The Empire Strikes Back

Compared to the Eurozone’s public finances, European energy policy looks decidedly bright. Capacity margins are high, prices are low, even emissions have dropped of late. The EU's 'Third Package' of gas and power market reforms, which took effect in March, is set to further enhance supply security, increase competition and improve consumer choice and services. It all sounds very good, but the problem is that such 'policy hits' are grounded in weak fundamentals–not silver bullet policy making. Shale gas developments have turned LNG markets on their head, while deep seated financial frailties and economic slumps have kept fundamentals weak and growth anemic across EU27 states. That's making energy policy look good, and political populism all too easy. But with growth showing tentative signs of recovery and climate policies still placing a premium on natural gas over coal, complacency and energy populism will come with costs. Nowhere more so than on natural gas – and the 158 billion cubic meters (bcm) of Russian supply that the EU will gobble up this year. After dipping to 2002 levels in 2009, EU gas consumption has surged by 7.2% in 2010, with most analysts expecting that by 2013, demand should have rebounded to pre-crisis levels. Increased LNG shipments to Asia have already added upward pressure on prices, and Germany’s snap decision to decommission its last nuclear power plants in 2022 will sustain demand growth for the foreseeable future. The European Commission, meanwhile, has taken its eyes off the Asian ball and remains undecided how it should deal with Russia, its single largest supplier. If RWE, Germany's second largest electricity producer, and Gazprom, the world's biggest gas firm, implement their recently announced Memorandum of Understanding (MoU) and establish a joint venture to manage coal and gas plants across Germany, the UK and the Benelux countries, the EU's Third Package might well follow Germany’s 2011 decision to toss nuclear power into the dustbin of history. Thanks to European politicking, Moscow holds the energy aces. Berlin's accelerated nuclear phase out may be popular, but it is likely to add as much as 20bcm/year to German gas imports alone. The French ban on shale gas drilling is hardly going to help reduce energy dependency, while Europe's renewed commitment to democracy and good governance in its neighborhood may chime with European values, but has done little to reassure the authoritarian rulers who control alternative upstream sources in Central Asia and the Middle East that Europe is a credible energy supply bet. Any European state that follows Germany's nuclear example, emulates France's disdain for fracking, or thinks it can 'play nice' and win with suspect neighbors will simply strengthen Russia’s hand. Missing the point? Overly dramatic? Perhaps. Conventional wisdom in Europe holds that Gazprom is in deep trouble. The main reason for this relates to cheap spot markets that have been growing in liquidity. Oil indexed gas from Russia is deemed too expensive for European consumers to bear, with independent benchmarks on Western European hubs the preferred option. Move over or lose market share is the clarion call from consumers: current price spreads clearly point towards this way of thinking between UK wholesale hub and oil-indexed Russo-German border prices. Unsurprisingly, producers have been screaming murder. In 2010 Gazprom reportedly agreed to cut oil indexation levels in some long-term contracts to 85%, but insisted that the three years exemption would not change its long-term contract system. Algeria went a little further and called for the formation of a fully fledged gas cartel. So far, it was only really Norway that took price corrections on the chin by rapidly revising contractual relations to retain its stake in European supplies.You’d think that with Gazprom on the ropes and shale gas starting to blossom beyond US shores that European capitals would not offer Russia an opportunity to