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Russia-Ukraine Crisis: Winter is Coming

The Pitfalls of targeting Nord Stream 2 to deter Russia in the Ukraine.




Last week in a two-hour call with Russian president Vladimir Putin, President Joe Biden made clear that there would be a heavy economic cost for any further military escalation on the Ukrainian border where a build-up of 175,000 Russian troops is taking place. Given that the White House has ruled out the use of US ground troops, economic coercion is the most visible deterrent to incentivize Putin’s return to the negotiation table.

The one action that has been most widely discussed is withholding approval of the Nord Stream 2 (“NS2”) pipeline. The controversial project, which connects Russian gas production in Western Siberia to EU consumers, had appeared on track for completion following the US-German agreement last July. However on Monday, German foreign minister, Annalena Baerbock, announced that the pipeline could not be approved until it complies with EU anti-monopoly laws, while citing the troop buildup in Ukraine, as “also a factor.” EU gas market futures in turn surged 11% on the news, reaching just short of the record high of €117.50/MWh from last October.

But how effective is preventing the startup of NS2 as an economic deterrent and what would be the potential impact for both Russia and the EU?

The NS2 pipeline is the latest transit route bringing Russian gas to the EU-27, which has a total annual gas demand of ~390 bcm of which ~40%, or 168 bcm, comes from Russia. The NS2 project doubles the Baltic Sea pipeline capacity from 55 bcm to 110 bcm per year, but there are plenty of other routes with spare capacity to the European market. An April 2021 study by the Atlantic Council showed that there was over 260 bcm/y in Russian pipeline capacity to the EU without NS2, a buffer of ~60%, raising questions on the financial justification of the project in the first place.

And although Russia failed to supply additional gas last October to beleaguered European markets, the IEA estimated that it has the ability to raise exports to the continent by an additional 15% of peak winter volumes. Given the available spare pipeline capacity, this could alleviate financial pressures on Moscow if NS2 is shut down.

Most critically, Russia has built up $620B in foreign reserves (~40% of 2020 Russian GDP) and has benefited from an +88% and +620% run-up in oil and gas prices, respectively, over the last year. That sort of war chest could further help it cushion any short to medium term impacts on loss of revenue associated with NS2.

For the EU however, the price of shutting down the NS2 is threefold. First, half of the project was funded by five of the largest energy companies in the EU, so delaying or eliminating those positive cashflows means less capital to reinvest in energy transition projects for companies already struggling to meet emission reduction targets.

Second, Germany was set to benefit from the project through annual transit fees of $2B/y since most of the gas was destined for southeastern European markets. This factor, combined with former Chancellor Gerhard Schröder’s chairmanship of the Russian owned parent company of NS2, explains why Germany has been strongly opposed to US and EU demands to scrap the project.

Finally, as portended by the rise in futures prices on Monday, the move introduces risk to a fragile European gas system already riddled by low gas storage volumes, losses of native gas sources like the Groningen Field in the Netherlands, and the strategically questionable removal of low carbon electrical generation sources like nuclear. All these factors have created an energy network that is ill equipped for supply uncertainty.

Given the ability of Russia to weather the loss of N2S and the financial pain to an already beleaguered EU consumer, the US and its NATO allies should look for alternative ways to deter Putin in what looks to be a long and difficult winter season ahead.

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