by Henrik Vorloeper
This article presents an assessment of the political and economic arguments against Europe’s current largest natural gas infrastructure project, Nord Stream 2. This project is the pipeline connecting Russia directly with Germany, Europe’s largest gas consumer and Russia’s most important customer, via the Baltic Sea. This article views the project in the context of European energy security. The European Union members are currently deeply divided in the question of EU energy security in general and natural gas supply security in particular. We would like to argue that the liberalization process of European gas markets (one of the strategies), is the preeminent way to achieve gas supply security in Europe. The case of Nord Stream 2 is almost symbolic on how deep the dispute across the continent regarding gas supply security has become. Nord Stream, next to the Greek bailout, the refugee crisis and ‘Brexit’, could become another step towards EU disintegration. The aim of this article is to overview the European dispute around Nord Stream 2 based on the five most articulate arguments against this project. While each of the arguments has the right to exist and certainly holds some truth in it, this article delivers an explanation why these things about Nord Stream 2 are not as bad as they appear to be, and why the project is benefitting European energy security.
Key words: Nord Stream 2; energy security; EU; Gazprom
Nord Stream 2 is an offshore gas pipeline project, designed to connect Russia with its main single European gas consumer, Germany, via the Baltic Sea (Figure 1). The pipeline will run from the Russian city of Vyborg (or Ust Luga) to Greifswald in Germany, in parallel to the already functioning Nord Stream 1 pipeline, which started operation in 2011. Nord Stream 2 is still in its planning and commissioning phase, but its main shareholder Gazprom anticipates the pipeline to go online by then end of 2019. The pipeline would add a capacity of 55 bcm of gas per year to the European market. Gazprom holds a 50 percent share in the project, followed by Uniper (Germany), Wintershall (Germany), Royal Dutch Shell (UK), OMV (Austria) and Engie (France), each holding a 10 percent share.
The construction of Nord Stream 2 has yet to officially start, but there are already plans for onshore interconnections into the European markets in place. According to the intention, there will be two pipelines taking a similar path as the onshore connection of Nord Stream 1: Germany’s gas transmission system operator “Gascade” plans to construct a new pipeline “EUGAL”, which will run parallel to “OPAL”, the main interconnector of Nord Stream 1 and feeds the German gas network as well as the Austrian gas hub “CEGH” in Baumgarten. The second onshore pipeline is the already existing pipeline “NEL”, which will receive a capacity upgrade, via another compressor station. NEL connects Nord Stream 1 and later also Nord Stream 2 with the Northern German network and the Dutch gas trading hub “TTF.”
Nord Stream 2 and European energy security
Very often Nord Stream 2 is labelled as a threat to European energy security. Energy security in this context refers to the stable supply of energy sources to economically reasonable prices. Natural gas is a primary and vital energy source for the EU and likely to stay important, and supply cuts would have detrimental effects for the internal security situation in Europe. Although consumption might not grow considerably over the next decade, it is still an important fuel for the heating and electricity generation sector.
The EU follows two concepts of energy security, which seem to be somewhat contradictory, despite following the same goal of a unified EU gas market. The first concept is targeted at the increase in competition in the European gas market, to be achieved through regulation. The example here is the introduction of the Third Energy Package, which among other things prevents large companies from taking a monopolistic position. Through these measures, the TEP regulation actually affects activities of Gazprom, but this is to the same extent as affecting activities of other large companies from outside of the EU. Another approach, on the contrary, is clearly anti-Russia, with reaching diversification away from Russia through large politically-driven choices. Already in these justifications, there is clear distinction between political and market aspects.
This leads to the situation that when Nord Stream is assessed from the point of view of natural gas supply security, the discussion is also characterised by the use of arguments of both political and economic nature. Opinion leaders often fail to distinguish between the market economic forces in European-Russian relations and the foreign political situation and geopolitics.
What I would like to do below is distinguish between political and economic aspects of the project. Here is the list of six most common arguments against Nord Stream 2:
- Nord Stream 2 increases Europe’s dependence on Russian gas.
- Nord Stream 2 does not contribute to supply diversification and hinders competition.
- Nord Stream 2 is not an economically viable project, because even Nord Stream 1 is not used at full capacity.
- Nord Stream 2 isolates Central- and Eastern European countries from Western European gas markets and makes them more vulnerable to Russian price dictation.
- Nord Stream 2 is a political project and aims to reduce Ukraine’s status as a gas transit state.
These arguments reflect the concerns of those who in general are wary about energy relations with Russia, which might to a large extend be based on negative experience in energy relations with Russia in the past. These selected arguments all have a certain degree of legitimacy and the aim here is neither to disagree or declare them void, but to demonstrate that the facts are not as negative as displayed and that Nord Stream 2 is a rational choice for European energy security.
- “Nord Stream 2 increases Europe’s dependence on Russian gas”
The amount of imported Russian gas is increasing throughout Europe. This is especially true for the case of Germany, which already imports around 40 per cent of its gas needs from Russia. That is the first element of the problem.
Russia can leverage dependencies either for political purposes or to exploit economic benefits as a monopolist.  In terms of political exploitation, there is indeed reason for some concern. The last time Russia used gas supply cuts for political reasons, took place in 2014, when Gazprom reduced gas supplies to Poland to the lowest limit permitted within the gas supply contract flexibility for several days. Gazprom intended to prevent Poland from supplying gas to Ukraine via reverse flow capacities, as Russia has stopped gas supplies to Ukraine. This situation has shown some peculiarities regarding changes in the European natural gas market.
Moreover, there is no immediate solution to import dependence on Russia: there are not many alternative supply sources, since conventional suppliers are either declining their production (Norway), or are unstable (North Africa), LNG supplies from the global market or pipeline gas from the Caucasus, Turkmenistan and Iran are too expensive.
Therefore, we may conclude that Europe’s dependence on Russian gas exists indeed and that dependence is hard to get rid of due to the fact that Russian supplies are among the cheapest available, with existing infrastructure etc.
However, Nord Stream 2 is not going to make this dependence stronger, but would actually improve the situation for Europe. The following four areas of development show, why this is the case.
First, Gazprom has already shown willingness and ability to make concessions in terms of gas prices. Especially for the upcoming availability of LNG, Gazprom has already stepped into are price competition to protect market share. The latter case provides evidence that Gazprom has already chosen to compete with other suppliers on the continent, even before LNG has arrived in large volumes on the EU market. Gazprom will stay in price competition as long as LNG and other sources remain an option for European customers.
Second, Germany and most of the EU have augmented the number of alternative sources of energy, primarily renewable energy for power generation. The EU’s environmental policies have reduced the role of gas as a vitally important energy source.
Third, Nord Stream 2 will back-up the already-improving interconnectivity within the EU gas network in a similar way as Nord Stream 1. For example, in a fictive and simplified scenario where Russia would cut gas supplies to Poland for a longer period of time, gas volumes delivered via Nord Stream 2 could be made available via reverse flow capacities. Reverse flow capacities between Germany and Poland already exist. If Russia wants to put political pressure on Poland, it would thus have to cut off supplies to Germany as well, to what in turn Gazprom would be reluctant to do. EU competition law restricts destination clauses within gas supply contracts, with the consequence that gas entering the European market can be traded freely within the EU. In other words, once arrived at the customer, Russian gas is not owned by Gazprom anymore. The new owner, in most cases the utility supplier, has the right to sell and distribute its acquired gas volumes freely in the EU and for other export markets. Nord Stream 2 will supply the continental European most mature gas markets of The Netherlands, Germany and Austria, where gas trade plays an increasingly important role.
Fourth, Russian gas sector is highly dependent on exports to Europe, which actually makes Russia reluctant to use natural gas supplies for political objectives. Instead, Russia has made effort to liberalize domestic market and integrate in international markets. This somewhat differs to a widely expected strategy of export markets diversification of Russia. Russia’s progress of increased presence in the Asian markets is slower than expected, so the willingness to adapt to the European concept of liberalization is likely to persist. This makes the political aspect less likely to interfere in European-Russian gas relations. Moreover, growing global trade of Liquefied Natural Gas (LNG) will pressure Russia to participate in a more competitive fashion on the global market in the future, which includes the Asian market as well.
Overall, Europe is dependent on natural gas imports, and especially on gas imports from Russia. The argument stated in the heading of the section thus holds true. However, the reason why this dependence becomes a threat to energy security loses its ground. Natural gas market conditions in Europe have gone through a substantial change during the last seven years. The increase in competitiveness significantly reduced the negative aspects of import dependency, hence also political and economic exploitation of natural gas trade. With the implementation of Nord Stream 2, the good news is that the pipeline, despite bringing more gas from Russia, is even supportive to diversification because it increases Russia’s export reliance on the European market and incentivises investments into the EU’s internal pipeline network.
- “Nord Stream 2 does not contribute to supply diversification and hinders competition”
Russian gas export monopoly Gazprom has is a major supplier of natural gas to the EU. In some Central- and Eastern European (CEE) countries, Gazprom is the only supplier. Most of Gazprom’s deliveries and handled under long-term contracts with mandatory take-or-pay levels and oil indexation. Both parameters are considered to be contradicting the free competition principle.
In order to enhance competition, the best solution is diversification of supply sources. In the case of Nord Stream 2, Gazprom still remains the main supplier, thus the objective of source diversification is not indeed the case. For the proponents of the Energy Union, supply source diversification appears to be the only option to enhance competition.
However, it is essential to look at the project in the context of the context of changing market conditions. There are two elements that make Nord Stream 2 in line with market development.
Firstly, it provides source of gas to be further delivered to the hubs (CEGH, Baumgarten), as well as to the locations that we previously supplied exclusively by direct Gazprom supplies (e.g. Ukraine via reverse flow capacity). Therefore, Nord Stream 2 does not contradict the interconnectivity / competition objectives of European gas market development.
Secondly, Nord Stream 2 does provide for the diversification of supply routes and thus provides for stronger security of supply, even if the source is still the same.
- “Nord Stream 2 is not an economically viable project, because even Nord Stream 1 is not used at full capacity”
Nord Stream 1 is currently not used at full capacity. While the pipeline is capable of bringing 55 bcm of natural gas from Russia to Germany, flows in 2015 were at 39 bcm. This leads many analysis to conclude that Nord Stream 2 is not needed in the situation when the first pipeline is not used at full capacity.
However, the fact that Nord Stream 1 is not used at full capacity is not caused by the lack of demand, but rather by regulatory restrictions. According to the TEP legislation, interconnecting onshore pipelines (OPAL and NEL) have to reserve part of their capacity open for third-party access, and in the lack thereof 50% of capacity sits idle. The reason of Nord Stream 1 underuse is therefore regulatory, not economic. Nord Stream 2 is actually under the danger of encountering the same challenges of regulatory nature, and probably they will be more complex and difficult to come through.
The argument against Nord Stream 2 claims “it cannot be used at full capacity rates as well; the investment costs do not justify the amount of unused capacity; and Nord Stream 2 in fact is a political project, for example to undermine Ukraine’s role as a transit state”. I believe that this is not completely true.
Firstly, Nord Stream 1 was not proven to be economically inefficient. The low rates of capacity utilization in the beginning of 2011 to 2012 were mostly related to problems with the interconnecting infrastructure, rather than shortcomings in demand. Nord Stream 1 has been increasingly utilized in a year to year comparison.  Gazprom appealed to the EU Commission several times, to grant an exemption of the usage of OPAL. The last time was in summer 2016, to which in the time of writing this article, the EU Commission did make a final verdict. Gazprom’s efforts provide evidence that there is an essential interest to make use of the full capacity, which will with a high probability being applied to Nord Stream 2 as well.
Secondly, Nord Stream 1 and Nord Stream 2 consortia are made of private or profit seeking companies and their investment decisions are simply based on profit maximization. Their investment decision is something that goes beyond the area or inquiry of the European Commission.
Thirdly, Gazprom is making adjustments to its business model for gas exports to Europe, and these changes may well improve the situation for both Nord Stream 1 and Nord Stream 2. Traditionally, Gazprom has been supplying its European customers through traditional LTCs with take-or-pay volumes as well as oil indexation as the core pricing mechanism. Besides introducing hub indexation in the LTCs, Gazprom has also started to test the mechanism of auctions, offering gas supplied via Nord Stream 1 on auctions for the first time in autumn 2015. Gas auctions were held since then several times and more auctions for Nord Stream 1 are planned for September 2016. In Gazprom’s most recent bid to the EU Commission on the OPAL exemption, the company asked if the unused capacity of OPAL could be offered on the European gas capacity auction platform PRISMA. If approved, this would give Gazprom the opportunity to bid for OPAL’s free capacity at capacity auctions. The same model of capacity auctions via PRISMA is applied to the NEL pipeline. This option has not yet been available for Gazprom and would make the necessity of gas auctions void. Still, capacity auctions via PRISMA, which is the running model for most of Europe’s gas infrastructure, would enabled Nord Stream 1 full capacity usage.
In conclusion: the reasons why Nord Stream 1 is not used under its full capacity is not based on economic reasons, but is of regulatory nature. The same difficulties are likely to appear for Nord Stream 2 project. However, it is questionable whether the experts and opinion makers outside Nord Stream 1 and Nord Stream 2 consortia should be concerned about the decision whether to build the Nord Stream 2 pipeline: it is the investment decision is made by the members of the consortium, and they have their reasons to see economic rationale in the project realisation. Moreover, there are some signs of improvement of the situation for Nord Stream 1 after a range of adjustments made by Gazprom, and this gives a reason to believe that solutions will also be found for Nord Stream 2.
- “Nord Stream 2 isolates Central and Eastern European countries from Western European gas markets and makes them more vulnerable to Russian price dictation”
Nord Stream 2, just as Nord Stream 1, directly connects Russia with Germany and bypasses Poland, Slovakia and the three Baltic states – this serves as the basis for the argument that Nord Stream 2 effectively isolates Central and Eastern European countries. Especially these countries that see themselves as circumvented perceive this as a general threat to their energy security.
Some of these countries are currently not only consumers of Russian gas, but also transit countries for gas deliveries to the rest of Europe. The transit status provides the country with some advantages – in particular, Gazprom is dependent on the transit country for further deliveries. The transit status also provides the country with income from transit fees, which would be reduced if gas deliveries are diverted from transit states to Nord Stream 2. Moreover, the direct link between Russia and its largest European buyers develop a sense of isolation of CEE countries from the European continent or even the EU.
An important issue to remember here is that firstly, Nord Stream 1 or Nord Stream 2 do not actually do anything to effectively isolate these markets from Western Europe. On the contrary, simultaneously the reverse flow capacities are built.
Additionally, with possibility of Gazprom’s supplies to Western Europe and CEE countries receiving their gas from the West, they might still end up receiving Gazprom gas which had arrived to Europe via Nord Stream, but with lessened Gazprom’s monopoly as their main supplier.
The concern of reduced transit fees, however, is an argument that stands against the idea of liberalization. Nord Stream 2 has the advantage that supplier and consumer are not bound on additional costs imposed by a third country. The third country that provides pipeline capacity, like Poland or Ukraine, will have to adapt to liberalization and offer transit capacities that are competitive to Nord Stream 1 and Nord Stream 2 gas transit costs.
Consequently, Nord Stream 2 would not lead to isolation. Instead, it would provide those countries that feel isolated with more opportunities to enhance supply diversification and strengthen energy security.
- “Nord Stream 2 is a political project and aims to reduce Ukraine’s status as a gas transit state”
Clearly, Nord Stream 2 construction and operation will result in reduced gas flows via Ukraine.
Ukraine will lose two important assets for the country’s internal stability. Firstly, it is political leverage over Russia in a situation where Russian-Ukrainian political relations are on the lowest level since the 1990s. Secondly, Ukraine will lose economic benefits in terms of transit fees, which annually add USD 2 Billion to the state budget. The Ukrainian state budget is already constraint due to the deteriorating economic situation, causing fragile political balance. Reduced gas flows for transit are therefore a destabilizing factor for Ukraine. In this respect, it is clear why Ukraine would like to see its status as a transit state protected.
Gazprom, however, has its valid reasons for looking at options of avoiding Ukraine as a transit state. One prominent reason to halt gas transit via Ukraine is a form of political punishment to the incumbent Ukrainian government for its “anti-Russian” politics. One more durable reason to halt gas transit via Ukraine, based on economic calculation, is that Ukraine has proven to be unreliable in several cases to provide transit security for Russian gas destined for European markets.
At the same time, Gazprom’s intention to stop transiting gas through Ukraine has to a large extent been political rhetoric. The company has already started talks with the Ukrainian pipeline owner in order to secure future contracts (beyond 2019, when the current contract expires). An agreement between Gazprom and the Slovakian pipeline owner EUSTREAM, which states that the pipeline will be utilized by Gazprom with gas flows from Ukraine despite Nord Stream 2, is the most recent example that Gazprom does not intend to stop using Ukrainian transit capacities.
Overall, political considerations for Russia’s avoidance of Ukraine’s transit pipeline cannot completely be excluded, although there is enough evidence that transit route diversification – or the so-called “transit avoidance corridor” by Gazprom – has economic reasons. It is in the interest of Ukraine and the EU that the country reduces its dependency on transit fees and thus basically from Russia. The availability of more gas in Europe a long with an improved interconnecting infrastructure improves the situation for Ukraine and both is supported if not to be made possible by Nord Stream 2.
Nord Stream 2 is an ambitious project facing a lot of obstacles, not least in terms of overall opposition from media and opinion makers. In this article, we have analysed some of these arguments and demonstrated that they are often only partly true. The most questionable aspect in relation to Nord Stream 2 is the fact that this project only provides route diversification and not source diversification. Gazprom maintains its market share in Europe and hinders other suppliers from entering the market.
However, the project itself actually contributes to overall liberalization of the European natural gas market. Nord Stream 2 increases gas supply volumes in Europe. The additional volumes increase the incentives to build new infrastructure that support interconnectivity between particular markets. Integrated pipeline network is one of the main preconditions to establish single and liberalized market.
Liberalization of gas markets is the chosen solution to provide energy security in Europe. And Nord Stream 2 does not hinder liberalization and energy security. Our main conclusion is that Nord Stream 2 in fact contributes to the liberalization process in the EU and thus supports energy security in the region.
 billion cubic meters
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