27/01/2014 10:03 GMT | Updated 29/03/2014 05:59 GMT

Russia Is Losing Its Grip on European Energy Supply

Russia pulled off a major diplomatic coup in November by inducing Ukraine to abandon its proposed association agreement with the EU, the consequences of which are currently being played out on the streets of Kiev. But it would wrong to assume that Russia now calls all the shots in relations with its ex-Soviet neighbour...

Russia pulled off a major diplomatic coup in November by inducing Ukraine to abandon its proposed association agreement with the EU, the consequences of which are currently being played out on the streets of Kiev. But it would wrong to assume that Russia now calls all the shots in relations with its ex-Soviet neighbour. The deal, in which Russia agreed to finance $15bn of Ukrainian debt and cut gas prices by a third, was notable for the absence of reciprocal concessions from Kiev in the strategically crucial field of energy. Longstanding Russian ambitions to control Ukraine's gas pipelines and domestic energy production remain unfulfilled. These tensions surfaced again earlier this month in the form of a Russian complaint that the development of shale gas in the eastern Ukraine poses an environmental threat to Russian water supplies. This is likely to become a source of rising geopolitical tension between the two countries whoever holds power in Kiev.

For all the talk of Ukraine being re-absorbed into Russia's sphere of influence, this is not what Ukrainian President Viktor Yanukovych has in mind. He and the oligarchs that support him know too much about the predatory methods of the Russian elite to surrender their national power base and turn Ukraine into a satellite state. What Yanukovych really wants is to emulate the approach of Kazakhstan by developing a "multi-vectored" foreign policy that maximises his freedom of manoeuvre by balancing the competing interests of the larger powers around him. Just as negotiations with the EU increased his bargaining power with Russia, concerns about rising Russian influence will be used seek concessions from the west.

Yanukovych knows that this balancing act will be all but impossible to achieve as long as Ukraine remains dependent on Russia for 70% of its gas supply. The new agreement to reduce gas prices also provides for them to be reviewed on a quarterly basis, enabling the Kremlin to retain a large measure of political leverage. Previous price hikes and the gas cut-offs of 2006 and 2009 are still fresh in the memory. That's why Ukraine has launched a major push to achieve energy independence by 2020. This involves a variety of projects, such as new offshore gas production, work to reverse pipeline flows to allow imports from the west and even a proposed liquefied natural gas (LNG) terminal on the Black Sea.

But the main plank of this new energy strategy involves the development of shale gas deposits that the government hopes will meet Ukraine's domestic needs and even allow it to become a net exporter within a few years. This is one interest Yanukovych has been unwilling to sacrifice. Shortly before agreeing terms with Russia, he was careful to reach a fifty-year production sharing deal with Chevron to extract shale gas and oil in western Ukraine. A similar agreement with Shell already covers the east of the country. Russia understands the strategic implications of losing its largest gas customer and is now looking ways to put a stop to these moves, hence the complaint about water standards from a government not usually noted for its environmental awareness.

Even more worrying for Russia, this seems to be part of a growing trend across much of Eastern Europe. Poland, another country that has found itself at the sharp end of Russian energy diplomacy, has embarked on a twin-track approach of developing its long-term shale gas potential and building new LNG capacity to meet more immediate needs. Until recently it looked like an outlier in its enthusiasm for shale gas within the EU, with environmental concerns leading several countries to declare moratoriums on drilling. That now seems to be changing. The decision of the Romanian government to end its own moratorium and grant exploration licences last year was linked by Prime Minister Victor Ponta to concerns that the country would become more exposed to high Russian pipeline prices as its economy expanded. Lithuanian government is now talking about revising its tax and environmental regulations to attract new shale gas investors after Chevron pulled out of a deal in October.

There are, of course, political and practical uncertainties about the extent to which Europe will be able to replicate the shale gas revolution that has already taken place in the US. Exploration work is only just beginning and estimates of likely reserves vary widely. There has also been significant organised opposition from environmental groups in places like Romania and Lithuania that has put the authorities on the defensive. The protestors are promising to fight shale gas production all the way, but the political momentum behind it looks strong. Besides, the growth of shale gas production beyond Europe, combined with the increasing availability of LNG, is already increasing European supply options, strengthening the spot market and forcing Gazprom to offer discounts and rebates.

All of this leaves Russia to contemplate the loss of market share among its main European customers. A report published last year by the Energy Research Institute of the Russian Academy of Sciences estimated that the growth of unconventional gas supply could reduce Russian exports by around 20% over the next ten to fifteen years. With energy revenues accounting for half the state budget and growth rates being revised downwards, this represents a challenge to a system that relies on a healthy surplus to guarantee elite loyalty and popular acquiescence. Perhaps even more than the loss of revenue, Russia fears the loss of political influence that would accompany its decline as a dominant energy supplier.

Russia doesn't appear to know how to respond to this challenge. It could break up Gazprom and restructure its energy sector around competitive market principles. This would help it to drive out inefficiencies, reduce costs, attract new investment and convince consumers that Russia wants to supply energy on purely commercial terms. Revenues would be preserved at the expense of geopolitical ambition. The main problem is that the system Putin created doesn't know how to let go. That may prove to be its great undoing.