Gas flare-up may light way to a cohesive EU energy plan

Wrangling between Russia and Ukraine has left their western neighbours cold, but it will cost them dearly if Europe chooses to seek alternative sources

Bulgarians freezing in their Soviet-era flats, Czech workers sent home because there is no power in the factory and Britons faced with higher gas bills – these are all victims of the Russia-Ukraine gas dispute. It is not, however, Bulgaria, the Czech Republic or Britain, no matter how bad the short term pain, that are the biggest losers in this dispute, but Ukraine and Russia.

Both countries depend on the EU as a market for gas. Russia's Gazprom relies on it for more than two-thirds of its revenues, while Ukraine gets a multi-billion-dollar flow into its coffers for allowing 120 billion cubic metres of gas to cross its territory.

The longer this dispute goes on, the more it is wrecking their commercial reputations. Unless it is ended soon, and measures are put in place to ensure it does not happen again, this argument will force the EU to adopt measures to reduce Moscow and Kiev to suppliers and shippers of last resort, damaging both economies.

The core of the dispute concerns the supply of gas to Ukraine. Gazprom wanted to increase the 2009 price from $179.50 to $250 per 1,000 m3. Gazprom argued that it was, in effect, subsidising Ukraine as prices in western Europe were reaching $500 per 1,000 m3. Ukraine's national energy company, Naftogaz, responded that as gas is linked to oil prices, gas prices were now going to fall so there was no justification in pushing gas up too far. Naftogaz also pointed out that Gazprom paid less for transit across Ukraine and storage than it would in Western Europe – hence any deal would have to see corresponding rises in transit and storage costs.

This ostensibly commercial conflict should have been relatively easy to resolve and it should not have had an impact on anybody else. Belarus and Bulgaria, with much less leverage than Ukraine, managed to strike transparent, effective deals on gas supply. Unfortunately, the relationship between Ukraine and Russia is not just commercial, it's political, personal, geo-strategic and deeply murky.

If Naftogaz and Gazprom were acting as real commercial partners they would not have got themselves into a situation of last-minute, crisis negotiations at the New Year. They both knew that the Ukrainian supply contract ended on 31 December and that a new contract had to be agreed. Why wait to the last minute to try to do a deal? Was Ukraine determined to fight it out with Gazprom because it had stockpiled vast amounts of gas in its underground storage facilities and could sit out the winter? Is this really an internal Ukrainian political game over whether Prime Minister Yulia Tymoshenko or President Viktor Yushchenko wins the next presidential election?

Gazprom admits to substantial reductions in gas flow through Ukraine. However, it claims that it only did this after Ukraine diverted Russian gas for its own use. Cases of Ukrainian gas theft were documented in the mid 1990s and 2000, so that is possible, but as Naftogaz has stockpiled so much gas, does it need to steal the Russian's? Are Gazprom's cuts in supply aimed at increasing pressure on the EU to intervene and force a deal over the supply contract between Russia and Ukraine? And if Russia is able to fix the blame on Ukraine, will that help it achieve its aim of cutting off Ukrainian hopes of EU membership, keeping it firmly in the Russian sphere of influence.

To make matters less clear, there is the role of the gas middleman, Rosukrenergo, which appears to make huge profits for doing little beyond delivering gas from Russia and Central Asia to Ukraine. Both sides of the dispute say they want to get rid of the middleman. But is Rosukrenergo fighting back and prolonging the dispute?

In the murky world of Ukrainian-Russian energy politics, with the background drama of Russian grief at losing Ukraine, seen by most Russians as an integral part of their state, who is right and who is wrong is difficult to gauge. What is certain is that this dispute has sent shockwaves across Europe. It has put energy security at the forefront of policy. Higher prices and freezing homes because of a dispute between unreliable suppliers and shippers is unacceptable.

Unless there is a step change in the approach to gas supply and transit by Russia and Ukraine, Europeans will have to take expensive measures to transform their energy markets. The first step EU states can take, individually and with some co-ordination, is the development of sufficient storage capacity. The UK in particular has little capacity, which leaves it vulnerable to rapid price rises caused by a supply shortage. Already, gas prices here have gone up far more than in continental Europe in response to the crisis, even though Britain takes little Russian gas (less than 2 per cent of consumption), because, with too little storage, the UK is reliant on volatile spot markets.

Second, the EU has already started to implement a plan for a single market in energy. The plan needs to be pushed forward rapidly. An all-European energy market will be less reliant on one major supplier. If gas is required, it can be pumped in from east or west, from liquid natural gas facilities or piped in from non-Russian sources such as Norway, Algeria, Libya or Egypt. The EU has also looked at increasing its support for the Nabucco pipeline which will ship gas from Central Asia to Europe via Turkey not Russia.

Third, and more broadly, the crisis puts a premium on the EU's energy efficiency and alternative fuels policies which will allow members to switch out of gas. Greater investment in renewable technology, clean coal and even nuclear power needs to be considered and then acted on to provide more reliable fuels than Russian gas shipped across Ukraine.

Did no one in Gazprom's headquarters think what a terrible message they were sending to the Europeans by severely cutting the supply of gas to Ukraine, which could have knock-on effects in Europe? Taking steps which could have such disastrous consequences for the market where you generate two-thirds of your revenues is not good business even if it makes some twisted political sense.

Both sides need to end their dispute rapidly, put in place measures to ensure that the crisis is not repeated, reassure Europeans, and ensure Russian gas is not reduced to "last resort" status. First, Ukraine and Russia need to put in place an effective, transparent and internationally monitored contract negotiation system for gas supply with a proper dispute settlement mechanism and international arbitrators. Second, the transit system needs to be internationalised. Ideally, the way to do so would be for both states to agree with the EU to finally adopt a Transit Protocol to the Energy Charter Treaty, which would provide a tough, transparent regime for the shipment of gas across national borders, with an enforcement authority and independent tribunal.

Professor Alan Riley is LLM director at the City Law School, City University