This article was first published by Geopolitical Futures and is reprinted here with permission.
Russia’s ongoing troop buildup near the Ukrainian border has led to more than a month of intense diplomacy as well as new U.S. military deployments in Eastern Europe. The West typically responds to Russian aggression with economic sanctions. But since the West has already been sanctioning Russia for years following Moscow’s annexation of Crimea and its role in the war in eastern Ukraine, to have an impact any new sanctions would need to tackle Russian energy supplies to Europe – especially the forthcoming Nord Stream 2 gas pipeline through the Baltic Sea.
In the current environment, this will be complicated if not impossible. The Ukraine crisis comes as Europe is dealing with soaring gas prices and internal divisions over how to reduce its usage of fossil fuels over the long term. The Kremlin knows this – and it has made the most of this chance to test the West. Moscow wanted to see if NATO (and the European Union) would stick together, and if so, what their response would be. While the discussions take place between the West and Russia and between Western allies, understanding what’s at the core of the crisis can help us anticipate the economic steps the players could take next.
Germany Is the Key
An agreement within the EU to sanction Russian energy flows is an impossible task. Such sanctions need unanimous support among the 27 EU member states. More than a third of Europe’s gas comes from Russia, and some countries, like the Baltics, Bulgaria and Austria, get more than 70 percent of their gas from their big eastern neighbor. What’s more, there are few alternative suppliers who could quickly meet Europe’s needs. This means Brussels is very limited in how aggressive it can be against Russia’s energy sector.
A more likely approach would be for Europe to sanction the crown jewel of Russia’s energy strategy toward Europe: the not-yet-operational Nord Stream 2. Cognizant of Russia’s energy strategy and the EU’s limitations, the United States for years has warned that the 750-mile (1,200-kilometer) Nord Stream 2 – by bypassing Ukraine and thus depriving it of leverage as well as transit fees – could further diminish Ukraine’s security. Washington’s allies in Eastern Europe saw things similarly. Poland and the Baltics noted that, once Nord Stream 2 is operational, Russia could better use energy as a geopolitical tool to influence and divide Europe. Moreover, Moscow could cut off supplies to Ukraine and, indirectly, to Eastern Europe, forcing those states to become more dependent on Western European energy infrastructure. But efforts to block construction of Nord Stream 2 failed and attempts to find alternative gas sources foundered over delays and cost. All the while, Europe’s dependence on Russian gas grew.
The pandemic closed off the opportunity for Europe to find alternatives to Russian energy. The supply chain crisis, followed by the energy crisis in 2021, has forced Europe to scramble to ensure it has enough stored gas to last through the winter. No matter how promising, investments in new technologies – be they batteries or hydrogen – will bear fruit only in the long term. To avoid further economic disruption, Europe needs to make the most of its existing contractual relationships and the existing energy infrastructure.
Since European energy prices started soaring late last year, many voices in the bloc and in the U.S. have accused Russia of market manipulation. Moscow has dismissed the charges, but the Ukraine crisis only made things worse. As a result, the U.S. joined in trying to secure alternative gas suppliers for Europe. On Jan. 7, U.S. Secretary of State Antony Blinken met with EU foreign policy chief Josep Borrell and Energy Commissioner Kadri Simson in Washington. Talks are underway to increase liquefied natural gas supplies to the EU from Norway, Qatar, Azerbaijan and Algeria. LNG isn’t a perfect replacement for Russian gas, but it can help. Another change over the past month or so is that the U.S. has insisted that Nord Stream 2 will not move forward if Russia invades Ukraine. In a more measured response, German Foreign Minister Annalena Baerbock said the pipeline could be up for discussion as part of sanctions measures.
Why Germany Can’t Give In
Germany’s energy consumption has rebounded from the pandemic, and although Berlin is an avid supporter of green energy, when confronted with the energy crisis it switched coal production back on. Conventional, nonrenewable sources of energy accounted for more than 50 percent of its electricity generation in the third quarter of 2021. The German coal industry association said in January that Germany imported 24.5 percent more coal by volume than in 2020, and it expects that figure to increase by 7.7 percent in 2022. (Even here, Germany relies on Russia: Approximately 53 percent of hard coal that goes into German power generators and steelmakers came from Russia last year, according to the coal industry association.)
Germany has invested in increasing its renewable energy, but wind and solar can’t yet replace natural gas, which comes almost exclusively from abroad. Germany produces only about 3 percent of the gas that it consumes, and more than one-third of its imported gas comes from Russia. Although natural gas burning accounts for only 15-17 percent of German electricity generation, according to the latest data from utility industry group BDEW, about half of German households rely on gas supplies for heating during the winter. When Germany loses part of its gas imports – for whatever reason and from whatever source – it must increase its coal-fired generation at home or import more power from neighbors to fill the gap.
The U.S. has offered to send Germany more LNG if Nord Stream 2 is abandoned, but Germany lacks LNG infrastructure. A few places in Europe have the port infrastructure to accept LNG, like Britain, northwestern Europe, Poland and the Mediterranean, but the latter two locations are still young in their development. What little LNG Germany imports mostly comes through the Dutch Gate Terminal, which can handle just 12 billion cubic meters per year. This could be expanded but it would take time and investment.
Finally, there’s a limit to how much Germany can phase out natural gas, and that limit is found in German manufacturing. Manufacturing accounts for more than half of the gas that Germany consumes. To consume less, some manufacturing sectors would need to reinvent their production processes and invest in new technologies – all of which is costly. But there are also industries for which hydrocarbons are not only a source of energy but also a raw material. The chemical sector is probably the best example. Chemical manufacturing involves the production of pretty much everything we use today – because (sadly) plastic is part of most things that we consume. The chemical industry also produces fertilizers, which are key to agriculture and thus the food supply chain, and supports the pharmaceutical industry.
The pharmaceutical sector is one reason it is unlikely that Germany’s dependence on natural gas imports will diminish. If anything, it could grow. Sometimes called the world’s pharmacy, Germany is home to more than 500 pharmaceutical companies, including big corporations like Bayer, Boehringer Ingelheim and Merck. Germany is also Europe’s largest and the world’s fourth-largest pharmaceutical market, and considering the country’s demographics, it is only going to grow in the coming years.
At the same time, the pandemic brought forth a key security problem for the health sector: the need to limit shortages in the supply of medicines and vaccines. This is why the new German governing coalition has announced that it wants to take steps to relocate the manufacturing of pharmaceuticals back to Germany. This includes reducing the bureaucratic burden, examining investment subsidies for production sites and considering subsidies to ensure security of supply. Moreover, in the field of biopharmaceuticals – the most advanced pharmaceutical production and an area with high growth potential – Germany is the most important player in Europe. In terms of the number of active ingredients produced, Germany ranks second worldwide, behind the U.S., an advantage that it intends to keep – but one that depends on a stable gas supply.
Pharmaceuticals alone are not the reason Berlin can’t say no to Nord Stream 2, but Germany’s strategy to reshore the most important industries from abroad, in an attempt to diminish supply chain shortages, certainly weighs on the decision. To produce more at home Germany needs energy, and with alternative sources expensive or years of research away, conventional energy sources and natural gas in particular remain important. Moscow is very aware of Germany’s threefold dependence on its gas, oil and coal. The reason for Russia’s buildup near Ukraine was in part to test the newly installed government in Berlin on its trans-Atlantic ties. In other words, Moscow stress-tested NATO and the EU. Neither bloc has broken, and in fact NATO has increased its troop presence along its eastern flank.
Creative Solutions
At the same time, the West needs to think about other ways to keep Russia from becoming more aggressive. The effectiveness of sanctions generally turns on two basic variables: domestic market size (the loss of the U.S. or EU as a potential market for one’s exports versus, say, the market of Kyrgyzstan) and global market share (when one country holds a near-monopoly on the production of certain goods, it’s hard to sanction that country). Considering the above, the EU may have reached the limit of using sanctions against Russia due to its near-monopoly position on the European (especially German) energy market.
However, Western countries have some of their own monopolies in the global economic system. A prominent example is SWIFT, the Society for Worldwide Interbank Financial Telecommunication network, which ensures the execution of virtually all banking payments. SWIFT is domiciled in Belgium – a member of both the EU and NATO – which makes it relatively simple to leverage it in the event of renewed, targeted sanctions. The U.S. has also threatened to cut Russia off from cutting-edge technologies.
For another example, the U.K. is a dominant player in the shipping insurance industry. In 2010, when the West was seeking to deter Iran’s nuclear ambitions, maritime insurer Lloyd’s announced that it would stop underwriting gasoline imports to Iran, a move that has had important consequences for Iran’s economy by exacerbating the plunge of Iran’s national currency and triggering a loss in Iran’s foreign reserves. In theory, it could do the same to Russia.
This is just speculation so far, but the point is that unless Berlin can be convinced to take a hard line against Moscow on energy, the West may have to get creative with its economic diplomacy. For now, military posturing is the strongest message the West has sent to Russia. If nothing else happens, NATO’s eastern frontier and Russia’s western border will remain the most militarized in Europe.
