October 8, 2008

Nabucco: Still Just a Pipedream?

Nabucco faces many difficulties, most significantly soaring construction costs and sourcing the gas. However, the EU ETS has the potential to make the project economically viable. Furthermore, Turkmenistan is showing signs of commitment to supply the pipeline, and although improved Western-Iranian relations are not on the horizon, Iran should be considered a viable supply solution in the long run.

French utility GDF-Suez has reiterated its interest in following in the footsteps of German rival RWE in joining the Nabucco consortium. Dutch firm Gasunie has also expressed its willingness to take part and Turkish president Abdullah Gul recently reaffirmed his country's support for the pipeline at a UN summit in New York. Although the short-term outlook for Nabucco undoubtedly remains difficult, this burgeoning confidence is underpinned by sound market fundamentals and arguably reflects promising geopolitical developments.

The planned Nabucco pipeline, running from Ezrum in Turkey to Baumgarten in Austria, has long been the target of ridicule and scorn. Strategies aimed at overcoming Europe's energy woes based on Nabucco are habitually derided for a whole raft of reasons: no one is sure where the gas will actually come from; project-costs have soared from E5 billion in 2005 to nearly E8 billion in March this year; the program has suffered repeated delays (construction is now expected to begin in 2010, at the earliest) and the vast number of governments and parties involved makes thrashing out a contract that satisfies all parties a legal and diplomatic nightmare.

Loudest among Nabucco's critics is Russia. Gazprom views the project as a threat to its monopoly of gas supply to Europe, and has consistently sought to undermine the pipeline from its inception. This agenda was graphically demonstrated in the 2007 memorandum of understanding between Eni and Gazprom to construct the South Stream pipeline, transporting gas from Russia's Black Sea to Bulgaria, and then to central Europe. Although Europe might feasibly require both pipelines should demand grow sufficiently, most observers have identified South Stream as a direct challenge to Nabucco for the right to supply gas to southern Europe. Equally, the August war with Georgia seemed to imply that Moscow would not hesitate to risk Trans-Caucasian supply lines in protecting its Diaspora and upholding Russian sovereignty. None of this bodes well for Nabucco.

Yet the fundamental principles which precipitated Nabucco in the first place not only remain but are set to become all the more pertinent. Europe's capacity generation will need to increase by around 30% over the next 15 years if it is to keep pace with demand. At the same time, as the EU Emissions Trading System (ETS) begins to take effect, the price of emitted carbon will rise significantly - potentially up to E40 per tonne according to Datamonitor models. As such, coal-fired generation plants will become extremely expensive to run on account of the high levels of CO2 they emit. By comparison, gas plants produce relatively low quantities of greenhouse gases. As such, the vast majority of European growth in generation capacity will come from natural gas. This is all the more true in the former-Soviet economies of eastern and central Europe: these states rely heavily on lignite sludge, a particularly dirty form of coal which is easily accessible across the region. Hence these countries not only face the task of increasing their capacity in the first place, they also need to replace existing plants with cleaner ones if they are to remain within the limits imposed by EU ETS.

As the cost of carbon increases, the demand for gas will grow even faster. Concurrently, as the value of gas grows, so the Nabucco project becomes economically viable. Thus, as analysts have recalculated projected carbon prices upwards, so the interest in Nabucco has become greater.

This argument is not just underpinned by economics. Gradual but important geopolitical developments also point to better prospects for Nabucco. Aside from high CAPEX costs, the central flaw in Nabucco is that no one is really sure who will supply the gas. Although Azerbaijan's Shah Deniz field will provide at least 50 billion cubic meters (bcm), the real prizes lie in Turkmenistan and Iran, which hold an estimated 2.86 trillion cubic meters (tcm) and 27.4tcm in proven natural gas reserves, respectively. Until recently, both of these states were considered too unstable or hostile to be willing to sell gas to Europe over Russia or China. That may be changing.

On September 5, Turkmenistan's President Gurbanguly Berdimuhammedov arrived in Brussels for his first official visit to the EU headquarters where, among others, he met Andris Piebalgs, Peter Mandelson and Jose Manuel Barroso. Tellingly, Mr Berdimuhammedov was also present at the NATO summit in Bucharest in April. Whereas EU-Turkmenistan relations under Mr Berdimuhammedov's predecessor, Saparmurat Niyazov, were characterized as rather static, hopes are high that the current administration will look genuinely to engage with Europe, rather than simply use it as a bargaining chip to gain leverage in bilateral deals with Moscow.

This hope is based upon two recent developments. Firstly, the resolution of a long-running debt dispute between Azerbaijan and Turkmenistan: in early March, the two countries concluded an agreement (sponsored by US and EU officials) under which Baku would pay $45 million of the $56 million that Ashgabat claimed it was owed. Although this settlement received little coverage in the global media, it represents a crucial milestone in eventually shipping Turkmenistan's gas to Europe via Azerbaijan. Secondly, in the same month Turkmenistan signed a separate deal with Brussels committing 10bcm (350 billion cubic feet) of gas for delivery to Europe from 2009. This is also a significant step in sourcing reserves to supply Nabucco.

Arguably Iran is far more important on account of its larger reserves. Here too, a glimmer of hope is discernable. In late September, deputy Iranian oil minister Akbar Torkan publicly outlined Iran's ambitions to export gas to Europe. The centerpiece of the Iranian plan is the proposed construction of a $4 billion pipeline that would deliver natural gas to Turkey for subsequent supply to Europe. Mr Torkan reported that Iranian officials are in talks with a "well-known European company" to develop the pipeline, which would have a capacity of just over 30bcm; coincidentally, the same projected volume as Nabucco.

Of course, US sanctions against Tehran's nuclear program have made Western energy firms' involvement in Iran very difficult; indeed, Shell and Total both recently suspended activities in Iran's LNG industry as talk of war with Israel grew louder. Without President Ahmadinejad dampening his fiery rhetoric, the prospects of Iran ever supplying Nabucco look weak. Yet on Monday September 29, Mr Ahmadinejad appeared to do just that. In an interview with the New York Times, he essentially acknowledged Israel's right to exist and accepted the possibility of a two-state solution. Perhaps more importantly, in July, Washington sent William Burns, a top US diplomat, to hold direct talks with the regime - another over-looked but significant step. With the end of the Bush administration in sight, the chances of meaningful negotiations developing, and consequently the chances of Iran supplying Nabucco in the long run, are surely stronger.

There remains every chance that Mr Ahmadinejad has no intention of thawing relations with the West. In the short term at least, there seems little prospect of Tehran giving up its nuclear ambitions. Equally, there is no guarantee that EU member states will rigidly stick to emission reductions targets. Poland, the Czech Republic and others have already made moves to negate the impact of caps on their industries and essentially continue using cheap but dirty coal.

Indeed, these actions reflect the most substantial threat to Nabucco; namely, the lack of political will in European capitals. Germany, Italy and even member states of the Nabucco consortium have all entered bilateral agreements with Russia, seemingly undermining the project. There is nothing new about this - the fact that Europe's difficulty in securing energy supplies derives from self-inflicted division is commonly accepted fact. But, as Mr Gul pointed out at the UN, "Many did not believe the implementation of the Baku-Tbilisi-Ceyhan pipeline was possible. But that has already been operating for several years". The same can apply to Nabucco: willingness to engage with Iran and determination to act in concert are distant prospects in the short term, but that does not mean that projects like Nabucco need remain pipedreams forever.