Policy Pulse – 25 January 2022 – Veritas Global
Key messages
Changing geopolitical calculus of US and Russia increases conflict risk but also creates opportunities for greater stability
EU has an urgent need to diversify natural gas supply to reduce Russia’s market dominance while promoting more stability in the region
Eastern Europe needs external assistance to better manage COVID-19 and its economic impacts
Source: Veritas Global created with MapChart.net
We were again broadly on target in our last year’s forecast on the economics of conflicts in Eastern Europe. As expected in 2021, the economic impact of COVID-19 has been uneven in the region and Russia emerged in a position of relative economic strength compared to its neighbors. As anticipated, in responding to the impacts of COVID-19, countries in the region reached unprecedent levels of reliance on external financial support, with the International Monetary Fund (IMF) playing a central role. Furthermore, as per our expectations, the change in US administration has translated to a different posture in US-Russia relations – with more cooperation on global challenges but more confrontation on regional European issues.
Looking ahead, 2022 presents an unprecedented opportunity. The shifting geopolitical backdrop could create an opening to normalize the situation in long-standing conflicts in Eastern Europe. However, this also means that there is a heightened risk of hostilities as well as potential for more hybrid attacks and a real possibility of renewed armed conflict across several hot spots in the region. There are three factors that will have a major impact on conflict economics in Eastern Europe in 2022.
1. Changing geopolitical calculus of US and Russia increases conflict risk but also creates opportunities for greater stability
More so than in previous years, events in the region in 2022 are likely to be shaped by the changing geopolitical calculus of the US and Russia. The US decision to withdraw troops from Afghanistan and stated priority to implement a “pivot to Asia” has created the perception of a power vacuum in Eastern Europe and Central Asia. Russia sees these developments as an opportunity to test US commitments to Eastern Europe and is trying to push back on NATO presence in the region. Russia has asked for legal security guarantees that include a permanent stop to NATO’s eastward expansion and reduced NATO troop presence close to Russian borders. Russia’s proposals point to an assertive stance, aimed at recreating a sphere of influence around its borders. By deploying troops on the eastern border with Ukraine, Russia is trying to signal that it is prepared to escalate if demands are not met.
Until recently, US engagement in the South Caucasus, and to an extent in Central Asia and Eastern Europe, was driven by three core interests. One core interest was access to a secure logistics corridor for US military operations in Afghanistan. US access to this corridor was essential for ensuring uninterrupted supply and maintaining leverage over alternative routes through Russia and Pakistan. The second core interest was the creation of an energy corridor for exporting oil and gas resources out of the Caspian basin, independent of transit through Russia. The third core interest was ideological and was targeted at promoting market-oriented democracies that could be forged into future trading and security partners.
The US withdrawal from Afghanistan has reduced the need for using the South Caucasus, Eastern Europe, and Central Asia as a logistics corridor for military operations. In terms of energy security, technological change driven by lower costs for extracting oil and gas through fracking has contributed to improving US energy independence. In 2019, the US became a net energy exporter for the first time in 67 years. Among some analysts, these developments have raised questions on the need to strengthen the South Caucasus energy corridor. However, the importance of this energy corridor was never about securing energy supply for the US. Rather it was always about creating an alternative source of secure natural gas supply for Europe while supporting diversification of supply in the global oil market. A Europe that is not overly dependent on Russian natural gas will be a more reliable partner for the US, not only in the European theater but also globally. Important to note is that while the US may supply modest quantities of liquified natural gas to Europe, it is unlikely to be able to sustain being a large-scale supplier on a continuous basis. Natural gas has a strong demand outlook in the US domestically while fracking practices are increasingly coming under pressure, including due to local environmental and health impacts. These developments raise questions about the extent to which fracking can sustain production volumes that will enable meeting local demand in the US while at the same time supporting large-scale natural gas exports. Therefore, the South Caucasus corridor is key to helping Europe avoid becoming overly dependent on Russian natural gas.
It is our assessment that from a US perspective, the short-term loss in value of the military corridor is significantly outweighed by the increasing strategic importance of the energy corridor. Nevertheless, US emphasis on a “pivot to Asia” may embolden Russia to apply maximum pressure to reduce the prospect of NATO presence in the South Caucasus and more broadly across all Eastern Europe.
2. EU has an urgent need to diversify natural gas supply to reduce Russia’s market dominance while promoting more stability in the region
European dependence on Russian natural gas has continued to increase significantly in recent years. Market share of petroleum gas and other gaseous hydrocarbon imports from Russia, which includes natural gas, liquified natural gas, propane, and other related products, increased from 17% in 2006 to about 35% in 2020 (see chart below). For comparison, OPEC’s share of total global crude oil production in 2020 was about 37% and the organization continued to be able to influence oil market outcomes. The dynamics of oil and natural gas markets are of course different both due to their geographic and product characteristics. Nevertheless, the comparison illustrates that market power can exist without majority control of the market.
It is important to note that Russia has invested heavily in further enhancing its natural gas export capacity to Europe. The high market share in combination with excess transit capacity will magnify Russia’s dominant position in natural gas markets across Europe. For example, the TurkStream project brings natural gas by pipeline from Russia to Turkey and onwards to other European states. The TurkStream project was operationalized in 2021 and is expected to reach full capacity once all the onward connections are completed. In 2021, Russia also completed construction of NordStream 2 although the project is not yet operational. NordStream 2 is designed to bring natural gas by pipeline from western Siberia directly to Germany.
Focusing on aggregate EU level market shares does not capture the extent of Russian dominance within individual EU members. For 11 of the 27 EU members, Russian natural gas consisted of over 60% of all natural gas imports. For 7 of the 27 EU members, Russian natural gas was over 90% of all natural gas imports. Included in these figures are cases when gas is purchased from Russia for re-export to other EU member states. Irrespective of re-export considerations, Russia is likely to have a higher degree of market power in countries where it is the main natural gas importer.
Some have argued that the increasing share of sales of Russian natural gas in Europe will create a dependency of Russia on the EU. However, this narrative is not supported by economic theory. To have countervailing power, consumers need to be able to have credible options for switching to other suppliers of natural gas or be able to use product substitutes to natural gas from non-Russian sources at relatively short notice. The high cost of switching to alternative options partly explains the upward price volatility observed across many EU gas markets in recent months. In the short-to-medium term, European consumers, especially in countries that are highly dependent on Russian natural gas, do not have alternative economically viable substitutes. Therefore, the power dynamics of the current market structure is likely to favor accumulation of market power for Russia. Crucially, it may be difficult to detect whether Russia has accumulated market power as it may choose to leverage its dominant position to influence other outcomes. Theoretically, one concern might be that it may use its leverage to influence political outcomes, for example over decisions taken at the European Council. Since many of the decisions taken by the Council are done either through unanimity or consensus, Russia may be able to exercise leverage over states that are highly dependent on Russian gas thereby giving Russia the ability to hold sway over some Council decisions.
At a global level, even under the scenario of net-zero greenhouse gas emissions by 2050, the International Energy Agency (IEA) expects demand for natural gas up to 2030 to continue to rise. Beyond 2030, our view is that the outlook is highly uncertain as models incorporate unproven technologies in projections. At the European level, the IEA has emphasized that it expects natural gas to retain a major role as a source of flexibility and back-up for many years to come. Therefore, incorporating diversification considerations in the supply of natural gas is important not only in the short or medium-term but also from a long-term perspective. To be effective, the diversification strategy needs to go beyond investments in storage capacity and focus on diversification of natural gas supply.
About one quarter of all proven natural gas reserves are in non-Russian countries of the Caspian basin and Central Asia. The potential benefits for Europe to access this vast energy pool are partially being realized through the Southern Gas Corridor, a project that was operationalized at the end of 2020 and continues to scale-up deliveries. However, the scope for scale-up is far greater than what is currently planned to be implemented. One of the best options for enhancing supply diversification to the EU is to develop additional capacity that brings Caspian gas to European markets through transit routes that do not pass-through Russia or other members of the Eurasian Economic Union. This is not a new idea but the lack of political will to realize the full potential of this corridor has resulted in Russia having a dominant position across many European gas markets.
One immediate opportunity is to link the Banka Livanova offshore field in Turkmenistan to the existing gas distribution infrastructure that originates in the Azeri Chirag Guneshli field in Azerbaijan. The Trans Caspian Pipeline projectenvisions to capture gas that is currently being vented and flared and pipe it to a nearby local natural gas distribution network. The climate change benefits alone could potentially justify the financing for this project and at a technical level a methodology already exists for quantifying the potential climate benefits from the reduced methane and carbon dioxide leakage. While this project is envisioned mostly for meeting local natural gas demand in Azerbaijan, it will create space for Azerbaijan to export more natural gas from other fields. While it is a good project, it is far too small to have an impact on European market outcomes. An additional large-scale effort is urgently needed to scale-up transit capacity of Caspian gas to European markets.
Explicitly including plans to expand this energy corridor within on-going discussions on long-term security guarantees between western powers and Russia could have a stabilizing effect on the region. It would telegraph planned developments and reduce potential of future friction. Development of diversified natural gas supplies that are complementary to Russian supply will also reduce resistance to Russian projects such as NordStream 2.
3. Eastern Europe needs external assistance to better manage COVID-19 and its economic impacts
The extent of COVID-19 impacts on the region in 2022 are very hard to predict. From an economic point of view, much of the region, except for Azerbaijan and Russia, will continue to face a challenging outlook for government finances. The ability of governments to cushion COVID-19 economic impacts through spending will become more difficult if access to external finances become constrained. Therefore, maintaining access to financing support facilities offered through the IMF, regional, and international financiers will continue to play a critical role. In the absence of continued external financing support, risks to macroeconomic stability across Eastern European countries is considerable. If these macroeconomic risks were to materialize there could be broader destabilizing impacts on fragile and conflict prone environments.
Countries in the region also have among the highest COVID-19 mortality rates in proportion to the total population (see chart below). It is difficult to assess the extent to which this will impact social stability and dynamics of conflicts in the region. However, given the high death toll, it may be appropriate to consider tailored technical assistance specifically targeting how to deal with the COVID-19 challenge. Furthermore, targeted interventions on COVID-19 management for conflict impacted and conflict prone communities could be an opportunity not only to save lives but also create goodwill. In some circumstances, it may be appropriate to provide this assistance through trusted independent third parties.
Belgrade – Pristina: talks continue but will they be meaningful?
The context is that Belgrade formally considers Kosovo as part of Serbia and actively promotes a policy of delegitimization of Pristina authorities internationally. An EU facilitated dialogue was launched in 2013 to support normalization of relations between Belgrade and Pristina. Normalization is also one of the conditions for Serbia’s eventual potential membership in the EU.
The external environment will remain challenging in 2022. The prospect of EU membership is a major incentive for Belgrade to normalize relations with Pristina. The lack of progress on formally launching EU accession negotiations with North Macedonia, and to an extent Albania, has created a perception in the Western Balkans that appetite of EU member states for further enlargement has soured. The launch of EU accession negotiations for North Macedonia in 2022 could create positive spillovers in the EU facilitated Belgrade – Pristina dialogue. Also at a regional level, the rising ethnic confrontation in Bosnia creates risks to stability in the region.
At the local level, there is room for cautious optimism but only if dialogue dynamics improve. The EU-facilitated dialogue on normalization of relations between Belgrade and Pristina continued in 2021 but did not deliver tangible outcomes. Unless the dynamics of the negotiations can be improved, there is a risk that the same will happen in 2022. We believe that an underused tool for improving negotiation dynamics is the use of economic analysis to better inform stakeholders on the benefits and costs of the issues being discussed. For example, assessing the economic costs of not implementing the Deçani Monastery decision of Kosovo’s constitutional court or the economic benefits of timely establishment of Serb-only association of municipalities. Furthermore, clearly articulating how outcomes from the dialogue can better leverage the support available through the EU Economic and Investment Plan for the Western Balkans can help drive better outcomes of negotiations.
Georgia – Russia: could the Norwegian security model work for Georgia?
The context remained largely unchanged over the past year. Georgia and Russia still do not have formal diplomatic relations. Russia continued to maintain a military presence in the regions of Abkhazia and South Ossetia, territories that Russia recognizes as independent states. Over 7% of the Georgian population continued to be internally displaced because of conflict. Periodic incidents such as kidnapping, detention and property damage occur in Georgia along the Russian controlled territories of Abkhazia and South Ossetia.
The external environment was difficult in 2021 and will remain tense in 2022. However, there is room for cautious optimism as dialogue between western powers and Russia could potentially resolve the principal source of conflict between Georgia and Russia, which is centered on future Georgian NATO membership. Russia has initiated dialogue with the US on legal guarantees to safeguard Russian security interests. The current Russian proposals include a demand to permanently stop NATO’s eastward expansion and reduced troop presence close to Russian borders. These demands are made at a time when decisions have already been taken by NATO on future membership, including future adhesion of Georgia and Ukraine to the alliance. NATO Heads of State adopted the 2008 Bucharest declaration through which they communicated their decision that Georgia and Ukraine would be members of the alliance but no date for accession was set. The decision has subsequently been reiterated on numerous occasions and through subsequent Heads of State declarations.
In the context of the future of NATO in Georgia, a security arrangement that is based on the Norwegian model could provide a much sought-after middle ground. Norway is a full-fledged member of NATO with all the related benefits and responsibilities, but at the same time it has committed not to host foreign military bases and does not allow the stockpiling of nuclear arms on its territory. The same framework could be applied in the Georgian context, potentially with additional provisions on limiting the application of collective defense to the Georgian territory where there is no presence of foreign troops at the time of adhesion (meaning exclusion of Abkhazia and South Ossetia from Article 5 until Russian troops are stationed there). This approach would allow NATO countries to have access to secure logistics and energy corridors in the South Caucasus while at the same time retaining credibility by not having to backtrack on previously taken decisions. Crucially, this arrangement would also address Russia’s security concerns as the threat to Russian security would be non-existent from a Georgia with no offensive weapons and no foreign military bases. The certainty that the Norwegian model offers would significantly reduce the risk perceptions of Georgia, thereby improving the business environment, boosting foreign direct investment, and accelerating economic growth.
The worst possible outcome for stability would be if the dialogue between Russia and the US results in a moratorium on NATO expansion. A moratorium or a halt to expansion over a certain period (for example 10 or 20 years) will motivate Russia to apply maximum pressure on Georgia and Ukraine to destabilize them and reduce prospects of future NATO membership. This is what happened after the 2008 Bucharest declaration, following which events were orchestrated in a way that resulted in Russia deploying troops to Abkhazia and South Ossetia as well as annexing Crimea and supporting separatism in eastern Ukraine. An outright commitment to permanently stop NATO expansion is a better outcome for promoting security then a moratorium, as it would allow Georgia and Ukraine to seek alternative security arrangements that are less inviting to Russian meddling. To be clear, an arrangement that is based on the Norwegian model offers the most promising outcome for promoting stability in the region for the short and long-term.
Irrespective of the security arrangements, continued integration of Georgia with European institutions and closer cooperation with the European Union offers the best prospect for promoting stability and recalibrating the Georgia – Russia relationship to one of mutual respect.
Ukraine – Russia: a relationship that risks going from bad to worse
The context of the Ukraine-Russia conflict was framed by the circumstances that followed popular protests and violent clashes in Ukraine in 2014, which resulted in a change of government. Russia considered the change in government and the new Ukrainian authorities as illegitimate. In the confusion that ensued, Russia moved to formally annex Crimea and supported separatist uprisings in eastern Ukraine. Russia has continued to support separatist groups in Ukraine and has amassed troops on the eastern Ukrainian border, threatening to invade if security of Ukraine’s Russian speaking population is in any way compromised.
The same issues discussed under the “Georgia – Russia” section also apply to Ukraine. Although, the situation is much more complicated and volatile in Ukraine. There are two main reasons for the complexity. One is that Russia’s openness to accept the Norwegian model for Ukraine may be somewhat more challenging since Ukraine represents a formidable military power on its own merits. Therefore, a Ukraine that is part of NATO, even without the presence of foreign bases or foreign weaponry, may still be perceived as a threat to Russian security. To address this, additional provisions may need to be included, for example related to troop positioning, weapons systems, and equipment deployments, that cater to potential Russian security concerns. Second, as a large country with a population of about 45 million, Ukraine’s integration into the European Union may prove to be politically more challenging for EU members domestically. Despite these complexities, in the long-term, a Ukraine that is better integrated into European institutions and has active collaboration with the European Union offers the best prospect for promoting stability and recalibrating the Ukraine – Russia relationship to one of mutual respect.
Nagorno-Karabakh: an opportunity not to be wasted
The context of the Nagorno-Karabakh conflict has changed significantly over the past two years. After armed hostilities at the end of 2020, a ceasefire agreement was secured between Armenia and Azerbaijan with Russian participation and facilitation. According to the agreement Azerbaijan retains control of areas surrounding Nagorno-Karabakh captured during the 44-day war. The agreement also envisions the creation of a transport corridor through Armenia to connect Nakhichevan with the rest of Azerbaijan. To date, the agreement has largely been successful in averting a restart of large-scale hostilities.
The relative stability has created an opening for Armenia to take steps towards normalizing relations with Azerbaijan and Turkey. There is a real opportunity to use economic projects, particularly related to rail and road infrastructure, to unlock the longer-term benefits of stability. The Economic and Investment Plan of the EU for the Eastern Partnership countries could potentially play an important role in providing the support needed to jump start the reconstruction of interconnections. Turkey could potentially also play a stabilizing role through more active development of economic projects in Armenia and more broadly across Eastern Europe and Central Asia.
Moldova: wait and see
The context of the Transnistria region largely remained unchanged over the past year. Transnistria is an unrecognized breakaway region of Moldova that benefits from political, military, and economic support from Russia. It is host to a contingent of Russian troops although Russia does not recognize the territory as an independent state. Transnistria’s leading industries include steel and textiles, but the region is also believed to be a hub for money laundrying and illegal smuggling. Negotiations on finding a settlement on the Transnistria issue are on-going for the past several years through facilitation and support of the OSCE as part of the 5+2 format, which includes participants from Moldova, Transnistria, the OSCE, Russia, Ukraine, US, and EU. Transnistria’s trade with the EU has grown significantly in recent years, which may create opportunities for normalizing relations through commercial cooperation. At the end of 2020 Moldova elected a reform minded President and in July of 2021 a reform minded parliament took-up office after a landslide victory.
The outlook for Moldova in 2022 is extremely uncertain as a combination of a deteriorating sanitary situation related to COVID-19 and on-going energy crisis add downside risks to economic stability. External financial assistance will continue to be critical for ensuring that the government has the space to maneuver to advance on committed reforms and maintain stability. Given the scale of the challenges facing Moldova in 2022 and highly volatile situation in neighboring Ukraine, the Moldovan leadership is unlikely to have the resources and capacity to go beyond existing efforts at addressing the Transnistrian issue. However, the dialogue initiated by Russia with the US on long-term security guarantees in Europe also has implications for Transnistria.
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