Economics of Natural Gas Supply Diversification for EU

Policy Pulse – 28 March 2022 – Veritas Global

Photo by Darya Jum on Unsplash

Key messages

• Expanding Caspian natural gas pipeline supply will greatly benefit EU’s energy security in the 2030-time horizon and beyond

• Had the White Stream project been realized, it would have brought more Caspian gas to EU, generating savings of between €24 bn to €48 bn in 2021 for natural gas users in EU

• Increasing capacity of natural gas supply to EU will improve price stability

• Support for receiving more LNG and development of new pipelines are mutually reinforcing policy measures that advance consumer interest

• EU can continue to use natural gas indefinitely while cost-effectively meeting its 2050 net carbon neutrality target

Background and context

On 8 March 2022 the European Commission proposed measures for addressing EU’s energy insecurity. The proposal identified diversification of supply as one of the key levers for addressing EU energy security. Specifically, the proposal looks to increase supply of non-Russian natural gas by sourcing more Liquefied Natural Gas (LNG) and increasing imports of pipeline natural gas. Other measures covered by the proposal include reducing demand for natural gas through developing renewable substitutes, including hydrogen produced from renewable energy sources.

The European Commission proposal outlines in detail immediate measures that can be taken to reduce EU’s dependence on Russian natural gas. However, for the 2030-time horizon the proposal simply extrapolates the current measures. In our view, there is an opportunity to improve EU’s energy security over the 2030-time horizon and beyond through focusing on increasing the capacity of new pipelines.

Our previously published analysis “Caspian Gas Is Key to EU Supply Diversification” highlighted that enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification. Caspian gas is a critically needed supplement to EU’s hydrogen strategy. The hydrogen strategy is an ambitious program for long-term decarbonization, but it does little to address EU’s energy security needs over the next two to three decades.

This policy brief explains how the full operationalization of the White Stream project, which would bring natural gas from the Caspian to EU, can contribute to price stability for European consumers. Furthermore, this brief explains how development of new natural gas pipelines and support for new LNG supply are mutually reinforcing policies. The brief also highlights that continued use of natural gas can be fully compatible with EU’s 2050 net carbon neutrality target.

Increasing capacity of natural gas supply to EU will improve price stability

As shown in Table 1, if the White Stream project had been implemented, there would have been an increase in supply of 5.8% in the European market which would have resulted in a 24% decrease in the wholesale price of natural gas. On aggregate, this would have generated savings for users in the European Union of between €24 bn to €48 bn in 2021.

Table 1: Savings to EU consumers in 2021 if White Stream had been implemented

The White Stream project, if fully operationalized, would bring 32 billion cubic meters (bcm) of natural gas from the Caspian to the European Union, which is the equivalent of about 5.8% of total natural gas consumption across Europe in 2021.

On aggregate, demand for natural gas is inelastic, meaning a large change in price is needed to produce a small change in quantity consumed. Short-term price elasticity of demand is estimated at - 0.24, which means that a 10% increase in price reduces demand by about 2.4%. In the absence of an estimate for short-term price elasticity of supply, this value for price elasticity of demand is assumed to be a reasonable proxy.

Using this short-term price elasticity, would mean that a 5.8% increase in supply would translate to a 24% decrease in the price, which if applied to the total natural gas spending by consumers would translate to savings to natural gas users in EU of about €48 billion in 2021. A more conservative approach for estimating the potential savings would be to calculate impacts only against the price increase since 2019, which we estimate at about €100 billion in the wholesale market. Using this more conservative approach would imply savings to natural gas users in EU of about €24 billion in 2021. While each approach has its merits, the range offers the most relevant reference point for policy makers.

A crucial point to realize is that the benefits of lower gas prices accumulate downstream and eventually are passed on to consumers. Given the structure of the gas market, these benefits are not captured by natural gas suppliers. In effect, the benefits of lower prices are transferred from current suppliers to consumers. This characteristic of the gas market means that existing suppliers of natural gas are incentivized to discourage entry of new suppliers. Given these features, there is a strong case for public sector intervention in facilitating new entry and development of diversified supply infrastructure.

Support for new LNG and development of new pipelines are mutually reinforcing policy measures that advance consumer interest

In our view, there is an opportunity to improve EU’s energy security over the 2030-time horizon and beyond by focusing more on increasing the capacity of new pipelines bringing gas from the Caspian. According to the European Commission, about 80% (or 50 bcm per year) of the natural gas supply diversification is planned to come from increasing LNG supply. The remaining 20% (10 bcm per year), is planned to come from new gas transported by pipelines. While this approach may be appropriate for the short-term, it is not appropriate for the medium term. Priority should be given to developing new natural gas pipelines.

Natural gas production cost modeling for the European market, commissioned by the UK Department for Business, Energy & Industrial Strategy, identified a cost advantage of new pipeline gas projects over new LNG supply (See Figure 1). The production cost curve presented in Figure 1, identifies different sources of natural gas that could be supplied to the European market. The height of each bar corresponds to the cost of supplying the natural gas from a particular source to the European market whereas the width of the bar corresponds to the estimated volume that could be delivered per year from the identified source. Caspian gas offers a cost competitive option for supplying the European market and could deliver over 50 bcm per year.

Figure 1:

Base Case Gas Supply Cost Curve – 2035 (2015 prices)

Source: Fossil Fuel Supply Curves, Report of the UK Department for Business, Energy & Industrial Strategy, May 2016, prepared by Wood Mackenzie Ltd.

The impact of increasing access to new LNG compared to increasing new sources of piped gas has different consequences for the natural gas supply curve. The impacts from these mutually reinforcing measures would further European consumer interests.

Policy support that is targeted at increasing access to future LNG projects will flatten the slope on the tip (right-hand side) of the natural gas supply curve (see image I in Figure 2 below). The reason is because the vast majority of future LNG potential is on the right-hand side of the production cost curve, therefore, the supply response will largely impact this segment.

However, increasing support for gas from new (future) pipelines will shift the entire supply curve to the right. The shift will be less pronounced on the left-hand side of the supply curve and more pronounced in the middle (see image II in Figure 2 below). The scale and segment of the shift in the supply curve is presented in proportion to opportunities identified in the production cost curve from future piped gas.

If the two measures are pursued in parallel, the cumulative impact will be both a flattening of the slope of the tip of the supply curve and a shift in the supply curve. Basically, the sum of the two effects (see image III in Figure 2 below).

Figure 2:

Impact of policy support for new LNG and new pipes on natural gas supply curve

Box 1: The Geographic Market – Is it Just Europe or Europe and Asia?

A relevant technical point to note, is that this analysis is done using the assumption that the geographic market for natural gas is Europe. However, some analysts consider that the relevant geographic market is broader and should encompass both Europe and Asia, as the two regions are linked indirectly through LNG trade. In fact, the price correlation across leading European and Asian benchmarks increased to 0.93 in 2021 compared to below 0.8 in 2019. Nevertheless, a correlation in spot prices across LNG products should not necessarily be interpreted as the existence of a single geographic market.

However, even if a broader geographic market definition is applied, that encompasses both Europe and Asia, the scale of the benefits estimated in the analysis from adding additional capacity would not change. Although, the benefits would be distributed more widely, accruing to both European and Asian consumers in the broader Europe-Asia natural gas geographic market. The addition of 32 bcm in 2021 would have increased supply in the broader Europe-Asia geographic market by about 2.2%. If the same price elasticity assumptions are used, this increase of supply would correspond to a decrease in prices by 9.2%. The benefits to consumers in 2021 would still have been in the range of €24 bn to €48 bn but these saving would be distributed more widely across the broader Europe-Asia geographic market.

Even under the broader geographic market definition, there are compelling reasons why Europe would find it in its interest to secure higher volumes of natural gas supply from the Caspian. The lower production cost of Caspian gas makes it possible for Europe to potentially lock in supply at a lower rate than offered through new LNG projects. Piped Caspian gas also offers the possibility to have certainty of supply and reduce over reliance on new LNG capacity, access to which depends on continuously outbidding Asia. Furthermore, enhanced access to piped gas from the Caspian will help reduce exposure of Europe against supply disruptions in natural gas markets.

EU can continue to use natural gas indefinitely while cost-effectively meeting its 2050 carbon neutrality target

Carbon capture and storage technology offers a technically viable solution for capturing nearly all carbon dioxide emissions that result from the combustion of natural gas. Currently, this method is not economically attractive as it is cost prohibitive. However, with research, development, learning, and accommodative polices, carbon capture and storage technology has the potential to become commercially viable.

In the meantime, there are vast pools of cost-effective emission reduction opportunities in developing countries. The newly agreed rules at UNFCCC COP 26 for international collaboration under the Paris Agreement (also known as Article 6 of the Paris Agreement) offer an unparalleled opportunity for delivering the best greenhouse gas emission reductions, which can be used to offset emissions from using natural gas.

But capturing “tailpipe” emissions and offsetting are not the only options. The rapid progress in recent years in direct air carbon capture processes and technology has the potential to be truly transformational. Based on our forthcoming assessment, which is in the process of being peer reviewed, our estimate is that certain companies, through leveraging existing mature technology and process innovation, have achieved the ability to capture carbon directly from the air at a cost of between US$90 to US$130 per metric ton of carbon dioxide. While this is much more expensive than the abatement opportunities available in developing countries, it is comparable to the current price point of carbon emission permits in EU. The significance of this development is that direct air carbon capture conceptually offers endless opportunities for emission reductions at the same carbon price. In effect, this technology puts a price ceiling on reducing carbon emissions.

Whether it is through carbon capture and storage, carbon offsets, or direct air carbon capture processes, there are many options available for neutralizing greenhouse gas emissions. EU can continue to use natural gas indefinitely and still meet its 2050 carbon neutrality target without incurring huge costs. Natural gas plays an important role in enabling greater renewable energy deployment by offering a viable solution for balancing capacity to manage fluctuations in renewable energy supply. 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.

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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.

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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