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2014-07-10 18:50:00



Poland's prime minister, Donald Tusk, has a battle on his hands. In April he proposed a European energy union to address one of the most glaring strategic weaknesses of a continent that imports more than half its energy. He will need all his reserves to achieve the goal.

His initial timing was perfect for political and economic reasons alike: the crisis in Ukraine and the shale boom in the US are forcing EU countries to assess the inefficiencies of their fragmented energy networks as never before.

If these systems were fully integrated, the consultancy Strategy& (formerly Booz & Co) estimates that Europe could benefit by as much as €40bn in savings each year by 2030.

Mr Tusk has launched a diplomatic tour to win round the EU to the idea, but he has received a cautious response. He grumbles that some national leaders agree in principle but react with "anxiety and fear" when discussing specifics.

He is now urging his counterparts to show the same dedication to a common energy policy as they (eventually) did to saving the euro. "The banking union also seemed close to impossible but the financial crisis dragged on precisely because of such lack of faith. The longer we delay, the higher the costs become," he complains.

Mr Tusk has reopened a longstanding conflict. His blueprint ties into one of Europe's most elusive dreams: a single internal energy market for gas and electricity.

Some elements of his plan are new: notably the proposal that EU nations and institutions should flex their muscles by working jointly to negotiate gas supply deals with Gazprom, the Russian state-controlled producer. That has proved controversial, not least with Gazprom. "Mr Tusk is a politician who has done quite a lot for the development of our relations. Suddenly for some reason he has, as they say, fallen out of the oak tree," says Alexander Medvedev, Gazprom's deputy chairman. "I could say plenty about why this is a stupid idea."

Yet Berlin and the European Commission are also worried for different reasons: that the proposal could defy international competition law. Günther Oettinger, the EU energy commissioner, cautioned that joint negotiation with Gazprom would be a "fundamental" change in practice. "Checking it with WTO rules, with our internal market rules, is now my priority," he said.

Mr Tusk's vision of a better connected market would reduce the need for Russian imports but the EU's progress in this field has been glacially slow, with many countries mired in energy disputes with their neighbours.

The vision is alluring because EU nations are often inefficient "energy islands". An internal market would bind them together with infrastructure such as cross-border gas and electrical interconnectors. In theory, this would foster greater competition and convergence in prices.

Mr Tusk's priority is that eastern European nations should no longer negotiate bilateral deals in secret with Gazprom. Instead, market-based prices would be set at trading hubs across the continent. Contracts would use those prices as a transparent reference. A more competitive market also means importing new sources of gas from Azerbaijan and the eastern Mediterranean, as well as building terminals for liquefied natural gas.

In the electricity market, interconnections can also combat Europe's economic inefficiencies, particularly by harnessing renewable energy. Spain's grid is barely connected to France so its wind farms cannot export their production when it exceeds domestic demand. Similarly, solar and wind energy from southern Italy is wasted because it is not effectively linked to the industrial north.

To link the continent's disjointed energy networks and unblock bottlenecks, the European Commission has identified 248 crucial infrastructure projects.

Spain is a prime example of why it is so difficult to build a single market. The idea of a new interconnector into France has proved contentious since the last one was built in the early 1980s. Plans for pylons across the Pyrenees angered protesters who said they would be an eyesore. France's nuclear industry was also reticent about cheap renewable energy streaming into the French grid on an uncertain timetable.

After years of political battles and public protests, a Pyrenean interconnector will open next year but with a €700m compromise: two 780-tonne drilling machines had to bore a tunnel through the mountains to hide the cables. Spain still needs more interconnectors and is now even considering a 895km submarine link to Britain that could cost as much as €2.5bn.

Projects for a single energy market were supposed to be boosted this year by EU funds. But even the commission has seemed embarrassed by the modest sums available, noting last month that €5.8bn for 2014-20 represented barely 3 per cent of what was needed.

Full energy convergence needs more than interconnectors. Widely divergent electricity prices are often determined by national tax rates. Grids that can respond to demand further afield in a continent-wide "supergrid" will need more direct (rather than alternating) current infrastructure. While it took Spain and France more than three decades to build a 64.5km interconnection, some 52,000km of lines need to be built or upgraded across the continent.

Gas infrastructure is even more politically divisive. Bulgaria is under pressure from Russia to host part of its South Stream pipeline, while EU officials object that it violates its competition rules. Equally, Berlin infuriated Warsaw with the Nord Stream pipeline that sends Russian gas to Germany, bypassing Poland.

Tim Boersma, energy expert at Brookings Institution in the US, argues that breaking EU dependence on Russia will not be rapid. "The ongoing crisis in Ukraine has confirmed two things: Europe continues to be divided on energy security issues, and the importance of energy related matters is modest compared to concern about the right and left wing drift of European politics," he wrote recently.

To Mr Tusk, that is why the EU now has to work together.

"The Ukraine crisis and the energy union is a test of what the EU is all about. It is a battle to decide what is more important: bilateral relations with Russia or internal relations within the EU."

Political support: Tension over competition policy

François Hollande, France's president, has no qualms about hijacking Mr Tusk's plan for an energy union. "I consider that today the proposal is Franco-Polish," he said only days after Mr Tusk launched his idea.

But not everyone has been so enthusiastic. Angela Merkel, Germany's chancellor, has agreed in principle but wants to delve deeper into the details. There is also suspicion from environmental groups because the plan emphasises the development of domestic fossil fuels. For Poland, that means coal and shale gas.

The most contentious element is that the EU should form a joint gas buying body to win leverage over Gazprom. Poland says the body could resemble Euratom, which deals with Europe's uranium purchases, but the EU has played down the potential parallels.

Poland argues that Gazprom has confidential data on each country it deals with, knowing its gas prices and infrastructure vulnerabilities. It can then use this data to its advantage, pushing some countries into more onerous contracts than others. Warsaw wants to level the playing field with an EU negotiating body that has access to shared commercial data so it can haggle for more uniform prices. The body should also be able to check the legality of deals, striking out any abusive clauses.

EU officials say they need to assess whether such a centralised body could contravene competition laws. But Mr Tusk retorts that they showed fewer concerns about access to corporate information during the financial crisis when creating a banking union. "Do gas secrets deserve more protection than banking secrets?" he asks.

Gas hubs: Lack of liquidity is a hindrance

Eastern European countries regard gas hubs as their salvation. Instead of Gazprom setting gas prices with arcane formulas linked to the cost of oil, the prices would be set transparently at trading centres.

But that will not happen easily. The key to successful hubs is high liquidity, ideally with many different sources for the gas.

So far, eastern European markets are poorly developed and could take as long as a decade to gain the necessary depth, according to Patrick Heather, a consultant and senior research fellow at the Oxford Institute for Energy Studies. "There's no liquidity in the east," he says.

In illiquid southern and central European markets in particular, trading hubs would not immediately help because Gazprom would be the dominant supplier and could still maintain control over prices.

The advantage of a hub would become more apparent when new supplies from Azerbaijan and the eastern Mediterranean are integrated into the market by means of the so-called southern corridor supply route.

The figure cited most often by experts to determine whether a gas hub is building liquidity is the "churn rate", which measures the number of times that gas is traded before actually being delivered. A churn above 10 is considered the hallmark of an effective market.

In 2013, Mr Heather calculates the net market churn in Britain at 18.7 and even higher in the Netherlands, at 19.3. In the rest of Europe the numbers are far lower. In Austria, the churn was 2.6, while it was only 0.4 in Italy.

Electricity links: Local rivals and green concerns

Spain's electrical interconnection with France is hardly unique in being delayed by protests and politics. Demonstrators concerned about damage to tourism and the environment are a common feature of interconnector projects. Geoffrey Feasey of the European Network of Transmission Systems Operators for Electricity says one-third of the most vital projects to connect Europe are being held up by "permitting and public acceptance".

This is a big challenge for Brussels, which wants to expand the EU's interconnectivity target. In 2002, it proposed that countries should be able export 10 per cent of their generational capacity. The current average is 8 per cent but countries such as Spain and Britain are very poorly connected. The commission is now proposing lifting the target to 15 per cent by 2030.

Europe's Agency for the Co-operation of Energy Regulators says that cross-border transfer capacity increased a "modest" 9 per cent between 2008 and 2012. Half of the increase was due to a connection between the Netherlands and Britain. The key to increased EU connectivity will be Germany because the industrial south is poorly connected to the north, where there are more renewable power sources.

The renewable electricity, which will become more significant as Germany scraps its nuclear power stations, shoots in a loop through neighbouring countries. Such large, intermittent flows are a technical dilemma for smaller neighbours.

Poland is responding to the problem with "phase shifter" transformers to prevent overloading on its grid. Green groups argue Poland is protecting its coal power stations with a firewall rather than embracing renewables.





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