Between Russia and a hard place: The effect of sanctions on Europe

On 2 August, U.S. President Donald J. Trump signed legislation imposing further sanctions on Russia in retaliation for its alleged interference in the U.S. elections, as well as its activities in Ukraine. The European Union (E.U.) institutions oppose the new sanctions and fear for Europe’s energy security.

Trump’s predecessor, then-President Barack Obama, first placed sanctions on Russia in 2014 as a result of its military intervention in Ukraine. The law signed by Trump not only tightens those restrictions, but also ensures that the president cannot remove the measures with an executive order.

The new law reduces the duration of U.S. loans to sanctioned Russian energy companies from 90 days to 60; freezes the funds of U.S. firms that conduct business with Russian citizens under sanction, and, crucially for Europe, punishes companies in the U.S. and abroad for working on Russian energy infrastructure.

The oil-and-gas sector is likely to be most affected by the legislation, which puts restrictions on deals involving Russian state-owned enterprises and foreign investment in the sector.

Immediate reactions

The Russian reaction – expelling 755 U.S. diplomatic staff members and seizing two U.S. diplomatic properties – was swift. The E.U. institutions’ response was equally rapid. Jean-Claude Juncker, president of one the E.U.’s executive arms, the European Commission, warned, ‘we must defend our economic interests vis-à-vis the United States. And we will do that’. He also ordered an urgent review of the E.U.’s possible responses.

The E.U. has a much stronger trade partnership with Russia than the U.S. does

The new U.S. legislation is unpopular in the E.U. for several reasons. Firstly, the E.U. argues that the sanctions regime contravenes the consensus among the Group of 7 (G7 – Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), the world’s seven major advanced economies. According to the European Commission, the fragile and failing peace agreements between Ukraine, Russia and Russia-backed Ukrainian separatists can only be properly implemented if all G7 countries agree to sanctions.

Secondly, despite sanctions and counter-sanctions, the E.U. has a much stronger trade relationship with Russia than the U.S. does. In 2016, despite a 13 per cent year-on-year drop in trade, Russia was the bloc’s fourth-largest trading partner. Energy imports from Russia feature prominently in this trade.

A divided union

The existing E.U. sanctions on Russia, first put in place in 2014 and extended in June 2017, were already a source of friction within the European Union. The sanctions ban European businesses from borrowing or lending money to the five biggest state-owned banks in Russia for more than 30 days. Companies cannot import or export arms or oil industry technology to or from Russia. Many high-profile Russian figures and Ukrainian separatists have had their assets in Europe frozen and been banned from travelling to the European Union.

The sanctions were designed to limit Russia’s economic capacity, forcing the country to retreat from Ukraine. However, there is little evidence to suggest that they have had the desired effect; indeed, there was an uptick in violence in eastern Ukraine in July and August. Enthusiasm for the sanctions in Europe is waning, in large part due to perceptions that Russia’s counter-sanctions on agri-food, which it imposed in August 2014, are hurting the E.U. economy.

The E.U.’s food sector perceives the impact of the counter-sanctions to be great, and the European Parliament estimates that the E.U. has lost more than EUR5 billion per year of agri-food exports to Russia, but it is difficult to quantify the effect.

Germany is the biggest exporter to Russia and has lost the most in absolute value but continues to support the sanctions

The severe economic downturn linked to falling energy prices has played a larger part in suppressing trade flow. While the absolute value of trade has decreased, countries that have sanctioned Russia have maintained their import share compared to non-sanctioning countries. Imports from the E.U. continue to account for around 50 per cent of Russia’s total imports. Additionally, the E.U. has offset much of its lost export revenue by increasing sales to the U.S. and China.

Though the economic impact of the sanctions is relatively insignificant, the symbolic impact is great, particularly as they concern the agricultural sector. Although agri-food exports account for just 7 per cent of E.U. goods exports, 92 per cent of E.U. citizens believe agriculture to be important for their future.

This perhaps explains the reluctance of Italy to continue sanctions. The country is one of the biggest losers in absolute trade value, but as exports to Russia account for just 2 per cent of the Italian export total, the economic impact is negligible. Other critics of the sanctions, notably Hungary and Slovenia, have experienced almost no decrease in trade with Russia as a result of the sanctions.

Conversely some of the strongest supporters of continued sanctions are those with the highest exposure to trade with Russia as a percentage of their GDP. Germany is the biggest exporter to Russia and has lost the most in absolute value but continues to support the sanctions. Estonia, Finland, Latvia, Lithuania and Poland, all of which border Russian territory, are most reliant on Russian markets but remain firm in their support for sanctions.

Wider Europe

This is mirrored outside the European Union, in Russia’s ‘sphere of influence’. Russia has often used sanctions as a punitive measure against Georgia, Moldova and Ukraine for attempting to integrate into the E.U. or Nato. For example, before the Ukraine crisis, Moldovan wine and food was already under Russian sanctions. Before 2014, Moldova exported 43 per cent of its agricultural produce to Russia, including 90 per cent of its apples and 30 per cent of its wine. When Moldova signed an agreement with the E.U. in July 2014, Russia reacted by imposing an embargo on its agricultural produce. Moldova was forced to ask for help from the E.U. and find new markets in Belarus, China, Egypt and Jordan. The country nevertheless copied E.U. sanctions and recently declared the Russian deputy prime minister, Dmitry Rogozin, persona non grata.

Despite its pro-E.U. government supporting sanctions, in November 2016, Moldovans narrowly elected a pro-Russian president. This cannot be attributed solely to sanctions, but frustration with the country’s enduring poverty, exacerbated by Russian import bans, were certainly a key factor in the vote.

Energy projects

Russia is one of the E.U.’s key suppliers of energy, accounting for 29.4 per cent of natural gas imports and 27.7 per cent of crude oil imports. While some states do not import gas directly from Russia, many E.U. states do: several countries, including Bulgaria, the Czech Republic, Estonia, Finland, Latvia and Slovakia, rely on Russia for more than half of their gas imports. Amongst these countries, particularly those with memories of Soviet occupation, there is a strong drive to reduce Europe’s energy dependence on Russia.

Germany is Europe’s biggest consumer of gas and imports roughly 40 per cent of its supplies from Russia. With domestic European output dropping, particularly from the Netherlands, Germany is likely to increase its dependence to around 50 per cent by 2025.

Energy, and specifically the bloc’s energy relationship with Russia, has long been a divisive subject within the European Union. Russia has exploited the lack of a single E.U. market for gas, completing deals with some E.U. member states such as Hungary. Now, the U.S. measures threaten European energy investments with Russian firms.

The sanctions are likely to affect a EUR9.5 billion pipeline project called Nord Stream 2. It is owned by the Russian state-owned enterprise Gazprom, but five European firms have part-financed the project: the Anglo-Dutch giant Royal Dutch Shell, Austrian major OMV, France’s Engie and two German firms: Uniper and Wintershall.

The project aims to transport 55 billion cubic metres of natural gas annually from Russia, via the Baltic Sea, to Germany. The pipeline would bypass Ukraine as well as the E.U. member states of Estonia, Latvia, Lithuania and Poland. Unsurprisingly, these countries are highly critical of the project. Poland in particular has emerged as a staunch opponent, originally managing to block a joint-venture application between Gazprom and its Western counterparts. However, German Chancellor Angela Merkel and the Western firms involved in the project insist that it is a purely economic venture with major advantages for Europe.

The CEO of OMV said in an interview in late July that the U.S., Poland and the Baltic states have ‘no right to exercise a veto over Euro-Russian gas relations’. The CEO of Uniper went a step further, arguing that the real reason for the U.S. sanctions is ‘strategic economic interests, meaning the targeted dominance of the U.S. in energy markets’.

Other major energy projects could also be jeopardised by the sanctions. The Italian firm Eni has a 50 per cent stake in the Blue Stream pipeline from Russia to Turkey as well as the CPC pipeline carrying oil from Kazakhstan to the Black Sea, in which Royal Dutch Shell and its subsidiary BG Overseas Holdings have also invested. British Petroleum’s co-operation with Rosneft, another Russian energy major, is also at risk.

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