Caspian Gas Is Key to EU Supply Diversification

Policy Pulse – 9 March 2022 – Veritas Global

Photo by KWON JUNHO on Unsplash

Key messages:

• The EU is right to be concerned about dependence on Russian natural gas

• Enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification

• Expected benefits to the European energy system include sustainability, security, stability, and competitiveness

On 8 March 2022 the European Commission proposed a series of measures for addressing the EU’s energy insecurity. The proposal includes both immediate and longer-term measures for addressing dependence on Russian natural gas. Crucially, the proposal identifies diversification of supply as one of the key levers for addressing EU energy security for the medium and long-term. In this context, there is an opportunity to build on the European Commission proposal and take decisive actions to diversify supply though enhancing access to Caspian and Central Asian natural gas.

Enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification

According to the European Commission, domestic supply of natural gas meets about 10% of total EU consumption and has limited scope to boost production. The EU is highly reliant on imports and has limited alternatives for diversifying away from Russian natural gas. North Sea production is at capacity and reserves have been significantly depleted, making it very difficult to maintain and grow supply. Algeria is already doing its part to supply the EU, with market share of natural gas imports increasing significantly in recent years. Suppliers of liquefied natural gas (LNG) are expected to boost production, but it is uncertain whether they can be a reliable source for meeting EU demand in the medium-to-long term. Qatar can significantly boost LNG production but is better positioned to serve markets in Asia. The US may continue to supply modest quantities of LNG to Europe, but it is unlikely to become a large-scale supplier. Fracking practices, which have been a key driver for increasing US natural gas production, are increasingly coming under pressure, including due to local environmental and health impacts. These developments raise questions about the viability of the US to sustain volumes needed to meet expected local natural gas demand while at the same time supporting large-scale exports.

The EU’s best option to diversify supply is to tap into resources in non-Russian countries of the Caspian basin and Central Asia, which are home to about one quarter of all proven natural gas reserves globally. Diagram 1 shows the largest proven natural gas reserves that exist in proximity to Europe with the size of white circles drawn in proportion to proven reserves.

Diagram 1:

Caspian and Central Asia region has the largest proven natural gas reserves in proximity to EU

Source: Veritas Global using graphics from mapchart.net and data from BP Statistical Review of World Energy July 2021

The benefits for Europe to access the vast energy pool in the Caspian and Central Asia is partially being realized through the Southern Gas Corridor, a project that was operationalized at the end of 2020 and continues to increase deliveries. However, the scope for scale-up is far greater than what is currently planned to be implemented. One of the best options for enhancing diversification of natural gas supply to Europe is to develop additional capacity that brings Caspian gas to European markets through transit routes that do not pass through Russia or other members of the Eurasian Economic Union.

The option that offers the best supply diversification benefits (known as White Stream) would bring natural gas from the Caspian to the EU. For example, natural gas could originate in Turkmenistan or in the shallow water offshore fields of the Caspian and be transported by pipeline through Azerbaijan and Georgia to the Black Sea. From the Georgian Black Sea coast, the gas could be transported by an underwater pipeline directly to Romania, where it would plug into the EU gas network (an alternative but more costly and technically complex option is to ship the natural gas across the Black Sea after converting it to LNG). The technical aspects of this project have been assessed in detail with feasibility studies supported through EU funding for common projects of interest. However, a lack of political will combined with misplaced concerns over the project’s climate change impacts has meant that the project has not received a green light despite being nearly shovel ready. The slow progress of developing this corridor has given Russia a dominant position across European gas markets and in practice has increased EU’s reliance on coal for electricity generation.

The EU has prioritized development of hydrogen-based energy obtained by using renewable energy as one of the main responses to addressing supply side dependence in natural gas markets. The EU’s hydrogen strategy, if fully implemented, targets production of up to 10 million metric tons of renewable hydrogen in the EU by 2030, which is the energy equivalent of about 5% of current natural gas demand in Europe. The European Commission proposal from 8 March 2022 sets 2030 targets that go beyond the hydrogen strategy, but these additions will have limited impact on overall natural gas demand. Between 2030 and 2050, the EU hopes that renewable hydrogen technologies reach maturity and start being deployed at a large scale. While this strategy offers an ambitious program for long-term decarbonization, it does little to address the EU’s short- and medium-term energy security needs. Even if all goes to plan, the EU hydrogen strategy implies that renewable hydrogen will not be effective at containing Russian’s dominant position in natural gas markets for at least the next two or possibly even three decades.

Expected benefits to the European energy system from improving access to Caspian and Central Asian natural gas include sustainability, security, stability, and competitiveness

• Sustainability: A key feature of the EU’s climate change mitigation strategy is to increase electrification in the economy while decarbonizing electricity generation. In significant part the EU plans to achieve this objective by deploying greater renewable energy. Natural gas plays an important role in enabling greater renewable energy deployment by offering a viable solution for addressing supply intermittency. Except for nuclear power, electricity generated through natural gas currently offers the most viable and low-carbon alternative to coal-based power as a solution for intermittency. In Europe, limiting supply of natural gas and making it more expensive in practice incentivizes the use of coal. In 2021, as natural gas prices rose, electricity generators across the EU switched from gas-to-coal leading to higher greenhouse gas emissions. For example, in Q4 of 2021 in northwest Europe, in response to record-high natural gas prices, coal fired power plants increased their output by 20% year on year. Natural gas plays an essential role in supporting a more sustainable energy system in Europe.

• Security: The crisis in Ukraine has also revealed that Europe is not immune from large scale military confrontation. The heightened risk environment exposes critical natural gas transmission infrastructure to the possibility of subversive actions which could include cyber or even direct attacks. Increasing the geographic scope for both the source of natural gas and transmission infrastructure helps improve system reliance and security. Access to a diversified pool of suppliers could also help limit the exposure to spillovers from broader supply disruptions in linked markets.

• Stability: LNG is the marginal source of gas for Europe, this means that non-LNG suppliers sell pipeline gas at the competitive equilibrium price with LNG. (The exceptions to this are the gas deliveries made against long-term contracts). However, pipeline suppliers may also influence market outcomes when LNG market condition are tight (demand exceeds supply). If a large enough pipeline supplier withholds natural gas sales it could drive up the LNG price. A key development in gas markets in 2021 has been an increase in the correlation between the European and Asian gas benchmarks to 0.93 (from below 0.8 in 2019). Given how tight natural gas markets have become across Europe and Asia, we think that a withholding in pipeline deliveries (or reduction in production) in one market could lead to upward price pressure in the LNG price in both markets. This in effect increases incentives for collusion across natural gas suppliers and encourages development of an OPEC equivalent for natural gas (it could also create incentives for collusion between OPEC and major natural gas producers that also produce oil). Broadening the pool of suppliers offers the best means through which to limit incentives for supplier collusion.

• Competitiveness: As highlighted by the European Commission, Russia has a large market share in natural gas markets across Europe. In addition, the combination of excess production and transmission capacity to Europe in our view magnifies Russia’s market dominance. Existence of excess capacity in transmission and production discourages new investments by other participants especially new entrants. The IEA estimates that in 2021, Gazprom production was about 7% below capacity despite strong domestic and external demand with historically high gas prices. In addition, domestic storage injections in Russia rose to new records while deliveries to the European Union fell by 3%. Furthermore, at the end of 2021, Gazprom while continuing to meet long-term contracts, nearly stopped making new sales on the spot market and did not fully use existing reserved capacity. While some of the disparities may be explained by technical disruptions, weather variance, and maintenance, the overall picture suggests strategic and anti-competitive behavior. Some observers have suggested the withholding of deliveries was part of Gazprom’s effort to drive up the gas price to increase incentives for the German regulator to approve certification of NordStream2 whereas others have linked the behavior to escalating tensions in Ukraine. In either case, the behavior would be considered strategic and is likely to have had a material impact on the entire gas market through creating upward price pressure. The observed dynamic further supports the notion that Russia has not only acquired monopoly power but has already abused it to intentionally influence market outcomes. Improving Europe’s access to Caspian and Central Asian natural gas could help, at least in part, to limit strategic behavior and improve the competitiveness of the natural gas market.

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About Veritas Global: Our vision is to have a positive impact on the world through truthful advice informed by robust analysis. We are a premier provider of tailored solutions on climate change, international conflict economics and infrastructure.

High risk of conflict escalation in 2022 in Eastern Europe but also an opening to secure stability

Policy Pulse – 25 January 2022 – Veritas Global

Key messages

• Changing geopolitical calculus of US and Russia increases conflict risk but also creates opportunities for greater stability

• EU has an urgent need to diversify natural gas supply to reduce Russia’s market dominance while promoting more stability in the region

• Eastern Europe needs external assistance to better manage COVID-19 and its economic impacts

Source: Veritas Global created with MapChart.net

We were again broadly on target in our last year’s forecast on the economics of conflicts in Eastern Europe. As expected in 2021, the economic impact of COVID-19 has been uneven in the region and Russia emerged in a position of relative economic strength compared to its neighbors. As anticipated, in responding to the impacts of COVID-19, countries in the region reached unprecedent levels of reliance on external financial support, with the International Monetary Fund (IMF) playing a central role. Furthermore, as per our expectations, the change in US administration has translated to a different posture in US-Russia relations – with more cooperation on global challenges but more confrontation on regional European issues.

Looking ahead, 2022 presents an unprecedented opportunity. The shifting geopolitical backdrop could create an opening to normalize the situation in long-standing conflicts in Eastern Europe. However, this also means that there is a heightened risk of hostilities as well as potential for more hybrid attacks and a real possibility of renewed armed conflict across several hot spots in the region. There are three factors that will have a major impact on conflict economics in Eastern Europe in 2022.

1. Changing geopolitical calculus of US and Russia increases conflict risk but also creates opportunities for greater stability

More so than in previous years, events in the region in 2022 are likely to be shaped by the changing geopolitical calculus of the US and Russia. The US decision to withdraw troops from Afghanistan and stated priority to implement a “pivot to Asia” has created the perception of a power vacuum in Eastern Europe and Central Asia. Russia sees these developments as an opportunity to test US commitments to Eastern Europe and is trying to push back on NATO presence in the region. Russia has asked for legal security guarantees that include a permanent stop to NATO’s eastward expansion and reduced NATO troop presence close to Russian borders. Russia’s proposals point to an assertive stance, aimed at recreating a sphere of influence around its borders. By deploying troops on the eastern border with Ukraine, Russia is trying to signal that it is prepared to escalate if demands are not met.

Until recently, US engagement in the South Caucasus, and to an extent in Central Asia and Eastern Europe, was driven by three core interests. One core interest was access to a secure logistics corridor for US military operations in Afghanistan. US access to this corridor was essential for ensuring uninterrupted supply and maintaining leverage over alternative routes through Russia and Pakistan. The second core interest was the creation of an energy corridor for exporting oil and gas resources out of the Caspian basin, independent of transit through Russia. The third core interest was ideological and was targeted at promoting market-oriented democracies that could be forged into future trading and security partners.

The US withdrawal from Afghanistan has reduced the need for using the South Caucasus, Eastern Europe, and Central Asia as a logistics corridor for military operations. In terms of energy security, technological change driven by lower costs for extracting oil and gas through fracking has contributed to improving US energy independence. In 2019, the US became a net energy exporter for the first time in 67 years. Among some analysts, these developments have raised questions on the need to strengthen the South Caucasus energy corridor. However, the importance of this energy corridor was never about securing energy supply for the US. Rather it was always about creating an alternative source of secure natural gas supply for Europe while supporting diversification of supply in the global oil market. A Europe that is not overly dependent on Russian natural gas will be a more reliable partner for the US, not only in the European theater but also globally. Important to note is that while the US may supply modest quantities of liquified natural gas to Europe, it is unlikely to be able to sustain being a large-scale supplier on a continuous basis. Natural gas has a strong demand outlook in the US domestically while fracking practices are increasingly coming under pressure, including due to local environmental and health impacts. These developments raise questions about the extent to which fracking can sustain production volumes that will enable meeting local demand in the US while at the same time supporting large-scale natural gas exports. Therefore, the South Caucasus corridor is key to helping Europe avoid becoming overly dependent on Russian natural gas.

It is our assessment that from a US perspective, the short-term loss in value of the military corridor is significantly outweighed by the increasing strategic importance of the energy corridor. Nevertheless, US emphasis on a “pivot to Asia” may embolden Russia to apply maximum pressure to reduce the prospect of NATO presence in the South Caucasus and more broadly across all Eastern Europe.

2. EU has an urgent need to diversify natural gas supply to reduce Russia’s market dominance while promoting more stability in the region

European dependence on Russian natural gas has continued to increase significantly in recent years. Market share of petroleum gas and other gaseous hydrocarbon imports from Russia, which includes natural gas, liquified natural gas, propane, and other related products, increased from 17% in 2006 to about 35% in 2020 (see chart below). For comparison, OPEC’s share of total global crude oil production in 2020 was about 37% and the organization continued to be able to influence oil market outcomes. The dynamics of oil and natural gas markets are of course different both due to their geographic and product characteristics. Nevertheless, the comparison illustrates that market power can exist without majority control of the market.

It is important to note that Russia has invested heavily in further enhancing its natural gas export capacity to Europe. The high market share in combination with excess transit capacity will magnify Russia’s dominant position in natural gas markets across Europe. For example, the TurkStream project brings natural gas by pipeline from Russia to Turkey and onwards to other European states. The TurkStream project was operationalized in 2021 and is expected to reach full capacity once all the onward connections are completed. In 2021, Russia also completed construction of NordStream 2 although the project is not yet operational. NordStream 2 is designed to bring natural gas by pipeline from western Siberia directly to Germany.

Focusing on aggregate EU level market shares does not capture the extent of Russian dominance within individual EU members. For 11 of the 27 EU members, Russian natural gas consisted of over 60% of all natural gas imports. For 7 of the 27 EU members, Russian natural gas was over 90% of all natural gas imports. Included in these figures are cases when gas is purchased from Russia for re-export to other EU member states. Irrespective of re-export considerations, Russia is likely to have a higher degree of market power in countries where it is the main natural gas importer.

Some have argued that the increasing share of sales of Russian natural gas in Europe will create a dependency of Russia on the EU. However, this narrative is not supported by economic theory. To have countervailing power, consumers need to be able to have credible options for switching to other suppliers of natural gas or be able to use product substitutes to natural gas from non-Russian sources at relatively short notice. The high cost of switching to alternative options partly explains the upward price volatility observed across many EU gas markets in recent months. In the short-to-medium term, European consumers, especially in countries that are highly dependent on Russian natural gas, do not have alternative economically viable substitutes. Therefore, the power dynamics of the current market structure is likely to favor accumulation of market power for Russia. Crucially, it may be difficult to detect whether Russia has accumulated market power as it may choose to leverage its dominant position to influence other outcomes. Theoretically, one concern might be that it may use its leverage to influence political outcomes, for example over decisions taken at the European Council. Since many of the decisions taken by the Council are done either through unanimity or consensus, Russia may be able to exercise leverage over states that are highly dependent on Russian gas thereby giving Russia the ability to hold sway over some Council decisions.

At a global level, even under the scenario of net-zero greenhouse gas emissions by 2050, the International Energy Agency (IEA) expects demand for natural gas up to 2030 to continue to rise. Beyond 2030, our view is that the outlook is highly uncertain as models incorporate unproven technologies in projections. At the European level, the IEA has emphasized that it expects natural gas to retain a major role as a source of flexibility and back-up for many years to come. Therefore, incorporating diversification considerations in the supply of natural gas is important not only in the short or medium-term but also from a long-term perspective. To be effective, the diversification strategy needs to go beyond investments in storage capacity and focus on diversification of natural gas supply.

About one quarter of all proven natural gas reserves are in non-Russian countries of the Caspian basin and Central Asia. The potential benefits for Europe to access this vast energy pool are partially being realized through the Southern Gas Corridor, a project that was operationalized at the end of 2020 and continues to scale-up deliveries. However, the scope for scale-up is far greater than what is currently planned to be implemented. One of the best options for enhancing supply diversification to the EU is to develop additional capacity that brings Caspian gas to European markets through transit routes that do not pass-through Russia or other members of the Eurasian Economic Union. This is not a new idea but the lack of political will to realize the full potential of this corridor has resulted in Russia having a dominant position across many European gas markets.

One immediate opportunity is to link the Banka Livanova offshore field in Turkmenistan to the existing gas distribution infrastructure that originates in the Azeri Chirag Guneshli field in Azerbaijan. The Trans Caspian Pipeline projectenvisions to capture gas that is currently being vented and flared and pipe it to a nearby local natural gas distribution network. The climate change benefits alone could potentially justify the financing for this project and at a technical level a methodology already exists for quantifying the potential climate benefits from the reduced methane and carbon dioxide leakage. While this project is envisioned mostly for meeting local natural gas demand in Azerbaijan, it will create space for Azerbaijan to export more natural gas from other fields. While it is a good project, it is far too small to have an impact on European market outcomes. An additional large-scale effort is urgently needed to scale-up transit capacity of Caspian gas to European markets.

Explicitly including plans to expand this energy corridor within on-going discussions on long-term security guarantees between western powers and Russia could have a stabilizing effect on the region. It would telegraph planned developments and reduce potential of future friction. Development of diversified natural gas supplies that are complementary to Russian supply will also reduce resistance to Russian projects such as NordStream 2.

3. Eastern Europe needs external assistance to better manage COVID-19 and its economic impacts

The extent of COVID-19 impacts on the region in 2022 are very hard to predict. From an economic point of view, much of the region, except for Azerbaijan and Russia, will continue to face a challenging outlook for government finances. The ability of governments to cushion COVID-19 economic impacts through spending will become more difficult if access to external finances become constrained. Therefore, maintaining access to financing support facilities offered through the IMF, regional, and international financiers will continue to play a critical role. In the absence of continued external financing support, risks to macroeconomic stability across Eastern European countries is considerable. If these macroeconomic risks were to materialize there could be broader destabilizing impacts on fragile and conflict prone environments.

Countries in the region also have among the highest COVID-19 mortality rates in proportion to the total population (see chart below). It is difficult to assess the extent to which this will impact social stability and dynamics of conflicts in the region. However, given the high death toll, it may be appropriate to consider tailored technical assistance specifically targeting how to deal with the COVID-19 challenge. Furthermore, targeted interventions on COVID-19 management for conflict impacted and conflict prone communities could be an opportunity not only to save lives but also create goodwill. In some circumstances, it may be appropriate to provide this assistance through trusted independent third parties.

Belgrade – Pristina: talks continue but will they be meaningful?

• The context is that Belgrade formally considers Kosovo as part of Serbia and actively promotes a policy of delegitimization of Pristina authorities internationally. An EU facilitated dialogue was launched in 2013 to support normalization of relations between Belgrade and Pristina. Normalization is also one of the conditions for Serbia’s eventual potential membership in the EU.

• The external environment will remain challenging in 2022. The prospect of EU membership is a major incentive for Belgrade to normalize relations with Pristina. The lack of progress on formally launching EU accession negotiations with North Macedonia, and to an extent Albania, has created a perception in the Western Balkans that appetite of EU member states for further enlargement has soured. The launch of EU accession negotiations for North Macedonia in 2022 could create positive spillovers in the EU facilitated Belgrade – Pristina dialogue. Also at a regional level, the rising ethnic confrontation in Bosnia creates risks to stability in the region.

• At the local level, there is room for cautious optimism but only if dialogue dynamics improve. The EU-facilitated dialogue on normalization of relations between Belgrade and Pristina continued in 2021 but did not deliver tangible outcomes. Unless the dynamics of the negotiations can be improved, there is a risk that the same will happen in 2022. We believe that an underused tool for improving negotiation dynamics is the use of economic analysis to better inform stakeholders on the benefits and costs of the issues being discussed. For example, assessing the economic costs of not implementing the Deçani Monastery decision of Kosovo’s constitutional court or the economic benefits of timely establishment of Serb-only association of municipalities. Furthermore, clearly articulating how outcomes from the dialogue can better leverage the support available through the EU Economic and Investment Plan for the Western Balkans can help drive better outcomes of negotiations.

Georgia – Russia: could the Norwegian security model work for Georgia?

• The context remained largely unchanged over the past year. Georgia and Russia still do not have formal diplomatic relations. Russia continued to maintain a military presence in the regions of Abkhazia and South Ossetia, territories that Russia recognizes as independent states. Over 7% of the Georgian population continued to be internally displaced because of conflict. Periodic incidents such as kidnapping, detention and property damage occur in Georgia along the Russian controlled territories of Abkhazia and South Ossetia.

• The external environment was difficult in 2021 and will remain tense in 2022. However, there is room for cautious optimism as dialogue between western powers and Russia could potentially resolve the principal source of conflict between Georgia and Russia, which is centered on future Georgian NATO membership. Russia has initiated dialogue with the US on legal guarantees to safeguard Russian security interests. The current Russian proposals include a demand to permanently stop NATO’s eastward expansion and reduced troop presence close to Russian borders. These demands are made at a time when decisions have already been taken by NATO on future membership, including future adhesion of Georgia and Ukraine to the alliance. NATO Heads of State adopted the 2008 Bucharest declaration through which they communicated their decision that Georgia and Ukraine would be members of the alliance but no date for accession was set. The decision has subsequently been reiterated on numerous occasions and through subsequent Heads of State declarations.

• In the context of the future of NATO in Georgia, a security arrangement that is based on the Norwegian model could provide a much sought-after middle ground. Norway is a full-fledged member of NATO with all the related benefits and responsibilities, but at the same time it has committed not to host foreign military bases and does not allow the stockpiling of nuclear arms on its territory. The same framework could be applied in the Georgian context, potentially with additional provisions on limiting the application of collective defense to the Georgian territory where there is no presence of foreign troops at the time of adhesion (meaning exclusion of Abkhazia and South Ossetia from Article 5 until Russian troops are stationed there). This approach would allow NATO countries to have access to secure logistics and energy corridors in the South Caucasus while at the same time retaining credibility by not having to backtrack on previously taken decisions. Crucially, this arrangement would also address Russia’s security concerns as the threat to Russian security would be non-existent from a Georgia with no offensive weapons and no foreign military bases. The certainty that the Norwegian model offers would significantly reduce the risk perceptions of Georgia, thereby improving the business environment, boosting foreign direct investment, and accelerating economic growth.

• The worst possible outcome for stability would be if the dialogue between Russia and the US results in a moratorium on NATO expansion. A moratorium or a halt to expansion over a certain period (for example 10 or 20 years) will motivate Russia to apply maximum pressure on Georgia and Ukraine to destabilize them and reduce prospects of future NATO membership. This is what happened after the 2008 Bucharest declaration, following which events were orchestrated in a way that resulted in Russia deploying troops to Abkhazia and South Ossetia as well as annexing Crimea and supporting separatism in eastern Ukraine. An outright commitment to permanently stop NATO expansion is a better outcome for promoting security then a moratorium, as it would allow Georgia and Ukraine to seek alternative security arrangements that are less inviting to Russian meddling. To be clear, an arrangement that is based on the Norwegian model offers the most promising outcome for promoting stability in the region for the short and long-term.

• Irrespective of the security arrangements, continued integration of Georgia with European institutions and closer cooperation with the European Union offers the best prospect for promoting stability and recalibrating the Georgia – Russia relationship to one of mutual respect.

Ukraine – Russia: a relationship that risks going from bad to worse

• The context of the Ukraine-Russia conflict was framed by the circumstances that followed popular protests and violent clashes in Ukraine in 2014, which resulted in a change of government. Russia considered the change in government and the new Ukrainian authorities as illegitimate. In the confusion that ensued, Russia moved to formally annex Crimea and supported separatist uprisings in eastern Ukraine. Russia has continued to support separatist groups in Ukraine and has amassed troops on the eastern Ukrainian border, threatening to invade if security of Ukraine’s Russian speaking population is in any way compromised.

• The same issues discussed under the “Georgia – Russia” section also apply to Ukraine. Although, the situation is much more complicated and volatile in Ukraine. There are two main reasons for the complexity. One is that Russia’s openness to accept the Norwegian model for Ukraine may be somewhat more challenging since Ukraine represents a formidable military power on its own merits. Therefore, a Ukraine that is part of NATO, even without the presence of foreign bases or foreign weaponry, may still be perceived as a threat to Russian security. To address this, additional provisions may need to be included, for example related to troop positioning, weapons systems, and equipment deployments, that cater to potential Russian security concerns. Second, as a large country with a population of about 45 million, Ukraine’s integration into the European Union may prove to be politically more challenging for EU members domestically. Despite these complexities, in the long-term, a Ukraine that is better integrated into European institutions and has active collaboration with the European Union offers the best prospect for promoting stability and recalibrating the Ukraine – Russia relationship to one of mutual respect.

Nagorno-Karabakh: an opportunity not to be wasted

• The context of the Nagorno-Karabakh conflict has changed significantly over the past two years. After armed hostilities at the end of 2020, a ceasefire agreement was secured between Armenia and Azerbaijan with Russian participation and facilitation. According to the agreement Azerbaijan retains control of areas surrounding Nagorno-Karabakh captured during the 44-day war. The agreement also envisions the creation of a transport corridor through Armenia to connect Nakhichevan with the rest of Azerbaijan. To date, the agreement has largely been successful in averting a restart of large-scale hostilities.

• The relative stability has created an opening for Armenia to take steps towards normalizing relations with Azerbaijan and Turkey. There is a real opportunity to use economic projects, particularly related to rail and road infrastructure, to unlock the longer-term benefits of stability. The Economic and Investment Plan of the EU for the Eastern Partnership countries could potentially play an important role in providing the support needed to jump start the reconstruction of interconnections. Turkey could potentially also play a stabilizing role through more active development of economic projects in Armenia and more broadly across Eastern Europe and Central Asia.

Moldova: wait and see

• The context of the Transnistria region largely remained unchanged over the past year. Transnistria is an unrecognized breakaway region of Moldova that benefits from political, military, and economic support from Russia. It is host to a contingent of Russian troops although Russia does not recognize the territory as an independent state. Transnistria’s leading industries include steel and textiles, but the region is also believed to be a hub for money laundrying and illegal smuggling. Negotiations on finding a settlement on the Transnistria issue are on-going for the past several years through facilitation and support of the OSCE as part of the 5+2 format, which includes participants from Moldova, Transnistria, the OSCE, Russia, Ukraine, US, and EU. Transnistria’s trade with the EU has grown significantly in recent years, which may create opportunities for normalizing relations through commercial cooperation. At the end of 2020 Moldova elected a reform minded President and in July of 2021 a reform minded parliament took-up office after a landslide victory.

• The outlook for Moldova in 2022 is extremely uncertain as a combination of a deteriorating sanitary situation related to COVID-19 and on-going energy crisis add downside risks to economic stability. External financial assistance will continue to be critical for ensuring that the government has the space to maneuver to advance on committed reforms and maintain stability. Given the scale of the challenges facing Moldova in 2022 and highly volatile situation in neighboring Ukraine, the Moldovan leadership is unlikely to have the resources and capacity to go beyond existing efforts at addressing the Transnistrian issue. However, the dialogue initiated by Russia with the US on long-term security guarantees in Europe also has implications for Transnistria.

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About Veritas Global: Our vision is to have a positive impact on the world through truthful advice informed by robust analysis. We are a premier provider of tailored solutions on climate change, international conflict economics and infrastructure.

Conflict Economics: Eastern Europe 2021

Policy Pulse - George Anjaparidze - 7 January 2021

Our last year’s forecast on the economics of conflicts in Eastern Europe was broadly on target. As expected, we saw positive momentum through a restart of dialogue between Belgrade and Pristina. We highlighted the heightened risk of conflict in Nagorno-Karabakh as well as continuing tensions in the Russia – Georgia relationship and turbulence in Moldovan politics. Our diagnosis on the intractable situation in eastern Ukraine and Crimea were also accurate.

“Defrosting” of conflicts in Eastern Europe is expected in 2021. Global developments will have a major influence on the economics of conflicts in the region.

First, the economic impact of the COVID-19 pandemic has been uneven across the region. While all countries have suffered, the negative economic impacts from COVID-19 have been more intense in tourism and remittance dependent economies such as Armenia, Georgia and Moldova. Russia is likely to emerge in a relatively stronger position compared to its neighbors. Russia has accumulated vast foreign currency reserves that give it sufficient buffers to manage the volatility arising from the COVID-19 pandemic.

Second, global debt levels have risen sharply and have reached all-time highs. According to International Monetary Fund calculations, global public debt stood at 83% of GDP in 2019 and is estimated to have made an unprecedented jump to about 100% of GDP in 2020. Although absolute debt levels among Eastern European countries are below the global average, the relative increase in debt has been significant. The strained fiscal position implies that countries in the region, with the exception of Russia and Azerbaijan, will be increasingly reliant on external support for sustaining a post COVID-19 recovery.

Third, the change in US administration is likely to translate to a different posture in US-Russia relations. On global issues, the Biden administration is likely to be more cooperative. For example, we expect the US not to pull out of the Strategic Arms Reduction Treaty and instead extend it while it is renegotiated. However, on regional issues within Europe, there is a heightened risk that the US-Russia relationship becomes more confrontational. Russia and Russia based groups have so far been successful in waging asymmetric warfare against western interests through meddling in neighboring states and allegedly launching cyber-attacks further afield. The US has been frustrated by the lack of coherence in policy by its EU allies, Germany in particular, who on the one hand condemn Russian aggression in neighboring states and impose targeted sanctions, but on the other hand sign multibillion euro commercial deals with Russian state companies. The US is especially concerned with the growing dependence on Russian natural gas among some EU countries, particularly in central and eastern Europe. The US Congress recently broadened the application of US sanctions to include any western companies involved in providing services to the NordStream 2 and TurkStream pipeline projects. These proposed pipelines would increase the capacity of Russia to supply natural gas to the EU. Given the advanced stage of construction of the NordStream 2, it is unlikely that these sanctions will derail the project. Nevertheless, it may motivate Russia to retaliate through destabilizing actions targeted at western interests in the Europe region.

Belgrade – Pristina: continued cautious optimism for 2021

The lack of normalization in relations between Belgrade and Pristina prevents people from realizing their potential and slows economic development. Normalization would reduce risk perception which would support much needed investment flows, in particular through implementation of the privatization program. Projects in Kosovo that stand to benefit include: the Brezovica ski resort, mines in extractive minerals such as magnesite and bauxite, communication and transportation infrastructure and real estate development. Normalization of relations between Belgrade and Pristina is also a prerequisite for Serbian EU membership. Overcoming the normalization obstacle, could potentially unlock significant funds during the pre-accession process. With eventual EU membership, Serbia would also gain access to massive amounts of concessional funding through the EU cohesion program, which could translate to about a 21 fold increase in EU assistance.

The EU facilitated dialogue on normalization between Pristina and Belgrade was restarted in 2020. This was made possible through skillful EU diplomacy and suspension of politically motivated tariffs on Serbian goods entering Kosovo. 2020 also marked an increase in activity of US diplomacy. The Trump administration was successful in getting sides to reach a principled agreement on economic normalization between Pristina and Belgrade.

2021 is potentially an opportunity for EU and US efforts to work in concert to ensure the political dialogue and economic incentives for normalization are better aligned. In addition to assistance in managing the COVID-19 pandemic, support from the EU, US and broader international community will be critically needed for the economic recovery. Keeping the normalization dialogue on track could help boost availability of much needed resources. Despite a conducive external environment to support dialogue, there are significant downside risks that could derail the normalization talks. In Pristina, snap elections have been called after the Constitutional Court ruled that the government was illegitimate. This introduces significant uncertainty on the policy of the future Kosovo leadership with regard to dialogue on normalization. Furthermore, the situation at the local level between ethnic Serb and ethnic Albanian communities remains tense. Local incidents are often characterized by rapid escalation. Despite these risks, we think as long as there is broad alignment between EU and US efforts and real economic incentives on the table, there is room for cautious optimism for a continuation of progress towards normalization.

Ukraine – Russia: an uneven fight persists

The conflict in eastern Ukraine imposes significantly higher economic costs on Ukraine (compared to Russia) in both relative and absolute terms. As highlighted in our last year’s analysis, western sanctions are likely to have lowered economic output by 0.5 to 1.5% of GDP in Russia. In Ukraine, factors directly attributable to armed conflict have led to a fall in economic output by about 50% in the Donbass region and about 15% in the rest of Ukraine. This means that in relative terms the conflict has about 10 to 30 times more of an adverse economic impact on Ukraine than it has on Russia.

Since our last year’s assessment, little has changed in strategic terms in the situation in Ukraine. In the absence of a major scale-up of western support for Ukraine, negotiations in 2021 are unlikely to be successful or at best will be extremely unbalanced (disproportionately favoring Russia). Ukraine’s willingness in 2020 to set up an Advisory Council that is comprised of Donbass separatists and Kiev backed authorities is a reflection of Russia’s stronger negotiating position. In the short term, the creation of such an Advisory Council risks giving legitimacy to Russian proxies and creates the mirage of an internal Ukrainian conflict, in effect absolving Russia of meddling in eastern Ukraine. Having said that, closer interaction between Kiev and Donbass has potential to be constructive in the long term but only if it is combined with large scale economic incentives that target closer integration of the Donbass region with the rest of Ukraine. A “Marshall Plan for Donbass” can help align incentives to promote greater cohesion within Ukraine while developing closer ties with the European Union.

To reach a balanced resolution of the conflict, Ukraine needs assistance and support from western partners to rebalance the cost equation. Furthermore, western partners need to support creation of new economic incentives that target integration of Donbass region with the rest of Ukraine. In the absence of such measures, we expect Russia will continue to engage from a position of strength and secure outcomes of negotiations that favor Russian proxies - eventually leading to further erode Kiev’s control and destabilize Ukraine more broadly. Crimea is an even more complex issue, with conditions in 2021 unlikely to be conducive for meaningful dialogue.

Nagorno-Karabakh: an Azeri military victory that is likely to stick

The Nagorno-Karabakh conflict imposes significant economic cost on both Azerbaijan and Armenia. As a result of conflict in the 1990s, about 700 thousand Azeris were internally displaced in Azerbaijan, which has meant that the country has had one of the world’s highest proportion of internally displaced people as a percentage of total population. In recent years, the government has intensified its efforts to rehouse people, leaving about 350 thousand Azeris with internally displaced status. Policies to support internally displaced people create a significant drain on Azeri public finances. In the case of Armenia, the conflict has meant that the country has been under embargo from both Turkey and Azerbaijan. This has led to new logistics and energy infrastructure, connecting the Caspian region to the world, to be developed in a way that bypasses Armenia. Instead, goods and energy resources flow through neighboring Georgia. Georgia is effectively the only unrestricted gateway for Armenia to access global markets as its other neighbor, Iran, faces significant restrictions of its own due to economic sanctions. Furthermore, as a result of the conflict, the people living in the enclave of Nagorno-Karabakh are faced with a life of limited opportunity that constrains their potential and locks many of them into poverty.

As we highlighted in our last year’s analysis, the risk of hostilities in 2020 was likely. Parties were no longer comfortable in continuing dialogue on the basis of previously accepted principles. Azerbaijan’s decisive military victory has reset the situation on the ground in line with Azeri negotiating proposals.

According to the 9 November 2020 ceasefire agreement, Azerbaijan will not control all of Nagorno-Karabakh but will instead retain control of surrounding territories recaptured as part of the 44-day war. The population of Nagorno-Karabakh itself is currently almost entirely ethnic Armenian, their security will be guaranteed through a contingent of Russian peacekeepers. Russian peacekeepers are also tasked with safeguarding logistics connections between Nagorno-Karabakh and Armenia. The ceasefire agreement also envisions the creation of a transport corridor through Armenian territory between the Azeri region of Nakhichevan and the rest of Azerbaijan. The transport corridor through Armenia is a long-standing demand of Azerbaijan as part of previous negotiations. In addition to having local significance for better connecting Nakhichevan to Baku, the transport corridor has potential to improve connectivity between Turkey and Central Asia as well as on-ward destinations. Under the ceasefire agreement, the transport corridor passing over Armenian territory will be overseen by Russian border control officers. Russian influence over traffic on this corridor will be sustained indefinitely given that Armenia is part Eurasian Economic Union. In the years to come, Russia will likely intensify efforts to strengthen this corridor and position it as an alternative to the Georgian route, over which Russia has no control.

The ceasefire agreement is extremely unpopular in Armenia and is largely viewed as a capitulation of Armenian interests. Public sentiment could lead to early parliamentary elections sometime in 2021. So the political viability of the agreement and the extent to which all aspects remain intact is subject to uncertainty. However, conditions on the ground leave Armenia with little room to maneuver.

Source: Eurasianet

Georgia – Russia: continue to be stuck playing a lose-lose game

The conflict between Russia and Georgia imposes debilitating costs on the Georgian regions of South Ossetia and Abkhazia. Russia has troops stationed in both of these regions without permission from Georgia. Both regions have had a mass exodus of its pre-conflict population, with more than half of the people (mostly of Georgian ethnicity) being forced to leave. This has resulted in Georgia now having about 300 thousand internally displaced people or over 7% of the total population, which is among the highest ratios in the world. Significant share of government finances are diverted for managing social issues of internally displaced people. Ongoing tensions between Russia and Georgia have also limited economic ties and people to people contact. Poor relations with Georgia have meant that Russia has been limited in its ability to create new infrastructure on Georgian territory to enable export of energy resources. Therefore, Russia has had to forgo cost-effective options for linking with distant markets. For example, instead of expanding existing gas transmission networks, Russia has had to make costly investments in constructing pipelines under the Black Sea to transport natural gas to fuel the rapidly growing Turkish demand. Russia has also systemically imposed trade barriers with Georgia and restricted movement of people. More recently in 2019, Russia issued bans on direct flights between Russia and Georgia, a move that harmed both countries but imposed higher economic costs on Russian airlines and consumers.

On aggregate, we estimate that the cost burden of poor relations between Tbilisi and Moscow results in about 3 to 11 times higher absolute costs on Russia compared to Georgia. However, given the difference in the size of the respective economies this translates to relatively higher costs for Georgia. The lack of predictability in access to the Russian market, has motivated Georgia to improve its goods and services and diversify its economy to compete in other markets through higher value-added products. Nevertheless, there have also been real lost opportunities, particularly in developing energy and logistics connectivity. Russia and Georgia continue to be stuck in a lose-lose game, where geopolitical calculus has clouded economically rational decisions.

2021 is likely to continue to be another difficult year in the Russia-Georgia relationship. Russia may put pressure on Georgia by intensifying “borderization” around Abkhazia and South Ossetia regions. This may be done in an effort to get Georgia to agree to replicate the eastern Ukrainian model of setting up an advisory council or some joint governance arrangement that consists of Abkhaz and South Ossetian separatists alongside Tbilisi backed authorities. Any such governance arrangement is unlikely to be politically palatable if it has official standing or if it is in some way used to dilute exiting formats for dialogue, where Georgia is jointly present with western partners. Nevertheless, setting up such a group may be appropriate if it is given an informal but potentially standing capacity. It can be seen as a form of stakeholder consultation with a remit to advise on ways to promote projects on economic cooperation, human to human contact and capacity building.

Another cause for tension could arise from new initiatives that bring natural gas from the Caspian to the European Union by bypassing Russia. The Southern Gas Corridor project brings natural gas to the EU from Azerbaijan by using the South Caucasus Pipeline (SCP), the Trans-Anatolian Pipeline (TANAP) and the Trans Adriatic Pipeline (TAP). This corridor was operationalized at the start of 2021 and may be further enhanced through the construction of additional modules. For example, feasibility studies are underway for construction of a Trans Caspian Pipeline (TCP) that would connect natural gas supplies from Turkmenistan. Another potential module, White Stream, would offer complementary capacity through a pipeline under the Black Sea. Further study is needed on whether an alternative option may be to develop LNG facilities on the Georgian Black Sea coast for shipping Caspian gas to global markets. In the long term, development of diversified natural gas supplies that are complementary to Russian supply may reduce resistance, among some EU members and the US, to Russian projects such as NordStream 2. By not medaling in projects such as the Southern Gas Corridor, Russia has an opportunity to demonstrate that it is a responsible player capable of functioning on commercial terms in a competitive environment.

Source: https://white-stream.com

Moldova: new economic ties could lead to changes in sentiment

Transnistria, a breakaway separatist region in Moldova is allegedly one of the major European hubs for money laundry and illegal smuggling. So the announced priorities of the new pro-European President, Maia Sandu, to fight corruption, tackle illicit economic activity and restore rule of law, will likely create unease among some factions in the breakaway region. The new president has also questioned the need for continued military presence of Russian peacekeepers in Transnistria and called for renewed efforts to resolve the frozen conflict. Transnistria has expressed a desire to join the Russia Federation and enjoys strong political and material support from Russia. However, officially Moscow recognizes Transnistria as part of Moldova. The Transnistrian economy benefits from strong links with Russia, which includes receipts of concessional Russian natural gas and significant trade turnover. However, since Moldova signed the EU association agreement in 2014 more trade has started to flow with the EU. Finding a solution to the conflict by also focusing on commercial and business interests is likely to be an increasingly important dimension.

However, the Moldovan economy is in a particularly difficult situation. A lack of progress on reforms has left Moldova cut off from much needed international assistance for recovery from the COVID-19 pandemic. Furthermore, the resignation of the government on 23 December 2020, means that parliamentary elections will be held in early 2021. This is likely to bode well for the newly elected pro-European president. However, it also introduces significant uncertainty and potentially exposes Moldova to external meddling.

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