Executive Summary
Even without a Russian attack on Ukraine, Europe’s energy crisis is set to worsen
The Kremlin has manufactured a crisis in Europe to achieve political and strategic goals regarding both Ukraine and NATO, with an endgame that remains obfuscated but could result in war.
As last-minute shuttle diplomacy to avert military aggression against Ukraine is underway, the broader effects on Europe’s energy security will be felt for much longer.
While China does not contribute to defusing the crisis, it plays an important part when it comes to exerting sanctions pressure on Russia should deterrence and de-escalation fail.
State of Play A Kremlin-engineered military crisis in Europe
Europe is facing the immediate threat of war, as Russia has amassed 150.000 combat ready troops at Ukraine’s borders, in Belarus and on landing ships entering the Black Sea. Despite U.S. efforts to expose Russia’s plans and thereby remove the element of surprise, this year-long buildup amounts to the largest concentration of troops in the region since World War II. Amid high-level phone calls and shuttle diplomacy by Western leaders, Moscow insists to turn Ukraine into a ‘buffer zone’ to protect itself from perceived military encroachments from NATO. Yet, Washington is convinced that President Vladimir Putin’s ultimate goal is war and partitioning of Ukraine, despite substantiated threats of unprecedented economic sanctions from both the U.S. and the EU. So far, the crisis has been unfolding on Russia’s terms, and the current stalemate leaves the West with few options.
Key Issues Europe is facing a worsening of the existing energy crisis amid standoff with Russia
In case of war, there will be severe consequences even beyond the disruption of business in and around Ukraine. On the energy front, Russia will not immediately stop shipping gas and oil to Europe because it relies on those revenues. The U.S. is also unlikely to push for an all-out embargo, given the severity of the energy crisis in Europe and global inflationary concerns. For 2022, Europe is expected to spend $1trn on energy, up from $500bn, even without a reduction in Russian gas supplies. Sanctions to target Russia’s financial sector will be priced by markets as a risk factor even without an actual tightening of supply. In turn, Western markets will see sectoral sanctions potentially affecting prices in metals (iron, copper, etc.), chemical production, machine parts, and timber. Furthermore, major risks to Europe’s natural gas supplies stem from disruptions of Ukraine’s direct supplies to Europe in case of war. Plus, the certification of Nord Stream 2 will be stopped, suspending the project for the foreseeable future, if not altogether. While Russia has enough pipeline capacity to pump gas through Nord Stream 1 beneath the Baltic Sea and the Yamal-Europe pipeline via Belarus, the Ukrainian route would be vulnerable. Internally, Russia would, however, be less hit, since oil sales contribute significantly more to its budget (55%+) than gas exports (ca. 15%).
In the short run, Europe would likely be able to obtain additional gas from the U.S. and the Gulf region to prevent further price hikes. War in Ukraine would also be an incentive to restore the nuclear deal with Iran and resume imports of Iranian hydrocarbons. However, it takes around five years to launch new gas projects, and the trans-Caspian pipeline from Central Asia is unlikely to materialize due to strong opposition from Russia and China. Europe will thus need to speed up its energy efficiency efforts, while trying short-term fixes through coal and oil-fired power generation and possibly the extension of other energy sources in the medium-to long-term.
China wisely weighs its economic interests to decide how to back its junior partner Russia
China publicly supported Russia’ demand vis-à-vis NATO in a joint statement by Presidents Putin and Xi Jinping in early February. Yet, should war erupt, Beijing is unlikely to take a public stance; instead, it may react similarly as during the 2014 annexation of Crimea: no criticism of Russian actions, but no overt support for war, coupled with calls for peace. One immediate effect of military conflict on China would be through its substantial wheat imports from Ukraine as well as the functioning of the country’s ports in Odessa and Nikolaev. Already, Beijing is looking to Latin America and Russia for a diversification of grain imports.
In the coming weeks, China will carefully monitor the introduction of new sanctions by the U.S. and the EU, avoiding transacting with U.S. designated entities as it did in the wake of 2014. However, China will exploit all legal means through its policy banks (ExIm, China Development Bank) and will create special infrastructure to work on some projects with Russia (as it does in Iran and North Korea). The most sensitive parts of the relationship, including the supply of Chinese-designed semiconductors and chips, will be moved to secrecy. A likely byproduct of the crisis will be the increased use of yuan instead of dollar and euro in business with Russia, despite existing capital controls. Chinese leverage will increase, driving up Russia’s reliance on China, and rendering the partnership more unequal. Some projects will thus be executed with significant concessions, e.g. the 50 bcm/year Power of Siberia 2 project that will bring gas to China from the same Yamal fields that serve Gazprom’s customers in Europe. All told, while carefully calibrating its response to the conflict itself and to possible Western sanctions, China will gradually move closer to Russia in joint opposition to the U.S. and an attempt to challenge the existing world order.