Trilateral talks on gas transit, held by Ukrainian, Russian and European Union representatives on September 19, failed to produce the breakthrough some may have hoped for.

The current gas transit contract between Gazprom and Naftogaz expires on December 31, 2019. This could threaten Europe and Ukraine with gas shortages — Naftogaz's base scenario is zero transit after 2019 — and a potential cut to Ukraine's GDP of 3 to 4 percent if sizable transit fees are lost.

Yet progress has been made. The issue of unbundling gas transmission, a key requirement that had been holding up Ukraine's integration into European energy structures, finally appears to be resolved. Whether that will prove to be enough to sign a deal that secures both Ukraine's and Europe's interests remains to be seen: Russians have the unacceptable requirement that revision of results of Stockholm arbitration is based on a "zero payments" amicable agreement (Naftogaz "forgives" Gazprom's $3 billion debt). Meanwhile, construction of the Nord Stream 2 pipeline that connects Russia to Germany continues, putting European solidarity to the test.

A giant leap on unbundling

Before the talks Ukraine finally made progress on the thorny question of unbundling its transmission system — a requirement for countries to comply with Europe's Third Energy Package — that had previously been gridlocked. While the previous government insisted on a specific approach to ownership unbundling, Naftogaz warned this would void its case in Stockholm to recover unpaid transit fees.

"The Third Energy Package is the DNA of European law," Dirk Buschle, Deputy Director of the Energy Community Secretariat told a September 11 conference in Kyiv, dedicated to energy security, transit and European integration. "Unbundling is the most painful reform. We have wasted years in an infight between the government and Naftogaz, about who controls and keeps controlling the assets."

That infight appeared to come to an end shortly thereafter when Ukraine's new Energy Minister Oleksiy Orzhel promised to "bring the needed solution" before the September 19 talks, with a Cabinet of Ministers decree to show that Ukraine has a working decision.
Indeed, both parties broke the deadlock, creating a "joint solution" in the words of Naftogaz Executive Director Yuriy Vitrenko, which provided full ownership unbundling — the desired government model — but with Naftogaz retaining economic interests. This way, Vitrenko explained, they could retain the right to pursue Stockholm arbitration procedures against Gazprom.

It is hard to understate the importance of this measure, not least because of the signal the new government is sending to European partners. "The substance of the previous resolution was to get control over the cash flows and operations over one of the subsidiaries of Naftogaz responsible for gas transmission," Vitrenko said. "The new government takes a very different approach — it's really about compliance with European rules."

The best possible solution, according to experts, would be to leverage unbundling to create a joint consortium with European players that could deal directly with Gazprom on the Ukrainian-Russian border — thus both avoiding direct purchases from Russia and creating a more competitive market in Ukraine. In the meantime, it should at least strengthen Naftogaz's negotiating position and allow for signing a new contract according to European Union rules.

Russia stalling

This did not produce the desired effect on the Russian side, which sent mixed messages following the September 19 talks. While agreeing to the position that any new deal should be signed under European rules, Gazprom also claimed that once Ukraine unbundles transmission Naftogaz can no longer be the counterparty to sign a new agreement.

Worse still, speaking on September 24, the Russian Energy Minister Aleksandr Novak reiterated that any agreement should have a "zero option" clause, under which Naftogaz and Gazprom have no mutual financial claims. Meanwhile, the European Community and Ukraine have a consolidated position that revision of results of Stockholm arbitration should not be a pre-condition for negotiations.

Experts note that Russia is running down the clock, hoping that Ukraine will be unable to adopt the necessary rules into its legislation before end‑2019. "[Russia's goal] is to extend the existing transit deal up until Gazprom completes the construction of Nord Steam 2, which bypasses Ukraine to Germany," noted Alexander Paraschiy, head of research at investment bank Concord Capital.

"Even if Ukraine does its homework in adopting the EU rules by the next negotiations in October, Gazprom will make some other demands," Paraschiy added.

Prospects for a full deal thus remain distant. "With no trust and the arbitration attrition taking place between those 2 countries, it remains nearly impossible to believe a long-term transit could be reached," said Thierry Bros, senior research fellow at the Oxford Institute for Energy Studies.

If the two parties do not agree, Bros expects that an interconnection deal will be reached — allowing to make deals on a daily basis in the absence of a longer-standing arrangement. "This would then allow Gazprom to nominate day ahead volumes for transit via Ukraine from 31 December 2019," he explained.

"Russian gas would therefore continue to flow in the first quarter of 2010, avoiding an energy crisis that would be very detrimental to the gas image at a time the new EU Commission will design its European Green Deal," he added.

European solidarity

European support for Ukraine has been mixed. While European countries continue to provide support in various forms, the overarching issue of the Nord Stream 2 — which is set to connect Russia to Germany under the Baltic from early 2020 but has been plagued with delays — continues to undermine those efforts. Germany, set to benefit the most, claims this is purely an economic deal.

Speaking at the Kyiv conference, the former Prime Minister of Sweden Carl Bildt pour cold water on those claims: "it doesn't make economic sense whatsoever to do it. But it's the question of the Russians trying to get rid of the dependence of the Ukraine transit system."

Ukraine gained some relief with a recent decision on the Opal pipeline in September, when the European court lifted a special status from the pipeline. The Opal pipeline connects Nord Stream 1 to the Czech Republic via Germany, a clause used to make it exempt from competition legislation and limiting third party access — thus allowing Russia to send larger amounts of gas to Europe, bypassing Ukraine.

The Opal decision in itself, however, will only provide so much relief. Once Nord Stream 2 and Turkstream, a similar pipeline linking Russia to Europe via the Black Sea, are online, Russia will be able to basically cut out Ukraine altogether.

In the end, Europe needs to re-emphasize the principle of solidarity, Bros argues. The position currently taken by Germany is akin to a free-rider problem — it is currently increasing the share of relatively cheap Russian gas (vs. North African supplies), but faces limited additional risk. That is because in cases of shortage, the principle of European solidarity means they will be spread across the wider region.

Instead, Bros argues, countries reducing the diversity of supply — as Germany is doing first with Nord Stream 1 and now with Nord Stream 2 — should end up paying some sort of "insurance premium" for the increased risks they are bringing. In practice, this would mean either limiting solidarity, increasing fees, or via legal restrictions as in the Opal case.

"If you are a free-rider, you are putting everyone at risk," Bros emphasized.

Whether this option is realized, or whether Europe will end up finding an alternative solution to support Kyiv in its ongoing feud with Moscow, remains an open question. The hope, experts note, is that the current push for reform will translate into additional support.

"It is important that Ukraine has shown it is worthy of European solidarity because it takes the hardship of reforms upon itself," Buschle noted at the Kyiv event.