Paying the piper: Gazprom stokes Europe's concerns

As Russia again threatens to cut Ukraine's gas supply, Sarah Arnott surveys a battleground of economics and power politics

As Ukraine and Russia lock horns in their annual tussle over gas bills, Gazprom's ambitious pipeline programme is stoking Europe's concerns over its eastern neighbour's dominance of energy supply routes.

The government-controlled Russian gas giant is threatening to turn off Ukraine's supply on 1 January if Kiev does not pay the outstanding $2bn (£1.4bn) of arrears. It could also more than double next year's charges.

Viktor Yushchenko, the Ukrainian President, said yesterday afternoon that the country had starting paying down the debt. But the claims were met with scepticism by sources close to the talks, who said negotiations between Gazprom's deputy chief executive, Alexander Medvedev, and Oleh Dubyna, chief executive of Ukraine's Naftogaz, were likely to continue through the night.

Possibilities under discussion include offsetting the debt with Gazprom's fees for sending gas for Europe through Ukraine. "One option is to use the pre-payment for transit and thus the debt would be covered," Sergei Kupriyanov, Gazprom's spokesman, told a press conference yesterday.

Russia and Ukraine fall out over gas every winter. Each time, concern ripples through Europe that the 25 per cent of its gas supplied from Russia, all of which comes through Ukraine, may be disrupted. Gazprom attempted to allay such fears yesterday, but it still fired a diplomatic warning shot. "The Ukrainian side is demonstrating preparedness to fulfil its transit obligation in any situation and we are glad to hear that," Mr Kupriyanov said. "But at the same time we have told our European partners that the way in which Ukraine is fulfilling its obligations does not make us fully convinced that there will be complete supplies."

The annual dispute – and Europe's worried response – is just the tip of the iceberg. Although the spats are ostensibly about money, Russia is widely viewed with suspicion, and often accused of using its resources as a political club to beat opponents down.

There is an alternative view. "Russia is a very reliable supplier of gas and always has been, even during the Cold War," Louise Boddy, from ICIS Heren, the gas pricing group, said. But there is no also shortage of "evidence" seized upon by the mistrustful. The first row with Ukraine followed hot on the heels of the Orange Revolution, which brought in a pro-Western government, for example.

The inevitability of demand is one reason that gas is so politicised. The inflexibility of supply is another. Until liquefied natural gas (LNG) technology gets going, gas can only be shipped through expensive, fixed infrastructure, and it does not lend itself to storage. Pipelines are key, and plans for new ones are a battleground of economics and power-mongering in equal measure.

Russia naturally wants to maintain its strong position in the EU gas market. It also wants to establish gas supplies that bypass troublesome Ukraine – hence the Nord Stream pipeline, which runs from Russia to Germany and should be up and running by 2011. But the big plan is South Stream. Although the route is not finalised, the plan is for a network to run from Russia through Bulgaria and then branch into Europe. But Russia does not have the stage to itself. There is stiff competition from Nabucco, a rival pipe that would enter Europe from Azerbaijan via Turkey, and could ultimately extend as far as Italy and Austria. The stakes are high, and although diplomatic project leaders maintain that the schemes are complementary, experts agree that there is unlikely to be sufficient gas to need two major new pieces of infrastructure.

Nabucco is backed by both Europe and the US because it provides an alternative to dependence on Russia. Although there are no supply contracts yet in place, negotiations are under way with Azeri groups and ultimately – geo-politics notwithstanding – the new infrastructure could even be used to ship gas from Iran. The result would be both additional energy security and lower prices.

Moscow, not surprisingly, is not so keen, and is manoeuvring hard to ensure its pet project comes out on top. "Russia wants to gain control of EU pipelines, and because Nabucco competes with South Stream, it is using all its influence to prevent its construction," Jonathan Simpson, a partner at Paul Hastings, the international law firm, said.

Just before Christmas, Gazprom clinched the deal to buy Serbia's state-owned oil and gas company for $400m, on the condition that South Stream get the go-ahead to be built through the country. And there are widespread rumours that Mol, the Hungarian energy group angling for a majority share in Croatia's Ina, is only doing so in order to sell it on to the Russians.

"The view in the market is that Mol has agreed with Russia to sell its interest, and if Russia controls Serbia and Croatia, in oil and gas terms, then it controls the Balkans," Mr Simpson said.