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Ukraine’s Natural Gas Transit Talks: Scant Progress as Supply Cutoff Looms

An under-appreciated development in Ukraine’s energy sector holds major political and economic implications for the country, its neighbors, and the broader European region.

The Druzhba pipeline (Skole district, Lviv region). Image courtesy of участник Водник © 2011

On September 19, officials from Ukraine, Russia, and the European Union (EU) met in Brussels for trilateral talks to discuss how the two countries might extend an agreement for natural gas transit that is set to expire at the end of this year. If no agreement is reached, Russian gas could cease to flow through Ukrainian pipelines toward Europe beginning on January 1, 2020.

While the most recent meeting’s outcome was essentially inconclusive, a subsequent meeting is planned for late October, when stakes will stand even higher than they do today as the agreement’s expiration date approaches. The political and economic effects of such a cutoff could worsen an already fraught relationship between Ukraine and Russia—who are fighting a low-intensity conflict in Ukraine’s Crimea and Donbas regions—and complicate the energy landscape for the countries’ customers and neighbors.

Politics are determining the immediate present of Ukraine’s gas transit position. The April election of Volodymyr Zelenskiy—who campaigned on promises to end the conflict with Russia and to tackle corruption—has charged the country with a sense of optimism, while the success of last month’s Ukraine-Russia prisoner swap has given Zelenskiy a decisive early political victory. Ukraine wants to build on the fresh momentum to alter the commercial terms of its ability to transport Russian gas to European customers that lie beyond Ukraine’s western border. The country hopes to sustain long-term gas deliveries, a $3 billion/year business and a major tax revenue source via the state hydrocarbon company, Naftogaz. Ukraine’s desire to one day join the EU has led to a raft of energy-related reforms, not least the establishment of the Main Gas Pipelines of Ukraine (MGU). The organization will act as an independent regulator and will help ‘unbundle,’ or demonopolize, the Ukrainian energy sector in line with the EU’s requirements on energy market liberalization. If the September 19 meeting resulted in any concrete progress, it was that Ukraine agreed bring the MGU into force by January 1.

The meeting’s parties also committed to a framework of EU rules for further discussion on how gas transmission capacity is reserved. This means, in layman’s terms, that both Ukraine and Russia have accepted to operate on a basis on EU regulations to decide which gas providers—whether Naftogaz, its Russian counterpart Gazprom, or any other company—can reserve space in Ukraine’s pipeline system. The rules will likewise determine how much capacity each player can reserve. Gazprom had insisted that discussions include a “reasonable” tariff, or usage fee, for its future contracts with Ukraine’s pipelines.

This in-principle agreement among Ukraine, Russia, and the EU—on the questions of who can use Ukrainian pipeline space, and how much gas can pass through Ukraine—notches a small but tangible improvement in Ukraine-Russia gas relations. It should provide a modicum of reassurance to European customers and countries that depend on continued cooperation between the two formerly Soviet states.

The economics of the gas transit story look grimmer by comparison. Gas stakeholders on every side are bracing for the worst, meaning a total cutoff of Russian gas to and through Ukraine. Gazprom has been increasing its gas storage across Europe. The stockpiled gas would allow Gazprom to fulfill its contracts to supply customers in the region if a Ukrainian route ceases to exist. Ukraine is likewise storing gas in record quantities, mostly to ensure that domestic customers are not literally left in the cold in the event of a mid-winter supply disruption.

Longer-term, Russia is striving to free itself of dependence on Ukrainian gas transit completely. The country is funding projects including: TurkStream, which traverses the Black Sea and would deliver gas to Europe via Turkey; deliveries to Europe via ships from Russian gas terminals along its Arctic coast; and the Nord Stream 2 project, an expansion of an existing pipeline to Germany’s Baltic coast. The scale and speed of these projects suggest that Russia is determined to work around Ukraine for good, even Russia continues to depend on Ukraine in the near term. Ukraine’s economic health hinges in large part on the continued revenues from Russian transit fees that support public coffers; Ukraine derives as much as four percent of its total GDP from Russian gas throughput.

The behind-the-scenes gas discussions between now and the October meeting will focus on technical issues, such as the design of a transit tariff that both Ukraine and Russia can agree to before any kind of transit contract extension. Barring progress on a substantial Ukraine-Russia gas deal, the parties will have precious little time to return to the drawing board. Their success, or their failure, will impact the European countries and industrial players that depend on Russia’s westbound gas. Ukraine’s ongoing energy reforms will shape its overall progress to a future within the EU. The outcome of the Ukraine gas transit story could to take Europe and its broader region by surprise, either before or after a potential gas cutoff to start the coming decade.

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William Fleeson

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