Nord Stream and Ukrainian Corruption

The Nord Stream 2 gas pipeline, intended to deliver some 55 billion cubic meters a year of Russian natural gas to Germany, is reaching completion. Long a source of intense division between the US and Germany, a recent agreement struck between German Chancellor Angela Merkel and US President Joe Biden appears to have put in place certain policy guarantees regarding Ukrainian energy security that resolve US concerns over the pipeline, paving the way for completion. While Russia will most likely avoid moves that would automatically trigger any punitive actions on the part of either Germany or the US, it could exploit corruption within the Ukrainian energy sector to undermine the guarantees that the US seeks for Ukraine. Moscow could use Ukrainian corruption as the basis for a legal argument for withdrawing from an existing gas transit agreement in a way that would be difficult for Germany to challenge, possibly damaging US-German relations.

The Nord Stream 2 project has been plagued with controversy. Conceived after Russia’s 2014 annexation of the Crimea and its ongoing support for pro-Russian separatists fighting in the Donbas region of eastern Ukraine, Nord Stream 2 is a major gas infrastructure project that has divided the Atlantic alliance.

A coalition of like-minded nations, led by the US, has opposed the project, which is led by Russia’s state-owned natural gas giant Gazprom, along with Western energy companies, including Royal Dutch Shell, German utility E.ON, Austria’s OMV and French utility Engie. And yet, despite US economic sanctions and legal obstacles from the EU, which sees Nord Stream 2 as undermining the diversification of EU gas supply, Germany has always been strongly in favor of the pipeline, arguing that it makes economic sense and will prove beneficial for all of Europe. Germany’s stance, supported in full by its chancellor, Merkel, drove a wedge between it and the US, which, under President Donald Trump, threatened to expand into an outright breach in relations between the two allies.

To restore relations between the US and Germany, Biden has agreed to view Nord Stream 2, which is scheduled to be finished in late August and enter service later this year, as a done deal, waiving some US sanctions and entering into an agreement with Germany that would allow the project to be completed in exchange for guarantees regarding Ukrainian energy security. While US-German discord over the political and economic wisdom of buying natural gas from Russia extends back to the 1980s, it is the Ukrainian dimension that differentiates the latest dispute.

Ukraine depends on Soviet-era gas pipelines controlled by Russia for both its supply of natural gas as well as the generation of income from gas transit fees amounting to between $2 billion and $3 billion dollars a year. The Ukrainian government is concerned that pipeline projects such as Nord Stream 2, which bypass Ukrainian territory, will enable Russia to cease the transmission of gas through the Ukrainian pipeline network, threatening both the energy security and financial stability of Ukraine. Poland is in a similar but less vulnerable position.

To mollify Ukrainian concerns, Biden and Merkel recently agreed to a package of proposals that provide funding designed to enhance long-term Ukrainian energy security while also promising in principle to enact economic sanctions on Russia should it seek to use natural gas as a weapon against Ukraine. A critical component of their agreement is Germany’s commitment to help extend the current Russian gas transit deal with Ukraine, which expires in 2024. Merkel has been in contact with Russian President Vladimir Putin over the possibility of a 10-year extension to this agreement.

Ukrainian Corruption

The biggest threat to the US-German deal, however, may be Ukraine itself. Corruption has been endemic to Ukrainian politics, seemingly like a drug addiction. And the gas sector in particular had been considered the most corrupt business in all of Europe. But post-2014, the Ukrainian government imposed reforms on the gas sector equivalent to a rehab treatment. In the span of five years the Ukrainian gas sector was transformed into a poster child for transparency and rule of law — a success story in a nation still struggling to find its feet since the Maidan Revolution.

But, like an addict, the Ukrainian body politic has recently relapsed, implementing a raft of domestic political decisions that will again facilitate the same corruption that the earlier reforms were intended to prevent. One of the red flags for gas sector corruption in Ukraine was the existence of subsidies that enable companies supplying gas to the civilian and commercial sectors to purchase gas inexpensively and then sell it to consumers at higher rates. The difference adds up to tens of millions of dollars, which is pocketed by the company owners and the politicians that support these schemes.

The Ukrainian government recently approved a price cap on natural gas sold to households, reversing the deregulation of gas prices that had been implemented a scant six months ago. This move appears to be a response to populist demands for lower energy prices but it also signals a return to corruption. Along with this return of gas subsidies, the Ukrainian government is in the process of transferring one of two major gas and electricity transmission companies, GTSO, back to the control of the ministry of energy. In 2019, these companies were placed under the control of the Ministry of Finance to eliminate the kinds of conflicts of interests that fueled corruption in the past.

The Ministry of Finance was chosen to run these companies in 2019 because it had no role in making energy policy. The combination of a return to subsidies set by the ministry of energy and a return of control of the gas distribution system to the ministry of energy creates a perfect recipe for exactly the kind of corruption that the reforms of 2014-19 were meant to stamp out.

Russia’s Opening

These policy changes in Ukraine could give Russia a way to challenge current and future transit agreements with Ukraine. Russia’s agreement to enter into a five-year gas transit deal with Ukraine in 2019 was contingent upon the certification that GTSO operated as an independent entity, which was the purpose of putting it under the direction of the finance ministry. If Russia can make a case that GTSO has lost its status as an independent operator, then it will have a valid legal basis for challenging the current gas transit deal, or at a minimum opposing any effort to extend it.

Russia has made no bones about its desire to end the status of Ukraine as a gas transit country following the termination of the current deal in 2024, if for no other reason than to deny Ukraine access to billions in transit fees paid by Russia. While the US-German agreement on Nord Stream 2 appears to curtail any blatant Russian efforts to leverage the Nord Stream 2 pipeline as an economic weapon against Ukraine, the probable resurgence of officially sanctioned corruption in the Ukrainian gas industry gives Russia an opportunity to squeeze Ukraine for geopolitical gain. That Russian strategy would also probably again drive a wedge between the US and Germany at a time when the US has made repairing the trans-Atlantic relationship a top priority.

Despite Biden’s successful effort to forge a compromise over Nord Stream 2, this is an uncomfortable compromise for the US that many in Congress still oppose. Russia is fully aware of this undercurrent of US opposition. The wild card in this equation is Germany. While Merkel has committed Germany to act in defense of Ukrainian energy security, her tenure as chancellor expires in September, leaving questions about the level of commitment of her successor. If Russia shrouds any anti-Ukrainian action under legal arguments linked to Ukraine’s recent policy changes regarding the independent operator status of GTSO, it will be hard for Germany to support Ukraine that strongly.

A likely scenario has Russia working with Germany in principle on the issue of an extension of the current gas transit deal until Merkel leaves office, only later, at a time of its choosing, opting to nullify the deal on the grounds of Ukrainian noncompliance. At this point, Germany’s new leadership will be confronted with a decision on whether to support the rule of law or be seen as facilitating Ukrainian corruption.

Judging from the past, Germany will be partial to the rule of law, siding with Russia and thereby putting itself at odds with the US. This would reopen the possibility of US sanctions against Germany, fomenting a crisis between the two trans-Atlantic partners. This scenario would be a win-win proposition for Russia. It also underscores the folly of both the US and Germany supporting a Ukrainian government that seems incapable of reforming its addiction to corruption.

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