Construction of the Nord Stream 2 pipeline, which runs 1,230 kilometers through the Baltic Sea from Ust-Luga in Russia, to Lubmin near Greifswald in Germany, has been completed on September 10, 2021. However, no gas has started flowing through this pipeline yet. Nord Stream 2 (NS2 for short) doubles the capacity of the existing Nord Stream 1 pipeline, each able to carry up to 55 billion cubic meters per year (Gm³/a or bcm/a). Yet, the future of the pipeline is steeped in uncertainty. In today's blog I try to answer a few of the many economic and political questions about this pipeline.

Who is behind the pipeline project?

The pipeline has been built by Nord Stream 2 AG, a wholly-owned subsidiary of Gazprom headquartered in Zug, Switzerland. Nord Stream 2 AG is the sister company of Nord Stream AG, which operates the existing pipeline. The latter is a consortium of five companies with Gazprom as the majority shareholder (51%). Two German companies, Wintershall Dea AG and E.ON, hold 15.5% each. The chairman of Nord Stream 2 AG is former chancellor Gerhard Schröder of Germany The construction of the pipeline was financed about half and half by Gazprom and a group of five energy companies including Wintershall and Shell. It cost about 9.5 billion euros to complete the project.

Nord Stream 2 is owned by Gazprom, a Russian majority state-owned energy company headquartered in the Lakhta Centre near St. Petersburg. (The Lakhta Center, at 462 meters height, is Europe's tallest building.). Gazprom came into existence in 1989 through the conversion of the Soviet Ministry of Gas Industry into a state-owned corporation. Eventually, Gazprom was privatized and today accounts for about two-thirds of Russia's gas production. The company employs nearly half a million people. In Europe, the Netherlands and Germany are among its largest customers with purchases of about 48 bcm/a and 42 bcm/a in 2020.

What is the economic value proposition of the pipeline?

If you multiply 55 bcm/a capacity with the conversion factor 0.0373 Gigajoules (GJ) per cubic meter, it translates to about 2 billion GJ per year. Assuming long-term natural gas prices of about €5/GJ, this amounts to about 10 billion euros worth of annual revenue. At current peak prices of €35/GJ, multiply this number by seven.

Proponents of the project argue that the additional pipeline capacity would increase security of supply and help with the transition away from coal-fired power plants. The economic value of the pipeline depends on extra demand for natural gas because existing pipelines already provide sufficient capacity, even a fair bit of spare capacity, to serve the existing demand in Europe. Realizing the economic potential of Nord Stream 2 thus depends crucially on new demand for natural gas that would come from the transition away from coal and for backing up intermittent renewable energy sources.

Opponents of the project, however, worry that increased supply of natural gas would hinder the transition to renewable energy more than it helps because it could lock in additional natural gas capacity for decades.

There is also fierce competition about who will provide natural gas to Europe in the future. The United States has become Europe's most important supplier of Liquefied Natural Gas (LNG), and LNG producers are vying to gain a larger market share.

How important is Nordstream 2 compared to the existing pipelines from Russia?

As the map above shows, there are three major routes for delivering Russian gas to European markets. The Jamal route through Poland has a capacity of only 33 bcm/a, while the existing Nordstream-1 line can carry 55 bcm/a. Much more important is the Transgas route through Ukraine, which can carry up to 146 bcm/a. The total existing capacity is thus 234 bcm/a, and adding the 55 bcm/a from Nordstream-2 would increase capacity by 23.5 percent. The Transgas line, it should be noted, is fed by three separate line: a spur line from the Jamal line that runs through Belarus, and the Soyuz and Brotherhood lines that run through Ukraine.

How has the liberalization of Europe's gas markets influenced the project?

Until about a decade ago, most natural gas prices in the European Union were linked to the price of oil through a system known as oil-indexation. This kept prices relatively stable and ensured the viability of long-term investments into pipeline capacity. In the last decade, the natural gas market in Europe has moved increasingly towards a "spot market" model, also known as gas-on-gas competition. This was in part facilitated by a large increase in liquefied natural gas (LNG) import terminals that allowed European customers access to overseas supplies. In the Netherlands, the Title Transfer Facility (TTF) has emerged as the leading clearing house for trading. The Dutch TTF Gas Futures, have essentially become the benchmark price for the spot market. While a year ago prices hovered at around €4-5/GJ, they have recently shot up to €35/GJ in forward contracts. This greater volatility has been caused by a combination of supply and demand factors in Europe and Asia.

Russia favours long-term contracting over spot markets, whereas Western European countries increasingly favour the economic advantages of spot markets. Russia's preference for long-term contracting has a political dimension. Once contractually locked in, it is unlikely that deliveries will become subject to economic sanctions against Russia in case political conflicts emerge. Spot purchases of natural gas could be cut off more easily. Increasingly, the political dimension overshadows the economic dimension of this pipeline project. The issue of long-term contracting is thus a trade-off between economic stability and political risks. If Russia-Europe relations were smooth, the economic calculus would probably favour long-term contracting, especially for markets close to the pipeline terminus. Of course, lower cost and stable prices were precisely the motivation behind building Nord Stream 2.

Generally, spot markets are advantageous when long-term prices decline because then gas purchased through long-term contracts is more expensive. The "fracking revolution" in natural gas production has lowered production costs in North America, and new natural gas fields have been explored in places such as Australia. Despite its typically higher cost compared to piped gas, LNG is advantageous where building lengthy pipelines would be too expensive.

Does Nord Stream 2 compete against LNG?

The answer is yes—both politically and economically. Politically, LNG imports into Europe are dominated by the United States, while pipeline imports into Europe are dominated by Russia. Economically, LNG tended to be more expensive than pipeline gas, but a glut of LNG capacity is starting to change this picture. Europe currently has 28 large-scale regasification terminals with 237 bcm/a import capacity, enough to provide about 40% of Europe's gas demand. More terminals are being planned or built. Today, Spain is Europe's largest importer of LNG, followed by the UK and France. Notably absent is Germany.

Why is Nord Stream 2 controversial?

There are two main points of contention. The first point is about the adverse effect on current transit countries: Ukraine and Poland are strongly opposed to the project. Both stand to lose transit fees. A gas transit deal between Russia and Poland expired in May 2020, and Poland has pivoted to importing its 17 bcm/a of natural gas supplies from Norway and via LNG. However, Poland's transit fee was a paltry €4.5 million. Polish relations with Russia have been difficult for many years. I have written previously about Poland's dual energy transition and its ambition to become more energy independent.

The second point is about the larger political issues relating to Ukraine. The circumvention of Ukraine for exports of Russian gas to Europe is considered a strategic concern. The Ukrainian pipeline system has spare capacity and could have met the needs for increased supply in Western Europe. The current transit agreement between Russia and Ukraine, brokered by the European Commission, is ending in 2024. Ukraine earns about three billion Dollars a year in transit fees. About 40% of the 200 bcm/a of gas that Russia supplies to Europe was transmitted through Ukraine.

The Nord Stream 2 pipeline is opposed vehemently by the United States. The US position is both driven by political and economic considerations. The economic consideration is LNG: the US would like to increase its market share for natural gas in Europe, mostly at the expense of Russia. Politically, the US argues that Nord Stream 2 could be used against Ukraine. In July 2021, the United States concluded a compromise agreement with Germany. Their joint statement committed Germany to ensure that Ukraine remains a transit country for natural gas, and respond economically should military conflict ensue.

Why is Nord Stream 2 not online yet?

The pipeline is technically complete but is not yet in operation. The German energy regulator, the Bundesnetzagentur (Federal Network Agency) has suspended the certification procedure for Nord Stream 2 and indicated that a decision about the required certification would not happen until the second half of 2022. The regulator maintained that the operating company did not meet conditions to be an "independent transmissions operator." Certification would require that the company "was organized in a legal form under German law." Recall that Nord Stream AG is headquartered in Switzerland, outside German and EU jurisdiction. Nord Stream AG is now opening a subsidiary in Germany in order to meet the requirements.

Based on the current timeline, Nord Stream 2 could launch into service by the end of 2022—unless there are further legal challenges. An EU gas rule requires that gas producers and pipeline operators are separate companies (known as the "unbundling rule"), which is not the case for Nord Stream 2 because Gazprom controls Nord Stream AG. A German Court in Düsseldorf rule in August 2921 that Gazprom is not exempt from the EU rule. The unbundling rule is intended to ensure fair competition and prevent producer companies from obstructing competitors, which they could if they control access to the transportation infrastructure.

Will Russia's conflict with Ukraine sink Nord Stream 2?

By far the biggest threat to Nord Stream 2 comes from escalating tensions between Russia and Ukraine. It has been widely reported that Russia has been amassing military personnel and materiel near Ukraine's border, reckoned to involve over fifty battalion tactical groups. Moscow is demanding guarantees from the West that Ukraine will not join NATO and that NATO countries refrain from military activities in Ukraine. The specter of a military offensive against Ukraine looms even though Moscow has been denying such plans. It appears more likely than not that Russia is using military deployment as a diplomatic bargaining chip, as a form of "strategic deterrence" to prevent Ukraine from joining NATO. There can be little doubt that military aggression against Ukraine would lead to far-reaching economic sanctions that include withholding the operational start of Nord Stream 2 indefinitely. This is the heart of the aforementioned German-US agreement, and Germany's new government would come under intense pressure to act firmly in case of a military escalation.

Germany has a new government; will it change course on NS2?

Germany's new Chancellor Olaf Scholz took office on December 8, 2021. The new government's foreign minister is Annalena Baerbock from the Green Party, who is closer to US positions on Nord Stream 2 than any of her predecessors and has opposed the pipeline project. As Patrick Wintour and Philip Olterman reported in The Guardian on December 9 (Germany's foreign minister under pressure over Nord Stream 2 sanction), the new coalition government is split over Nord Stream 2 with Social Democrats generally being more favourably disposed to the project than their coalition partner. Yet, in case of military escalation in Ukraine, it is almost inconceivable that Nord Stream 2 will not be included in economic sanctions against Russia. Germany's position is conciliatory towards Russia but should not be mistaken for strategic indifference. If push comes to shove, Germany's new government can be expected to respond more firmly than Germany's previous governments.

Does Nord Stream 2 threaten Europe's energy sovereignty?

Energy sovereignty is a vague term and means different things to different people. The term has been used and misused in the debate about Nord Stream 2. I much prefer clearer terms: true energy independence means not relying on imported energy, which for countries without their own vast sources of energy is often a near-impossibility. If true independence is not achievable, the next best goal is import diversification in order to spread economic and political risks over a larger number of sources. By that token, the European Union would be well advised to seek out diversification. But this is no free lunch. Natural gas diversification requires more infrastructure: more LNG terminals, but even more importantly, more storage facilities and significant strategic gas reserves. All of that comes at a steep cost. Are Europeans willing to pay the price for what I would label energy resilience?

Should Nord Stream 2 go ahead?

On balance, in my view Nord Stream 2 should proceed with caution. But operation of Nord Stream 2 must be coupled with greater energy resilience of the European Union, and a healthy balance of long-term contracting and spot-market purchases of natural gas. As for the politics, Wolfgang Ischinger pointed out in Foreign Affairs earlier this year that the pipeline can provide leverage rater than liability. In any case, the European Union is right to insist on competitive fairness and access neutrality. The current ownership structure of the pipeline remains an obstacle to its commercial success.