ICIS EXPLAINS: EU, Russia and Ukraine's gas transit negotiations

Author: Aura Sabadus

2019/09/23

By Aura Sabadus

BUCHAREST (ICIS)--Ukraine, the European Commission and Russia resumed negotiations on 19 September over the possible extension of a gas transit contract through Ukraine from 2020.

The results of the discussions will have implications for gas deliveries to Europe and Turkey, the long-term outlook for European supply dynamics, the liberalisation of the Ukrainian gas sector and political risk in eastern Europe.

1. What has been discussed?

The issues discussed during the trilateral talks hosted by the European Commission in Brussels on 19th September included:

- the extension of Russia’s transit contract with Ukraine as the existing 10-year agreement expires on 31 December 2019

- the unbundling of the Ukrainian incumbent Naftogaz

- a Stockholm arbitration award which requires Gazprom make a net $2.6bn payment, exclusive of interest, to Naftogaz for underdelivered gas.

2. What does each party want?

Ukraine is fighting to retain its historic role as Europe’s main transit route for Russian gas, insisting on extending a long-term transit agreement for Russian gas to European countries.

Russian transit gas has provided some $3bn in revenue for Ukraine annually, which amounts to just over 2% of its GDP, allowing Ukraine to lower maintenance cost for its vast and complex transmission system. Losing that income would mean a burden on the budget for maintaining the pipelines as well as higher gas prices for end consumers, who would ultimately have to underwrite the bill.

For its part, the commission has been asking for a new 10-year transit contract with a guaranteed minimum annual transit volume of 60 billion cubic metres (bcm) and an additional flexibility of 30bcm/year. The Ukrainian transit route has been favoured by many European customers because of the flexibility granted by the Ukrainian transmission system.

The commission has also been pushing for the unbundling of Naftogaz, insisting that the divestment of the transmission arm under EU rules would be a precondition for successful negotiations.

Although more than a third of Russian gas to Europe has been crossing Ukraine in recent years, Russia has been keen to discontinue this route and divert volumes to Nord Stream 2, a new 55bcm/year corridor linking Russia to Germany via the Baltic Sea. The reason has been largely political as Moscow has sought to reduce its dependence on Ukrainian transit for supplying gas to Europe.

Russia, for its part, wants to ensure that if it were to sign a new long-term transit contract, it would do so with an independent transmission system operator.

3. What are their strengths and weaknesses?

Ukraine’s negotiating position has been boosted this month after the European Court of Justice ruled to limit Gazprom’s use of OPAL , a pipeline which connects directly with Nord Stream 1, carrying Russian gas via eastern Germany into the Czech Republic. Russia had planned to use the 32bcm/year OPAL for Nord Stream 2 flows once they become available. However, as Gazprom’s share of the pipeline has now been curtailed to 12.5bcm/year, Russian flows to eastern Europe via the Nord Stream-OPAL corridor will be limited. This strengthens Ukraine’s position as the principal transit route to central and eastern Europe. Ukraine’s position is also boosted by the fact that the commissioning of Nord Stream 2 may be delayed because of issues linked to obtaining construction permits in the Danish economic zone of the Baltic Sea.

Finally, Ukraine may also retain its exclusive transit route of Russian gas to eastern Europe and Turkey as the proposed TurkStream, a 31.5bcm/year corridor feeding the Turkish and CEE gas markets is likely to be delayed at least until the second half of 2020 because of legal issues linked to the Bulgarian leg of the project.

On the downside, Ukraine is unlikely to find alternative replacements for Russian gas in the immediate future, which means that securing a long-term contract is imperative.

Russia was expected to call the shots in negotiations, but the latest OPAL ruling has dented its strength. Its two projects – Nord Stream 2 and TurkStream - are also under threat from US sanctions as Congress has prepared a bill which could penalise anyone who sells, leases or provides pipe-laying vessels that would be used for the construction of the two projects. The construction of the pipelines is already advanced and the bill is yet to be passed by the House of Representatives and the Senate. However, the mere threat of sanctions may deter potential suppliers and possibly delay the projects further.

Despite all this, Russia continues to hold a trump card at the negotiation table – its gas. It knows that although Europe has been ramping up its imports of LNG in recent months, consumers still depend on it to a large extent, while Ukraine needs the transit. For that reason, it is unlikely to agree to concessions easily.

4. What was agreed on 19 September?

The commission said both sides agreed in principle that a future contract would have to be based on EU law. In essence, that would mean booking capacity in line with the EU’s network codes. It also said Russia had asked for assurances that Ukraine, as a member of the Energy Community, would harmonise its legislation with that of the EU. Russia’s eagerness in seeing Ukraine transposing EU rules may come as a surprise. But it shouldn’t. Under the EU’s network codes, Russia could book Ukrainian transmission capacity on a short-term basis – daily, monthly, quarterly or yearly. This means Russia would not be under any pressure to sign a long-term contract, but could book capacity on a short-term basis, at least until Nord Stream 2 and TurkStream would be ready for commissioning. It would also have enough flexibility to book capacity in Ukraine as and when convenient, should problems occur in the transit of gas via Nord Stream, TurkStream or the Yamal corridor via Belarus and Poland.

Of course, it is yet unknown whether the off-take points for European consumers would continue to be on Ukraine’s borders with Hungary, Romania, Slovakia and Poland or whether they would be moved to Ukraine’s borders with Russia or Belarus. Some high-profile western European energy companies are thought to be exploring the possibility of receiving their volumes directly on the Russian-Ukrainian border. However, there are no indications that this may actually materialise under a hypothetically new deal.

The takeaway conclusion from the latest round of talks is that all parties would agree to a possible transit under EU rules. It is the picture-perfect message that all three have been keen to send out.

The commission would be seen as having done its homework in getting Ukraine to implement EU rules.

Ukraine would tick the EU compliance box, while Russia would get enough flexible options.

5. Duration and volumes – what next?

In order to make it worthwhile, Ukraine would need to secure a long-term contract for volumes that would be large enough to guarantee current revenue levels. The commission has proposed a 10-year agreement that would guarantee a minimum transit of 60bcm/year and another 30bcm/year flexibility. Altogether this would amount to 90bcm/year, or just 4bcm/year more than the maximum combined volumes that could be shipped via Nord Stream 2 and TurkStream, the two Russian-backed projects designed to divert the current Ukrainian transit via the Baltic and Black Seas.

If Russia accepts the commission’s offer to transit at least 60bcm/year via Ukraine, it would either have to ship fewer volumes via Nord Stream 2 and TurkStream or agree to ramp up its exports to ensure that the two projects which are now nearly complete are profitable. The idea may be tempting to Gazprom particularly at a time when it has been losing European market share to LNG supplied by foreign companies as well as rival Russian outfits such as Novatek. Nevertheless, the latest European Court of Justice decision to curb Gazprom’s monopoly on the OPAL pipeline could thwart any ambitions for expansion.

6. And what about tariffs?

The attraction of the Ukrainian transmission system has been its flexibility. The other inducement could be its tariffs. Ukraine offers daily, monthly, quarterly and annual transmission capacity - all at the same price.

However, tariffs had been a sticking point in negotiations not only with Gazprom, but also internally, between the existing transmission system operator Ukrtransgaz and the regulator NERC . The watchdog slashed them last year to a level where they became competitive enough to attract more companies to import and store gas in Ukraine. However, the reduction also proved harmful to Ukrtransgaz because the level they had been set at were too low to allow the grid operator to record operational costs. Ukrtransgaz had insisted at the time that NERC should have calculated them on the German NCG forward hub prices to take into consideration expenditure on technical gas bought to facilitate the transit.

So in order for Ukraine and Russia to agree on the transmission tariffs, the grid operator and the regulator would first have to agree among themselves. The issue may however be delayed because the regulator itself is restructuring.

7. Will Russia agree?

Russia had repeatedly refused to sign a new contract with Ukraine, claiming that Naftogaz was breaking EU regulations by not divesting its transmission operations as required by Brussels. It matters to Russia whether Naftogaz is unbundled because it will affect the outcome of an arbitration claim Naftogaz has made against Gazprom.

Naftogas has launched a claim for $2.6bn (excluding interest) in an arbitration awarded by the Stockholm tribunal for Russian transit under-deliveries and over $11bn in an ongoing lawsuit that would compensate Ukraine in case it loses transit. Under this latest lawsuit, Naftogaz is essentially claiming that Russia did not warn Ukraine that it was looking to build alternative transit routes - Nord Stream 2 and TurkStream – to bypass it.

As a vertically integrated company, Naftogaz owns the transmission assets. However, if it were to lose the ownership of the assets, it may no longer be entitled to make any claims in lawsuits with Gazprom.

8. What progress has been made on Naftogaz unbundling?

On 18 September, just a day before the trilateral talks, Ukraine’s cabinet of ministers (KMU) said the parties had reached an overdue consensus on the unbundling of Naftogaz after long drawn-out disputes over the form it should take. It said parties had agreed on the independent transmission operator model as opposed to ownership unbundling, which had been opposed by Naftogaz.

This means that from 1 January 2020, the operation of the transmission system operator will be handed over to MGU, a previously established shell company which will in turn operate under the control of the ministry of finance.

Ukraine’s vast storage sites, which are currently operated by Ukrtransgaz could remain with Naftogaz, although it is not clear whether the incumbent will retain full rights or may agree to allow a private operator to gain access over part of the storage capacity.

The independent operator model is compliant with EU regulations and has been adopted by Portugal for its gas and electricity incumbents as well as by Romania for its electricity grid operator.

In order for Naftogaz to retain its claims in the arbitration award, it needs, to continue owning the transmission assets, even if their operation is handed over to MGU.

If Naftogaz loses ownership of the transmission assets, it would lose its position in the ongoing $11-14bn arbitration. This is because it could be argued that the Ukrainian state company and Gazprom could cancel each other’s debt and remove the award issue entirely from the agenda. This would weaken Ukraine’s position in the trilateral talks.

The unbundling process is not complete yet.

The Ukrainian parliament would have to clarify the existing concession law in the upcoming weeks to ensure the independence of the transmission system operator.

Secondly, the certification of the new TSO by the regulator could not happen unless there were firm guarantees of unbundling. The certification process could be delayed by uncertainties related to the regulator itself as NERC is in the process of being overhauled.

Thirdly, even if the unbundling is complete, Ukraine will need to ensure the new TSO finds reliable foreign partners to oversee its operation and to guarantee the outfit is shielded from political interference or corrupt practices.

9. So then, will Russia agree to a new transit contract?

The odds for a deal look more promising now than a few weeks ago. Ukraine has covered considerable ground getting the unbundling process underway, while the OPAL ruling may hamstring Russia in its attempt to divert Ukrainian gas flows to the Nord Stream corridor.

From this vantage point, the question is not whether a deal would be signed, but what form it would take, namely whether it will be a short or long-term agreement and what volumes could be secured from 1 January 2020.

Judging by the position of the recently elected president and his ruling party, Servant of the People, Ukraine may now be more amenable to negotiations with Russia than the previous administration.

But Ukraine will have to balance its social and economic gains in the last five years with the loss of Crimea and of life in its clash with Russia in the eastern part of the country.