’s strategy. It is a clear, robust pursuit of Russia’s national interest, at least as Putin sees it. The strategy has an inner logic: because it is a resource-based economy, monopolising its production and supplies, acting as a price discriminating monopolist and encouraging dependence are all rational economic strategies.

At the recent European Council meeting in March, the first tentative steps were taken to face up to this reality. The Council agreed to draw up a plan by June to reduce European dependency on Russian gas. If it means what it says, then the necessary steps are obvious—and challenging.

The essence of the plan is to confront Gazprom’s monopoly of supply with a monopoly of demand. Seller power needs to be confronted with buyer power. Out should go long-term take-or-pay contracts, indexed to the oil price. Terms should be the same for all EU member states.

Gazprom might complain, but its hand is not quite as strong as one might think. Russia needs to sell gas to Europe for a long time to come. It needs the money. Oil and gas prices may have been rising since Putin came to power, helping to finance his regime, but they might not carry on going up. The bigger revenues have disguised the sheer inefficiency of the Russian economy. They have now been spent. Russia under Putin is addicted to oil and gas, and the threat of the loss of market share is already alarming Gazprom. The coming of shale gas is encouraging it to renegotiate its contracts. It is not fanciful to imagine a combination of falling oil and gas prices bringing the Russian economy to its knees—as happened in 1998.

Russia does have other markets—notably in China and the Far East. But for all the opportunities, there are problems there too. China is not likely to be the soft touch that Europe has been in negotiating prices and contracts, and the geography is very challenging. There are other suppliers in central Asia, too. It would take years for Russia to replace its European markets, and in any case, it still cherishes its European heritage. The ghost of Catherine the Great and Russia’s pretensions to be a European power have not been laid to rest.

To reinforce Europe’s buying power, the EU needs to develop its own antidote to the bear hug. Less dependency means alternative supplies, and Europe is surrounded by other gas resources. To the north, Norway is one obvious partner. Then there are the north African countries—notably Libya and Algeria. To the southeast there are not only the Caspian supplies, but big potential reserves in northern Iraq and Iran. There is liquefied natural gas as well. But it takes determination, political will and deep strategic alliances to make these supplies long-term, stable realities. This is the sort of thing European foreign policy needs to focus on.

Long-distance strategic pipelines do not tend to get built by the private sector alone. If Europe is serious about the Southern Corridor, it needs to put money on the table. The sums are not huge. Nabucco, for example, would have cost not much more than the twin nuclear reactor planned for Hinkley Point on the Somerset coast—a small price to pay for limiting Gazprom’s power. Indeed, the lower prices that Gazprom might be forced to accept as Nabucco supplies cut into its market share might even pay for the pipeline.

Next, Europe needs to decide how much it really cares about the frontline states. Take Poland as an example. Here is a country dependent on coal for over 90 per cent of its electricity generation. Germany has deliberately bypassed it with the Nord Stream pipeline. Applying the “20-20-20” targets to Poland means it is effectively being forced to abandon coal. But for what? Gas direct from Russia?

What the eastern members of the EU need is a credible energy supply. Wind farms and solar panels do little to solve the basic problem. They need liquefied natural gas terminals and perhaps new nuclear power stations. They need credible back-up supplies to call upon in the face of threats, and this requires a coherent emergency procedure that would allow them to withstand the pressures.

Germany’s special relationship with Russia is a major impediment to a serious European strategy, however. German corporates are lobbying hard against sanctions, German energy companies are urging caution and understanding and the German government has its foot firmly on the brake when it comes to real action.

Putin’s strategy has worked: Germany is not the only European country Russia has captured. Europe is not merely timid, it is also divided. So far, the gas has continued to flow, unlike in 2006 and 2009. In all likelihood, and despite a lot of brave rhetoric, nothing much will happen. It may take much more than the annexation of Crimea for things to change. An invasion of eastern Ukraine might do the trick, but even then there will be powerful voices urging caution. Putin is right: Europe is weak.

It remains to be seen whether Europe can summon the courage to act. The eurozone crisis has sapped solidarity and left Germany as the dominant power. European energy policy may default to “every country for itself.” That is familiar territory, at least. But it need not be like this. There is nothing particularly complicated about designing a credible European energy policy. It just takes that scarce resource—political will.