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Russia Wants Concessions from Ukraine for Continuing Gas Transit to Europe

UKRAINE -- FILES -- A gas pressure-gauge of the gas-compressor station in Mryn village, about 130 km of Kyiv, Ukraine, 15 October 2015.
UKRAINE -- FILES -- A gas pressure-gauge of the gas-compressor station in Mryn village, about 130 km of Kyiv, Ukraine, 15 October 2015.
Aleksandr Novak

Aleksandr Novak

Russia’s Energy Minister

"Ukraine today is not yet ready, from the point of view of changes to the existing legislation, to ensure the conclusion of the contract on terms used in Europe. In fact, the easiest option is to extend the existing contract, which was offered to the Ukrainian side."

Moscow blames Ukraine’s unfinished energy reforms for its refusal to sign a new long-term gas transit contract with Kyiv

Russian Energy Minister Aleksandr Novak told journalists in Moscow on June 13 that Ukraine is not ready to conclude a new natural gas transmission contract with Russia on terms required by the European Union. Novak was referring to the ongoing reforms of Ukraine’s gas sector in lieu of the EU’s Third Energy Package, which are not completed.

The Russian energy minister was speaking at a press briefing after his talks with European Commission Vice President Maroš Šefčovič about the continuation of natural gas transit through Ukraine after the current agreement between Kyiv and Moscow expires at the end of 2019.

Russian Energy Minister Aleksandr Novak and European Commission's Vice President Maroš Šefčovič
Russian Energy Minister Aleksandr Novak and European Commission's Vice President Maroš Šefčovič

​The European Commission has facilitated several rounds of trilateral talks between Ukraine and Russia aimed at ensuring the uninterrupted transit of natural gas from Russia to Europe via Ukraine.

"Ukraine today is not yet ready, from the point of view of changes to the existing legislation, to ensure the conclusion of the contract on terms used in Europe,” Novak said. “In fact, the easiest option is to extend the existing contract, which was offered to the Ukrainian side."

Novak’s claim is false.

An American lawyer, Myron B. Rabij, a partner at McCarter & English, told that Novak was referring to the expected unbundling of the Ukrainian gas transmission system -- i.e., separating the ownership from the operation of the gas network. The process of unbundling and subsequent appointment of an independent transmission system operator is critical to the Ukrainian gas sector reforms.

Ukraine is a member of the European Energy Community and has started restructuring its energy sector in compliance with EU’s energy and competition regulations. The country committed to implement fully the Third Energy Package under the Protocol of Accession to the Energy Community Treaty, signed in 2010 and ratified by the Verkhovna Rada.

But the process of unbundling and creating a transmission system operator (TSO), as required by the EU’s Third Energy Package, has been slow, according to Energy Community Secretariat Director Janez Kopač.

At the same time, “Gazprom is saying that it wants to sign a contract not with Naftogaz Ukraine, but with a certified TSO that does not exist, while they are trying to quickly build gas pipelines bypassing Ukraine - TurkStream and Nord Stream 2,” Kopač said at the annual Flame conference in Amsterdam last month.

“Russia’s question is in respect to unbundling,” Rabij said. “Namely, with whom is Russia signing an agreement – is it Naftogaz or is it an unbundled entity that is going to sign the agreement on January 1, 2020? It is an important question of how to make the contract legally binding if the unbundling takes place six months from now.”

Rabij said this concern is unsubstantiated: “What Russia says, however, is a nonsense because you can take care of it with one paragraph in the future contract that would stipulate that the new unbundled entity would assume all responsibilities outlined in the agreement.”

Furthermore, Rabij noted that international contracts signed by Ukrainian state-owned energy companies are compatible with the Energy Community requirements, coordinated with the European Commission and valid before European arbitration bodies. This means that if a contracting body, such as Naftogaz Ukraine, needs to be restructured after a new agreement with Gazprom is signed, that agreement would contain provisions transferring all contractual responsibilities to the new transmission system operator.

Major natural gas transit pipelines to Europe flowing through Ukraine
Major natural gas transit pipelines to Europe flowing through Ukraine

​Russian Gas Transit through Ukraine

Currently, Russia exports half of its gas to Europe and Turkey via Ukraine. If both Nord Stream 2 and TurkStream are completed, Russia will stop using the Ukrainian transit route or will need it only at peak season for small volumes of gas.

The EU has been negotiating with Moscow and Kyiv to make sure that gas supplies to Europe continue uninterrupted after December 2019. Novak assured Šefčovič that “Russia is taking a constructive position; it is ready to continue gas transit through Ukraine and ensure supplies to European customers. We are ready for the extension of the contract under the existing terms.”

Ambassador Richard Morningstar, former Special Envoy of the U.S. Secretary of State for Eurasian Energy, told “I know that the EU is very much committed to working with Ukraine and working with Russia to come to an appropriate agreement. If there is a will to make a deal between the two parties, a deal can be made.”

But the Russian energy minister only proposed extending the current contract between Gazprom and Naftogaz Ukraine, instead of signing a new long-term agreement. This would allow Russia to commit to just a short-term extension and easily suspend all gas transit through Ukraine if Nord Stream 2 and TurkStream become operational.

However, since the two pipelines have not been completed and Nord Stream 2 faces potential U.S. sanctions, Russia will still need the Ukrainian transit route after December 2019.

Novak, nevertheless, blamed Ukraine for Moscow’s unwillingness to commit to a new gas transit agreement with a country against which it initiated an armed conflict in 2014.

Russian Conditions for Ukraine

The Russian foreign minister used several other false narratives that gave away the real reasons behind Moscow’s negotiating tactics: Moscow is apparently setting conditions for Ukraine.

"If there is a constructive approach, if acceptable and economically competitive tariffs are offered, if relations are settled -- agreements on arbitration courts cases [between Ukraine and Russia], then, in principle, the transport system [of Ukraine] can be used, but we know that there are no such proposals from our Ukrainian colleagues so far," Novak said.

In other words, Moscow wants concessions on Ukrainian gas transmission tariffs and to have forgiven the $2.56 billion in damages for undelivered gas that the Stockholm arbitration court ordered Gazprom pay to Naftogaz.

EU-Russia-Gas Pipelines-Turkish Stream-TransBalkan-TurkStream
EU-Russia-Gas Pipelines-Turkish Stream-TransBalkan-TurkStream

Ukrainian Gas Transmission Tariffs

Ukrtransgaz became a participant-observer of the European Network of Transmission System Operators for Gas (ENTSOG) in 2013. The European Commission constantly monitors gas flows via Ukraine and has full access to the gas infrastructure.

As required by the EU’s Third Energy Package, Ukraine’s independent regulator determines the gas transmission tariffs. Ukraine introduced new RAB-tariffs, approved by a Ukrainian Regulator in December 2015, which are cost-reflective and based on Energy Community rules, the Ukrainian law “On Natural Gas Market” and Ukrainian RAB entry/exit tariffs methodology compliant with European regulation. After 2020, the transit tariffs can significantly decrease, due to the end of the RAB-tariffs duration, bringing them down to 3-4 times cheaper than tariffs for Nord Stream 2.

Transit tariffs in the current contract between Gazprom and Naftogaz Ukraine, which the Russian energy minister wants to have extended, are not cost-reflective. Gazprom has refused to pay the new tariffs introduced in 2015 and prefers to pay the tariffs in the contract signed in 2009.

Stockholm Arbitration

In 2015, Gazprom refused to extend an agreement to suspend its take-or-pay claims and payment demands for gas supplies to the occupied regions in eastern Ukraine until a decision by Arbitration Institute of the Stockholm Chamber of Commerce. On February 28, 2018, the arbitrators ruled that Russia’s gas giant Gazprom should pay $4.63 billion to Naftogaz Ukraine for the failure to meet minimum gas transit obligations. Since the court previously ordered Naftogaz to pay Gazprom for gas supply arrears, Gazprom’s net payment will be $2.56 billion. Naftogaz said that the interest on Gazprom's debt is $526,000 per day.

The arbitrators also decided that gas supplied by Gazprom to Ukraine’s war-torn Donetsk and Luhansk regions, which are not under Kyiv’s control, could not be billed to Naftogaz. The court reduced the take-or-pay obligation of Naftogaz from 41.6 bcm to 4 bcm per year, while ordering Gazprom to sell 5 bcm of gas to Naftogaz at the price of the nearest liquid European hub. The price is lower than the current price available to Ukrainian companies on the country’s western border.

Gazprom reacted harshly to the decision, calling it biased, and immediately returned Naftogaz a pre-paid amount for small volumes of gas ordered in the midst of a cold spell in Europe in March 2018. As the expected gas was not delivered, pressure in the gas system suddenly fell, and Kyiv scrambled to send gas to European gas consumers. Ukraine had to reduce domestic gas consumption by 14 percent and buy emergency gas supply from Poland at a higher price to ensure gas transit to its European customers, earning the praise of the U.S. State Department.

Following the arbitration decision, Gazprom announced that the company had launched procedures in the Stockholm international arbitration court to terminate its gas supply contracts with Ukrainian company Naftogaz. The Russian company also declared that it would not sign a new contract with Naftogaz once the current one expires at the end of 2019. Subsequently, Gazprom filed a request to the Court of Appeals in the Svea District of Stockholm to partially annul the final arbitration ruling regarding Naftogaz Ukraine on the subject of deliveries.

In the meantime, Ukraine started collecting the debt by requesting that Gazprom assets abroad be used as payment.

Sweden - Old Town (Gamla Stan) pier architecture in Stockholm, Sweden
Sweden - Old Town (Gamla Stan) pier architecture in Stockholm, Sweden

Can Gazprom Operate Ukraine’s Gas Network?

Instead of settling the debt to Ukraine, Russia’s energy minister went further, proposing that Gazprom participate in a future consortium that would serve as an independent system operator (ISO) in Ukraine. This proposal demonstrates either a lack of understanding on the part of Russian officials or their blatant disregard for the basic competition rules outlined in the EU’s Third Energy Package. According to those rules, an independent system operator cannot own the gas pipelines or the natural gas transmitted through them. Since Gazprom produces and owns the natural gas transiting through the Ukrainian gas transmission system, the Russian company cannot take part in operating that system.

Such disregard for the rules was the main reason the EU objected to the construction of Russia’s South Stream natural gas pipeline under the Black Sea and through the Balkans to Central Europe: Gazprom was planning to serve simultaneously as a gas producer and the South Stream pipeline owner and operator. The EU wants these functions separated in order to prevent monopolies.

Novak’s claim that Ukraine is not ready to sign a new contract on European terms seems to be a pretext for Russia to avoid a long-term commitment to using the Ukrainian gas transit route. By making such claims Moscow appears to be trying to extort concessions from Kyiv such as lower tariffs, arbitration court fines forgiveness, and inclusion of Russian Gazprom in operating Ukrainian gas network.

Gasprom dependency in Europe
Gasprom dependency in Europe