Russia is busy trying to slice and dice opposition to the Nord Stream 2 gas pipeline. Although longtime supporter Germany is the jewel in the crown, Gazprom is also keen to offer a share of the spoils to states in Central and Eastern Europe in a bid to split the EU further. Brussels may finally be altering its strategy to face up to the challenge.

Gazprom announced on April 24 that it has closed a €4.75bn financing deal for the construction of Nord Stream 2 with five major European companies, two of them German. The deal secures 50% of the project’s cost from Engie, OMV, Shell, Uniper and Wintershall, but will leave full equity in the Russian state company’s hands, which is a reaction to an injunction against the Western companies’ role in the project due to a Polish legal challenge.

It’s the exploitation of such loopholes that has critics blasting Brussels for a limp-wristed stance on Nord Stream 2. The European Commission is struggling to find legal means to halt the project, which would add a second 63bn cubic metre a year (cm) pipeline below the Baltic Sea to Germany. The first was opened in 2012.

Critics point out that EU objections successfully saw off plans for the South Stream gas pipeline and that deliveries from Nord Stream 1 were limited for years by applying EU rules to the Opal link – the onshore pipeline which carries the gas to German hubs. However, that arrangement was rejigged late last year, opening the way for greater volumes to flow.

The difference, many in CEE would claim, is that Nord Stream 2 has German support.

That’s a credible argument. But in the meantime, the EU strategy appears to have shifted somewhat. Weary with trying to block Russian efforts to build pipeline infrastructure to bypass Ukraine, and facing additional resistance from its largest member state, Brussels instead seems to now be seeking to turn the Russian tactic of divide and rule to its advantage.

Thanks to the recent compromise offered by Gazprom to avert the EU’s massive competition probe, which will allow cross-border trading between importers, member states in CEE will have greater leverage in negotiating Russian gas supply deals. That is, assuming they sign up wholeheartedly to the Energy Union and continue to improve cross-border links.

The European Commission surprised in March by announcing the proposed deal with Gazprom. It is now canvassing “opinion” from the CEE states that had previously hoped to see Brussels take a hardline approach to claims of anti-competitive behaviour by the Russian gas giant in supply contracts.

Around the same time, the Commission pushed through rules that allow the EU to be party to the contract talks of member states. However, driven by their stance demanding greater national sovereignty, and likely some less idealistic issues also, some CEE countries have resisted efforts from the EU to involve itself in such negotiations.

Yet that clearly weakens their hand in talks with Russia. Moscow is pouring huge resources into the construction of permanent links to the European market. The EU's challenge is to turn the tables by unifying that market and exploiting Russia's huge economic dependence on it.

Two-way street

While Russia supplies the bulk of gas in CEE, its role in overall EU supply - although the largest - is a far less dominant 30% or so. Meanwhile, a full 75% of Gazprom’s exports head to the European bloc. Moscow’s revenues from oil and gas accounted for over 43% of federal budget revenue in 2015.

Plugging Russia’s gas export business even deeper into the EU via yet another expensive pipeline is no one way street then, despite claims from opponents of Nord Stream 2 that it will simply increase dependence.

On the one hand, Russia hopes that boosting its supply of relatively cheap gas to the EU will help kill off the development of alternative sources such as LNG. However, it also weds Gazprom to its EU customers, offering them greater leverage on price if they stick together.

“Gas supplies are extremely dependent on costly infrastructure, delivered … via expensive pipelines,” noted the European Bank for Reconstruction and Development (EBRD) in late April. “Only working across borders can ensure that a country avoids being dependent on a single supplier of gas. Having access to a regional gas market means access to various suppliers who are competing to provide the best price. It also means better security of supply.”

The European Commission sent a letter to member states in March inviting them to voice concerns over Nord Stream 2, but also seeking a mandate to negotiate an agreement with Moscow over applying a legal regime on the offshore section. However, Brussels did not say it would seek to block the project, which is what many CEE member states would like to hear.

Instead, facing opposition from Moscow and Berlin, the commission appears to be carefully picking its fights. If the EU can’t halt Nord Stream 2, it could let Russia hoist itself by its own petard, and encourage greater unity amongst member states into the bargain.

Financial analysts covering Gazprom have cautioned against the Kremlin-driven strategy to build an additional pipeline into Europe for years. The financing deal announced on April 24 was welcomed because it will “spread some of the project risks and ease pressure on the gas giant’s capex programme over the next few years,” wrote VTB Capital.

“The ability to share costs with partners is positive for Gazprom … given that Nord Stream 2 will lead to a decrease in the value of the company,” noted BSC Equity.

Many CEE states howled with fury when the EU surprised with its compromise deal with Gazprom over the competition probe. However, the official green light for cross-border trading is a huge step towards reducing Russian leverage. It would allow virtual gas trading, meaning member states from the Baltic to the Adriatic could sell spare Russian gas anywhere in Europe.

Hand in hand with continued EU efforts to push CEE states to improve links across the region, that breaks Russia’s ability to wield its dominance of gas supply as a political weapon. During the gas wars in 2006 and 2009, some CEE states froze, while the likes of Poland and Slovakia were punished with lowered deliveries in 2015 as they sent gas to Ukraine. Under the new contract commitments, Russia would need to cut supply to the whole EU in order to reduce the volumes received by certain states.

The EU is acting swiftly to shore up the security of member states. On April 27, the European Parliament announced an deal with the European Council on new rules that open the way for countries to demand help from the rest of the bloc in case of a supply cut. The measure "will make us more secure and resilient to external disruptions and to the abuse of energy supply as a political weapon," stated rapporteur Jerzy Buzek, a former Polish prime minister.

Split

Still, Moscow continues to work at its favourite tactic of splitting individual states from the EU line as it pushes the new pipeline.

“Nord Stream 2 is yet another Russian effort to “divide and rule” in the European energy space, just what the ‘solidarity’ of the Energy Union was meant to avoid,” according to Douglas Hengel at the German Marshall Fund.

Exposing the self interest at the heart of the Visegrad Group, the Czech Republic is already in the bag, thanks to the fact that it is promised a role as a gas hub. Over 50bn cm arriving via Nord Stream 2 would be piped to the country, the bulk of it set to be sent onwards. Prague has largely remained silent while its neighbours have raised a hullabaloo.

As the operator of the mainline between Ukraine and Western European hubs, the Czech’s Visegrad peer Slovakia is the most directly exposed member state to the Russian plan. However, Bratislava has remained relatively restrained in its criticism of Nord Stream 2.

Transmission system operator Eustream has long noted a ‘ship or pay’ clause in its contract with Gazprom running until 2028. The Russian company announced in April, however, a deal reportedly worth €5.3bn that extends the agreement to 2050.

To the north, Russia is also seeking to buy off Latvia. However, Riga rejected in late April an offer that would hand the Ventspils Port a deal worth around €25mn for a role in building Nord Stream 2. While the size of the offer is small fry, it lit a fire under Aivars Lembergs, the combustible mayor of Ventspils, who is also the major shareholder in the port and a prominent leader for Latvia’s large ethnic Russian population.

On the other hand, Poland and Lithuania - which retain the most hawkish stance on Russia in Europe - will get nothing from Gazprom. The pair have both already opened their own LNG terminals to mark their intention to fight the leverage that gas hands Moscow.

However, despite bullish claims from both, they are unlikely to be able to dispense with Russian gas any time soon. Gazprom supplies 70% of the 16bn cm Poland guzzles each year and aside from the small volumes that are imported via Lithuania's LNG terminal, remains the only gas seller in the Baltic states.

The pair are spending billions on accessing alternative supplies that arrive with a higher price tag than Russian gas. Jumping wholeheartedly into the EU strategy would be a cheaper alternative, and earn greater leverage.

In fact, the stance of Poland’s nationalist PiS government is actually a boon to Russia at times. Incensed by the potential Czech role in distributing gas from Nord Stream 2, Warsaw delayed a plan to build a new cross-border link late last year, while it has also postponed an interconnector which would finally plug the Baltic states into the EU network to help end the isolation bequeathed by their Soviet history.

Soft power

Yet, as the compromise deal with Gazprom hints, the EU may have little choice but to shift its strategy to accept that Nord Stream 2 will eventually make land in Germany, and try to pull CEE states into line with the Energy Union.

The key question for the EU’s ability to block Nord Stream 2 is whether the pipeline is a commercial or a geopolitical project. The short answer is that it is both; the project is commercial for the European companies involved, but undeniably political given the Kremlin’s urge to punish Ukraine.

“From the perspective of the private European companies involved in the project, Nord Stream 2 is clearly seen as a commercial activity,” wrote Severin Fischer of the Centre for Security Studies at ETH Zurich in a report last year. “From the side of … Gazprom, it certainly has a geopolitical dimension. Whether Nord Stream 2 is a geopolitical threat or not, depends a lot on the perspective one has on the EU: is it one single market or are there 28 national consumers competing against each other?”

The long answer is a tangle of legal loopholes, realpolitik and geopolitical lobbying. The EU may be able to block the project, either via member states’ territorial rights in the Baltic Sea, or by putting its foot on the pipe once it makes landfall. However, that is a route festooned with the risks of deepening the bitter ongoing fight with Russia, which either way will remain Europe’s largest gas supplier for the coming decades at the very least, and overcoming German support.

The European Commission’s surprising recent détente with Gazprom hints at hopes Moscow will hoist itself by its own petard.

As the EU and US launched sanctions against Russia in 2014, Moscow boasted that it would simply turn to the east instead. Gazprom finally signed a gas deal with China after over a decade of trying, but it was limited, and little has been heard of the Asian tilt since.

Instead, the company has become excited again that the prime target recipients of Nord Stream 2 gas are finally raising consumption. Export data provided by Gazprom shows first quarter exports to Austria rose 67.9% y/y, with Hungary, Germany and France also buying larger volumes. Overall, Gazprom supplies to foreign countries not part of the former Soviet Union grew by 15% to 51bn cm.

The rise follows a surge in demand from EU countries last year, albeit from previous lows. That helped push Gazprom’s net profit for 2016 21% higher. The company increased sales to Europe by 12.5% to account for 34% of the EU market. The gas giant says it is targeting double-digit growth again in 2017.

However, while the rise in exports was driven by the economic rebound in Europe, Gazprom is also pushing hard to help the recovery of demand; the Russian company dropped prices to 12-year lows in 2016.

The fall in prices stems from weak global energy markets, but it can also be seen as part of a longer term effort by Gazprom to see off the development in the EU of more expensive alternative supplies.

However, the EU clearly holds significant power in the relationship, and appears to be starting to understand just how much. In the 2016 State of the Energy Union report, Russia gets just one mention.

The world’s leading proponent of soft power rarely wields its status as the largest trading bloc on the planet effectively. The awkwardness of the CEE states help perpetuate that failure. Brussels’ job is now to convince them to jump on board the Energy Union and create that leverage.

Sacrifice

However, the fact that the Energy Union was originally proposed by former Polish prime minister and current president of the European Council Donald Tusk makes that a very hard sell in Poland. The country’s current leader Jaroslaw Kaczynski is a bitter enemy who recently humiliated the country in a failed attempt to oust him.

Yet giving up on efforts to block Nord Stream 2 would sacrifice Ukraine’s role in transiting Russian gas to Europe. Gazprom claims that Nord Stream 2 will allow it to drop transit through Ukraine from around 60bn cm to as little as 10bn cm by 2020.

Again, Moscow is playing the commercial card, citing Ukraine’s lack of reliability as a transit partner as the reason for the switch. Yet the annexation of Crimea and the Russian orchestrated conflict in the east of the country clearly make the goal geopolitical also.

“Nord Stream 2 needs European political agreement on decreasing gas transit through Ukraine, and that’s what makes it a political project,” notes Polish energy analyst Wojciech Jakobik. “Decreasing Ukrainian transit will mean serious losses for Ukraine’s budget and stability.”

While the EU could offer Ukraine some compensation for the $2bn or so Kyiv claims it will lose annually should it lose its role carrying gas from Central Europe to the Balkans - potentially as part of Slovakia’s “Eastring” project - it would not make many of the losses up. Still, Kyiv signed off on a preliminary deal that could hand Slovakia’s Eustream the use of parts of its dilapidated network earlier this month.

Still, although the EU remains a keen supporter of Kyiv in its stand off with Moscow, it is also clearly tiring of the lack of reform in Ukraine, of which the massive corruption in the gas industry is a prime emblem. The EBRD warned earlier this month that the possible collapse of the country’s energy sector reform could “shatter international confidence” in the current government in Kyiv.