Moscow’s Gas Freeze Shows EU-Russian Trade Is Doomed

Since Feb. 21, unprecedented sanctions have not only targeted important sectors of the Russian economy but also frozen Russian central bank reserves. The idea was to impose severe economic pain on Russia and indirectly affect its ability to sustain a prolonged war.

Although sanctions on cutting-edge technologies, dual-use, and luxury goods were put in place immediately, sanctions on energy were delayed. The delay was needed because the European Union imported 40 percent of its natural gas from Russia.

But today, the situation has reversed, and Russia is self-sanctioning by restricting its gas supplies to the EU. Instead of reaping the revenue from the gas sale over the long term, Russia is choosing to cut the gas flow. By the end of June, gas supplies through Nord Stream 1 were down by 60 percent. Even the trickle that is still flowing is subject to sudden stops.

Why would Russia self-sanction ahead of EU sanctions? There are two factors that can help us understand Russia’s behavior.

The first is the EU’s commitment to a future without Russian energy.

If, as after Russia’s first invasion of Ukraine in 2014, the West’s response to the new war had been lukewarm, Russia would not have chosen this route. Less stringent sanctions and low levels of resolve from the EU would have meant that Russia would gain more by maintaining its long-term relationship with the bloc.

However, the failure of Germany’s long-standing policy of “change through trade,” the EU’s unprecedented response, public commitments by leading politicians like German Chancellor Olaf Scholz and European Commission President Ursula von der Leyen, and overwhelmingly strong anti-Russian public sentiment have made it clear that the EU’s long-term relationship with Russia will change. This means, at least until Russian President Vladimir Putin loses his grip on power, that the trade relationship between Russia and the EU is doomed.

In the long term, the EU is thus going to diversify its energy imports and close its doors to energy from Russia. But in the short term, as demand for energy is not flexible, any supply restrictions by Russia push prices higher, resulting in higher revenue.

Russia has internalized the EU’s commitment to change in its energy policy, and the choice it faces is clear. In the long term, it faces the prospect of no energy exports to the EU. However, in the short term, by limiting its own exports, it can generate higher revenue. Russia has been forced to choose the best among a bad set of options.

Although this is an indication that Russia believes in the EU’s commitment going forward, it is also a cause for concern for energy-deprived EU countries. As Moscow’s economic and, possibly, military prospects continue to grow dimmer—as evinced recently in Kharkiv, Ukraine—Russia will become more focused on the short term, leading to higher costs for the EU.

The second factor is Russia’s desire to break the unity of the EU’s response to the invasion.

Although countries like Germany, due to their past policies, are heavily reliant on Russian gas, countries like Lithuania started to wean themselves off of Russian gas in 2014. Differences in exposure to Russian energy perhaps made Putin hopeful before the invasion that the EU response would not be unanimous. Fortunately, he was wrong.

Self-sanctioning by imposing different costs on different EU countries allows Russia to gamble on breaking EU unity. In the short term, tight energy markets have responded frantically, forcing governments to choose between toeing the line proposed in Brussels or making deals with Russia. One example is Latvia, which has resumed buying gas from Russia despite strong public opposition to the invasion.

So, what can the EU do?

In our view, any EU strategy and its execution must satisfy two objectives: reducing the cost imposed by the energy crisis and avoiding incentivizing Russia to throw another temper tantrum in the future. The following three-pronged approach would accomplish that. Although some aspects have been implemented, albeit haphazardly, others have so far only been considered.

First, reduce misallocation of energy across EU users and increase the efficiency of its usage. As the International Energy Agency outlines, there are several ways to achieve this, varying from introducing auction platforms for gas, firing up alternative sources of energy like nuclear power plants, enhancing coordination among gas and electricity operators across the EU, and implementing dynamic pricing for some energy users. These steps can alleviate the burden and prepare Europe for what might be a tough winter.

Second, redistribute the higher energy cost across households in a progressive manner. By targeting subsidies and taxes, costs across different households can be equalized. As richer households consume more energy relative to poorer households, a targeted tax on the rich can reduce energy consumption more than targeted subsidies to the poor. At the same time, EU governments must resist the temptation of populist policies that can inflict higher costs in the future without resolving the current problem. For instance, British Prime Minister Liz Truss’s new plan, like France’s, is to freeze prices for two years, and it will cost more than 100 billion pounds (or $115 billion), financed by borrowing. These policies will fail to bring down energy demand but continue to impose higher costs on government coffers.

Finally, prepare the public for the costs—especially as winter draws near. This must combine a sense of shared purpose with a clear explanation of why these costs are worth it—both for Ukraine’s freedom and for Europe’s future security. As French President Emmanuel Macron succinctly put it, there is a choice between “the easy way out” and “[paying] the price for our freedom and our values.” The world, and especially Europe, must make the right choice.