EU ENERGY SECURITY

Introduction: The Failure of EU Integration and the Threat to Supply Security in the Western Balkans.

With the annexation of Crimea by the Russian Federation, the realization that Russia is becoming a revanchist and destabilizing power gave the EU no alternative but to prioritize its energy security. Gazprom provided 27% of European gas supply in 2013. But that figure underestimates Gazprom's impact because of the lack of interconnection and supply diversity in Central and Eastern Europe. States such as Poland, Hungary, Slovakia and Bulgaria are subject to either monopoly or dominant supply dependence on Gazprom. Given the threat that a revanchist Russia will now be much more prepared to use gas dependence as a political lever, it is vital for Europe's supply security to diversify away from Russian sources of supply.

The Western Balkans are a key point for Europe to achieve supply diversity. Croatia has the deep-water facilities for LNG tankers and a significant pipeline capacity which could provide Central Europe with alternative gas supplies. The Western Balkan states could also provide a route for an extension of the TAP pipeline into their own states and on into Central Europe. There is also the prospect of developing significant offshore resources in the economic zone of the coastal Balkan states.

With Croatia's July 2013 accession to the European Union and the opening of accession negotiations with Serbia, it looks at first sight like the EU is strengthening its supply security. As the Western Balkan states make their way toward the Union they are required to comply with the market liberalization and transparency rules of EU law. This should ensure that investment flows in to develop their resources and to ensure that pipelines are interconnected and new facilities brought on stream.

Unfortunately, despite accession - or the prospect of accession - to the EU, the Western Balkan states are proving profoundly resistant to EU rules and values. The overhang of legal dysfunctionality, protectionism and corruption from the communist period and the 1990s Balkan conflict acts as a powerful counterweight to the 'magnet' of EU membership. This problem is compounded by Russian interest in the region. Russian companies, often state-owned or controlled, are happy to acquire assets, work with existing elites and frustrate EU attempts to develop new energy resources and interconnections. This is underlined by significant regional support for the South Stream project.

This history has generated two major negative effects. First, legal dysfunctionality in the Western Balkans undermines the willingness of investors to finance new infrastructure and enter local energy markets. Second, it encourages a protectionist, statist approach to energy markets which is diametrically opposed to EU norms. The knock on effect of these two factors is to undermine EU's supply security, jeopardizing the prospects for new networks, new sources of gas and renewables, and new import terminals.

It is argued that the only way to deal with this problem is to launch a multi-prong strategy of reform in addition to the accession process. This would include a wide range of rule of law measures, working particularly with those states who show the greatest willingness to reform. In parallel, it is argued, it would be necessary to upgrade significantly the operation of the European Energy Community. Full 'Europeanisation' of the Energy Community would extend the EU energy acquis to the West Balkan markets. Applying the EU energy acquis in full would open up those markets and provide for EU levels of surveillance, thereby making them more attractive to investors. A more stable and secure legal framework which attracted investment would also ensure that investments which added to the Union's energy security actually took place.

Western Balkans Dysfunctional Legalism v. the Rule of Law

For the Central and Eastern European states, the fall of the Berlin Wall a quarter of a century ago was a great moment in their history. It allowed those states - with support of the EU and the US, domestic dissidents, NGOs and reformed communists - to embrace a liberal, democratic, open market future. All of these states have joined the EU and NATO and have more or less successfully transformed themselves into liberal democratic open market states.

By contrast, the fall of the Wall in the Western Balkans triggered one of the most bloody episodes in modern European history. It not only led to the break up of Yugoslavia and the creation of a number of new states, but the process of conflict empowered the old communist elites, robber barons and warlords. Rather than moving toward the light of democratic reform and open markets, the Western Balkans moved toward the dark of kleptocracy; corruption, opaque markets and the formation of new market-controlling elites.

Formally, the states of the Western Balkans are pledged to reform themselves to prepare for accession to the European Union. EU programmes are introduced and adopted as part of the accession process. However, in practice the unreformed post-conflict systems remain in place.

This can be demonstrated by the looking at some recent examples across the region. For example, in 2009 Serbia undertook pro-European reform of the judiciary, supposed to deliver a more independent and professional bench. Instead, the reform process was used as an opportunity to remove hundreds of judges without any transparent or objective criteria being applied. Essentially, the EU reform process was deployed to achieve local elite objectives to further control, rather than any real reform of the judiciary. This failure to reform the judiciary effectively is underlined by a June 2012 TNS Medium Gallup poll. It found that 87% believed that the judiciary had a valuable role to play in dealing with corruption, but also that the Serbian judiciary were too corrupt to play that role.

Another example of Serbian resistance to adopting Western norms of legality is the saga over Article 359/234 of the Criminal Code. Under communist rule, Article 359 had an ostensible legitimate purpose. In a society where all major businesses were supposed to be owned by the state, Article 359 was designed to protect state assets from being looted by their managers. Hence, those who ran these businesses were prohibited from profiting from their operation. Clearly in a market economy where managers are usually the owners of the business they run, Article 359 is nonsensical.

However, Article 359 has been very useful for local elites wishing to seize assets and to gaol opponents. A wide range of business leaders have been charged under Article 359 including Milija Babovic of Victoria Holdings, Vuk Hamovic of EFT, and Miroslav Miskovic, Serbia's richest business executive. The European Parliament protested at this use of Article 359. It was 'seriously concerned about repeated allegations of misuse of Article 359 of the Criminal Code on abuse of office, which was accompanied by alleged widespread unjustified freezes of company and private assets; underlines that these allegations have undermined trust in the rule of law in the country; calls on the authorities to swiftly proceed with a revision of the Criminal Code to ensure that it is in line with European standards and to immediately put an end to the bringing of charges of abuse of office in private enterprises with majority private ownership and to discontinue pending criminal proceedings'

Ultimately the Serbian Parliament did repeal Article 359, only to reenact it as Article 234. In essence, under European pressure Serbia not only did not end its abuse of Article 359 but, in flagrant disregard of the concerns raised by the European Parliament and other EU institutions, it merely swapped one provision for another new provision. It then re-charged all the executives originally charged under Article 359. In other words all the executives charged under Article 359, when it was repealed were re-charged under Article 234, even though Article 234 had not been on the statute book at the time of the alleged offence. The overall result of European pressure in Serbia is that the Serbian government has gone from one form of major breach of the rule of law to another. It is now also in breach of one of the oldest principles of the rule of law, lex retro non agit, the prohibition on retroactive criminal law.

The European Parliament has protested at this gross breach of the rule of law in a resolution in April 2013. The European Commission has also raised the enactment of Article 234 with the Serbian government. As yet it remains on the statute book and criminal charges remain against many business executives.

Another telling example of dysfunctional legalism can be found in the Ivanovski case in Macedonia. The most recent OECD Assessment Report refers obliquely to the Ivanovski case. In that case a lustration law was deployed to remove the President of the Constitutional Court.

'The circumstances related to the dismissal of a Constitutional Court judge and the appointment of his successor within three days in April 2011 cannot be seen as proof of the political independence of the (appointing) Judicial Council nor as an objective process to select a candidate for one of the highest public offices in a democratic state. Apparently, the judiciary is still understood to be, and used as, a political instrument.

Mr Ivanovski has now filed a case against FYROM with the European Court of Human Rights alleging violation of Articles 6 and Article 8, breach of a right to a fair trial and his right to privacy. The ECHR Statement of Facts and Questions to the Parties in the case reinforces the concerns raised by the OECD. These include: inadequate opportunities to respond to the allegations made; violation of the presumption of innocence (the President of the Supreme Court speaking to the media on the conclusion of an appeal several days before judgment was handed down); and allegations that judges who had been involved in the case being subsequently promoted, including to Mr Ivanovski's own position on the Constitutional Court.

The adoption of a broad lustration law by the current government is a further cause for concern beyond the Ivanovski case. It raises significant questions as to the quality of evidence being deployed in the making of assessments, due process, data protection and privacy. It also appears to target a range of individuals who have crossed or are at odds with the current administration.

These questions regarding judicial independence are reinforced by the European Commission Progress Reports. They note that little progress has been made in respect of the independence and impartiality of the judiciary. It observes that the general capacity of the judiciary to deal with corruption cases remains low. Very few high level anti-corruption cases have been brought to a successful conclusion as a result of mis-steps in procedure which have resulted in lengthy retrials. It also notes that corruption in respect of public procurement remains a serious problem.

The latest OECD report for Bosnia-Herzegovina also makes disappointing reading. It says that the 'underlying reason for major deficiencies in the governance system is the lack of respect for fundamental democratic tenets (individual political rights versus ethnic or group based), the disrespect of law and existing institutions by the major actors whether they be parliament, the executive or civil society and its organisations.

In this context it is not surprising that the OECD took the view that the effective application of the rule of law remains a matter of serious concern. It also noted as in a number of other states in the region that public sector institutions did not hesitate to override legal provisions. This view is reinforced by the European Commission Progress Report which notes shortcomings in ensuring the independence and impartiality of the judiciary.

One specific distinguishing negative feature of Bosnia-Herzegovina is the impact of the Dayton Peace Accords on the ability of the country to operate as a functioning democratic state. The OECD report argues that the Peace Accord, while ending the war, deprived local politicians of both real responsibility and accountability. The Accord makes it difficult to create an effective state while enshrining religious and ethnic based polities. The Accord also creates an unmanageable number of legal orders with 14 governments in place across the state, many of which hold significant veto rights. The consequence is that Accord 'inhibits the development of a culture of political compromise inherent in any democratic regime. This factor is underlined by the European Commission's Progress Report, which notes that the Federal Constitution 'entails costly and complex governance structures with certain overlapping competences between the Federation, Cantons and Municipalities.

The Report also makes the point that the very complexity and weakness of BH's public governance system makes it prone to capture by private interests.

Croatia, which joined the European Union on 1st July 2013, also raises some serious worries. The latest OECD Assessment Report and European Commission Progress Report are more positive than the other states of South Eastern Europe. However, the OECD does note that respect for the rule of law remains a source of concern and needs to be continuously monitored. The OECD raises concerns in respect of the operation of fast track legislative procedures as well as the overall quality of the legislation being adopted. Concern is also expressed that, as in other states in the region, it is only pressure from the Union that is forcing the pace of anti-corruption investigations. The core concern for the OECD is that the pressure being external is not sustainable over time.

This concern is underlined by the Sanader case, which ended with conviction for corruption of the former Prime Minister in November 2012. This case was trumpeted as a great victory for the country's anti-corruption campaign and demonstration of the country's European commitment. However, on close examination of the oral judgment it is difficult to feel quite so confident.

One of the underlying principles of western legal systems is that there should be no appearance of or actual bias in any court judgment. Any fair-minded observer would have been concerned at the language used by the presiding Judge, Ivan Turudic. For instance, in the discussion of Sanader's defence the judgment is peppered with 'that of course, is not true', 'truly sounds bizarre', 'truly sacrilegious', 'a degree of arrogance'. Then again, during the presentation of the initial ruling a claim by Sanader that a preference for competent Hungarian over incompetent Croatian managers, the judicial concerns are expressed that as a result Mr Sanader's claim of 'patriotism' cannot 'be taken seriously.

This appearance of, or potentially actual, bias is reinforced by the Judge's failure to address the evidence procured by Hungarian prosecutors and made available to the court. The failure to inquire into the source of the alleged bribery payments, or to explain why MOL would seek to bribe anyone in the Croatian government when the object of the bribe-control over INA, flowed from agreements already in place with Zagreb.

The compound impact of these comments on Sanader's defence, his political administration and the judicial failures, would give any reasonable external observer reason to believe there was at least an appearance of bias.

The Sanader case is disturbing for the rule of law in Croatia. If the criminal justice system cannot prosecute a case against a former Prime Minister according to normal standards of due process, it is right to be concerned as to the credibility of the rest of the criminal justice system.

European Energy Security & the Western Balkans

The Western Balkans could play a major role in improving the EU's and its own supply security and reducing its dependence on Russian gas. Through investment in a LNG terminal, reverse flow capacity, the IAP and new offshore and onshore resources, the region could make a significant contribution. However, all these states have substantial and systemic rule of law problems. This dysfunctional legality is likely to make most investors very wary of entering these markets and providing the capital necessary to complete these projects.

The dysfunctional legalism of the Western Balkan states post the Crimean annexation and Russian revisionism is, therefore, a threat to the European Union's supply security. The Western Balkans are a key crossroads between the hydrocarbon resource rich states of Central Asia and the Middle East and the EU's energy consumers in Western and Central Europe. The region's dysfunctional legalism as described above undermines the willingness of international investors to develop new pipelines, terminals and new energy sources.

This situation is made worse by two further factors. First, Russian interests, which use local rule of law failures combined with their commercial influence to ensure the region remains almost wholly dependent on Russian energy supplies. Second, an underlying protectionism reinforced by weak rule of law which again undermines EU attempts to liberalise Western Balkan markets.

The Western Balkans can improve Europe's energy security in several ways. To begin with, there is the potential of a gas terminal in Krk Croatia. This has been discussed for many years but no development has occurred. The proposed Krk LNG facility is slated to provide 5bcm capacity (with possible expansion to 15bcm) and would provide a substantial amount of that gas for export (Croatia's annual consumption is only 3bcm). There is already a pipeline connection between Croatia and Hungary which, with very little new investment, could provide 1.5-2.5bcm into Central Europe. With new compressor stations it could provide 6.5bcm.

The LNG terminal option plus full physical reverse flow would make a significant difference to supply security in Central and Eastern Europe and could provide a route to bring non-Russian gas into Ukraine. The difference a 6.5bcm reverse flow pipeline could make in the region is underlined by the fact that Hungary's total Russian gas imports are only 6bcm. Not all that gas would go to Hungary, some would go into other Central and Eastern European states, and some on to Ukraine. Croatian sourced gas in the region would reinforce the impact of new gas sources coming out of the Swinoujscie LNG terminal, and reverse gas flows from Western Europe. Together, those sources would place significant pricing pressure on Gazprom and reduce the company's commercial and political leverage.

The region also has the prospect of becoming part of a new southern corridor for gas resources from the Caspian. This would involve developing a pipeline dubbed the Ioanian-Adriatic Pipeline (IAP) and carrying up to 5bcm of gas as far north as Croatia. IAP would be an extension of the Trans-Adriatic Pipeline (TAP) which will carry Azerbaijani gas from Greece to Italy. The current TAP project is currently the largest confirmed gas supply project which will come online in the next five years. It will bring in all around 10bcm from the shores of the Caspian to Europe. TAP's connecting pipeline, the Trans-Anatolian Natural Gas (TANAP) pipeline, can be upgraded to almost double capacity with compressor stations. Given the grave supply security situation and the fact that the initial pipeline will be built, there is likely to be considerable pressure to seek extra gas for TANAP/TAP either from the Caspian or from Northern Iraq.

Any significant additional supplies would be likely to make the IAP viable. It would run up from Albania to Croatia. With a capacity of 5bcm it would have the capacity to significantly displace Russian gas in the region as well as adding further liquidity to markets in Croatia and Central Europe.

These problems are reinforced by two other factors; first and foremost, the impact of Russian influence on the region. Russia is the dominant supplier of oil and gas. Save for Croatia, no other state in the region has significant 'own resource' gas. This supply dependence gives Russian firms, notably Gazprom, significant leverage over states in the region. The most notable recent example is found in Serbia.

Serbia had already delivered almost the entirety of its oil and gas sector to Gazprom in 2008. It was also one of the first Western Balkan states to support Southstream. Construction of Southstream's Serbian section began in November 2013. Because of significant debts to Gazprom for gas (over $80 million) and to Gazprom's oil subsidiary NIS (of €225 million), the terms of the Southstream deal are unfavourable to Serbia. These debts are likely to escalate with the current supply contract contracting Serbia to take twice the country's actual demand. This 'take or pay' clause is not actually enforced but hangs over the domestic firm as a threat that it could be applied. Other terms include acceptance of total dependence on Gazprom supplies; to wit, a Russian company to control the gas storage facility and handing over a 51% share of the investment company to Gazprom (something which no other state involved in the Southstream project has accepted).

Serbia is part of the Energy Community. This applies the EU acquis in energy (and flanking measures in competition and environmental law) to the states of the Western Balkans, Moldova and Ukraine. The energy acquis includes rules on the unbundling of pipeline networks, third party access and transparent tariffs. None of these conditions apply to Southstream. The Energy Secretariat, which supervises the operation of the Energy Community system, has continually raised concerns and objections to the non-application of the energy acquis by Serbia in respect of Southstream, but to no effect.

Unfortunately, the Energy Community system lacks any features of direct applicability or direct enforcement as exists in the EU system. Therefore, the Secretariat having failed to get a resolution of the non-compatibility of Southstream with the acquis, its only alternative is to file the case with the EU Council for political resolution.

There are a number of questions here. How can a candidate Member State simply ignore requests from a regulator such as the Energy Secretariat regarding the compliance of the energy aquis? What is a Candidate Member State doing seeking to increase its own supply dependence, and that of other EU and candidate Member States, on Russia?

The second problem is that of anti-open market state protectionism in domestic energy markets which undermines the willingness of investors to enter this sector in the Western Balkans. The most comprehensive example can be found in Croatia. Croatia was a member of the Energy Community for eight years before it joined the EU in July 2013. It is obliged under its Energy Community rules to liberalise its energy market. On becoming a Member State it is obliged to fully comply with the EU rules on free movement and over a three year time period fully liberalise its energy market.

Despite these international, and now EU legal, obligations Croatia has in fact been moving in the opposite direction. To give three examples.

Croatia deemed almost its entire energy infrastructure a 'Special Interest'. EU law allows states to deem certain key elements of infrastructure a 'special interest' where such a measure is proportionate and objectively justified. It would be difficult to provide any justification, either under EU law on free movement of capital or establishment, when almost the entire infrastructure is deemed a special interest and thereby subject to significant additional non-commercial obligations.

Imposing regulated tariffs across the whole distribution chain for the next three years. Croatia appears to have infringed the Gas Market Directive by imposing regulated prices for up to 3 years across the whole distribution chain from producers through to consumers. Such a measure deprives existing investors of revenues and lowers their return on capital while undermining the incentive of investors to enter the market.

Delay in establishing reverse flow the Hungarian-Croatian interconnector. Despite the fact that with limited investment some reverse flow capacity could be provided to Hungary, this has not yet taken place. The consequence is that, because of the economic crisis and the anti-market regulatory developments in Croatia, INA could be faced with excess gas supplies which could be sold onto the European market, but which may instead have to be flared.

These measures all appear in breach of EU freedom of movement and energy liberalization law and to be aimed at protecting the Croatian government's interests in INA and reducing the role of foreign capital. There are numerous comments by government officials in the local media which reinforce the impression of a government bent on protectionism. For instance, in February 2013, Economy Minister Mr Ivan Vrdoljak explained in the Croatian business journal Lider that 'the government wants INA to be a Croatian company. In September 2013 the Finance Minister Mr Slavko Linc, said that the Croatian state was prepared to create 'impossible conditions' for MOL. The state can 'change the amounts of the concession, we can shut down the filling stations'.

Protectionist policies in Croatia are a particular problem because, as explained above, Croatia could have a key role in improving Europe's energy security. Investors are unlikely, however, to be willing to invest to provide the facilities which would enhance European energy security when Croatia is refusing to comply with EU internal market rules. Investors are also unlikely to be impressed with a state that is supposed to be liberalizing its energy market, when in fact it is going in the opposite direction.

There is also a specific energy problem in Bosnia-Hercegovina. The legal 'balkanization' and multi-jurisdictions within that state as a result of the Dayton Accords have negatively impacted the energy sector. As a consequence, a number of separate mini-energy markets have been developed. Most of the power sector makes losses, regulatory systems differ and there is a lack of connection even across the domestic market. So the state, in addition to the rule of law problems, Russian influence and protectionism, cannot attract investment because of the lack of a single internal energy market.

EU Energy Security & the Western Balkans: Solutions and Conclusions

The first requirement for dealing with the energy security problems in the Western Balkans would be for the EU to recognize the key role that the Western Balkans can play. Brussels also needs to recognize that the exceptional legal dysfunctionality in the region directly affects the Union's energy security as it makes it very difficult for investors to put in place the finance to build the required infrastructure.

The Ukraine crisis does appear to have galvanized the European institutions to begin to take action - most notably with the infringement proceedings against Bulgaria in respect of its Southstream agreements operating in breach of the competition and energy liberalization rules. It is also notable that the Commission has now instituted infringement proceedings against Croatia in respect of its infringement of the free movement, establishment and liberalization rules.

Nevertheless, given the level of legal dysfunctionality and protectionism, combined with other factors such as Russian influence, the Union needs to develop an effective strategy in this region to protect and then enhance its supply security. The EU needs to develop a two pronged approach to deal with these problems. At a horizontal level, a rule of law and anti-corruption programme needs to be put in place across the region to tackle legal dysfunctionality.

One specific horizontal approach would be to re-introduce the Co-operation and Verification Mechanism (CVM) which was deployed successfully in respect of the Bulgaria and Romanian accessions to the EU. The CVM gave the European Commission the ability to hold both states closely to account - even after they joined the Union - for non-compliance with the EU law. This was, perhaps unwisely, abandoned in respect of Croatia. If candidate Member States in the Balkans knew a CVM regime applied to their accession process, they would treat the need for compliance with all EU norms more seriously. The adoption of a CVM regime, combined with a broader and deeper rule of law programme in the Western Balkan states' accession process, would provide a basis for challenging the scale of domestic legal dysfunctionality.

In respect of the energy sector itself, the EU could seek a significant upgrade of the Energy Community Treaty. The Energy Community Treaty seeks to apply the EU's energy acquis but does not actually have the tools to ensure enforcement. The Energy Secretariat does not have the enforcement powers against states and companies that the European Commission has. Nor is there a court in which states and companies can be held to account. "Europeanising" the Energy Community Treaty system would make it much more difficult for states to resort to protectionism, limit Russian influence and enhance the application of the rule of law. Investors would know that EU open market and liberalization rules could be relied upon because they would be guaranteed by a supranational agency and court with direct applicability.

The net effect of a more 'Europeanised' Energy Community, ensuring greater compliance with open market energy rules, greater transparency and more effective surveillance, would be a significant enhancement to the Union's supply security in the region.

The Union, also needs to give consideration as to whether it should introduce into the accession conditions the requirement that no candidate Member State can increase its supply dependence. Such a requirement would be of practical benefit to the Union in reducing its supply dependence risk, while at the same time making it more difficult for Russia to succeed in increasing Europe's supply dependence. Serbia and other candidate states would have to consider carefully which energy projects they undertake and whom they worked with in developing their energy markets.

It may be that EU and US pressure on Bulgaria and the need to comply with EU third energy package rules may make it impossible for Bulgaria, and therefore practically for Serbia, to take participate in Southstream. However, there is still the prospect of alternative projects being undertaken in Southstream and across the region, from acquisition of interconnectors to LNG facilities to powerplants, which reinforce the case for a supply security obligation to be required from Member States. Hence it is worth the Union considering prescribing a 'supply security' condition into the accession process for candidate Member States.

There also has to be a recognition amongst the elites of the states of the Western Balkans, whether in the EU or aspirant Member States, that the 'Tito Game' played in the former Yugoslavia - i.e. playing the West off against Russia - is no longer an option. By either joining the EU or entering upon the accession process, the successor states of the former Yugoslavia have made a definitive choice of the West and the EU.

The Western Balkans could play a significant role in enhancing the Union's energy security at a time of increasing insecurity. However, the EU has to take problems of legal and energy market dysfunctionality seriously and develop a credible, and not just a reactive, response. The Union potentially has the tools in EU law, the accession process and the Energy Community Treaty. It needs to develop them and then be prepared actually to apply them. Meanwhile, the local elites have to recognize that, by entering the EU or the accession process, they have made a decisive choice to which they must now be true.

naturalgaseurope.com