June 2018: Energy Litigation Update

Quinn Emanuel Urquhart & Sullivan, LLP
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The EU’s Bid to Regulate Russia’s Nord Stream 2. The EU has for some time sought to impose its rules in the Third Energy Package (the “TEP”) on third country pipelines entering the EU. These rules cover such matters as unbundling (which requires the separation of network ownership from production and transportation of gas), transparency of network capacity, non-discriminatory third party access, and transparent, regulated tariffs. The driver for the EU’s desire to extend the TEP is the Nord Stream 2 pipeline (“Nord Stream 2”). Nord Stream 2 is a twin pipeline comprising more than 200,000 pipe segments running from Vyborg in Russia, along an offshore route of some 1,200 kilometers under the Baltic Sea to an area near the German port of Greifswald. Once completed, the total capacity of each of the two strings will be 55 billion cubic meters of gas per year, making an aggregate annual capacity of 110 billion cubic meters of gas per year for Nord Stream 1 and Nord Stream 2 combined. The estimated doubling of volumes of gas imported from Russia to the EU once Nord Stream 2 comes on-stream causes concern in Brussels, as it runs somewhat contrary to the EU’s current energy strategy both to secure and diversify its energy supplies and to reduce EU dependence on Russian gas supplies.

The EU’s primary concern is that when Nord Stream 2 comes on-stream (currently estimated to occur by the end of 2019) Gazprom – the sole shareholder in Nord Stream AG, which owns the pipeline - will have the ability to significantly increase the volumes of natural gas that it transports into the EU without the application of the rules in the TEP. Moreover, Russia is currently challenging these rules before the World Trade Organization, claiming that they are inconsistent with the EU’s obligations under a number of international agreements, including the General Agreement on Trade in Services, the General Agreement on Tariffs and Trade and the World Trade Organization Agreement.

Whether and to what extent EU law applies to Nord Stream 2 has therefore been in the spotlight, with the EU Council Legal Service and other expert commentators issuing contradictory views. Even the Council Legal Service has issued incongruent opinions. The outcome of this issue is important, not only because clarity is needed in relation to Nord Stream 2 but also because it will set a precedent for other pipelines, both existing and future, that import natural gas from third countries into the EU. Aside from the EU’s bid to regulate Nord Stream  2, there are more problems on the horizon for this controversial project: as recently  as May 18, 2018, a senior US State Department official has reiterated a US threat to impose  sanctions over Nord Stream 2 (see Oilprice.com, May 20, 2018), a move that is opposed  by Germany. Also, on May 9, 2018, Poland’s competition authority announced that it had  initiated proceedings against Gazprom and the five other European companies financing Nord  Stream 2, ENGIE, OMV, Shell, Uniper and Wintershall, over a potential breach of anti-monopoly law. See Financial Times, May 9, 2018.

Background
The EU is a party to the United National Convention on the Law of the Sea, 1982 (“UNCLOS”), which  is therefore binding the EU member states as well as the EU itself. The EU has sovereignty in its own territory and, under UNCLOS, EU territory extends beyond its land territory and internal waters to its territorial sea (Article 2). Accordingly, EU energy law is applicable to pipelines in the territorial sea and onshore. From a sovereignty perspective, therefore, the Gas Market Directive (Directive 2009/73/EC, referred to here as the “Gas Directive”) is capable of applying to the parts of Nord Stream 2 that pass through its territorial waters and onshore to the receiving terminal, just as Russian law will apply to that part of the pipeline which passes through Russian territory, except that at present, it is framed as applying to the EU’s internal natural gas market only. As such, the law would need to be amended for it to apply.

Beyond the territorial sea, the position is different. Pursuant to Articles 56 and 58 of UNCLOS, no member state has full sovereign rights in the area of sea immediately beyond its territorial sea, known as the Exclusive Economic Zone (“EEZ”). The EEZ is subject to the specific legal regime established in Part V of UNCLOS. Although coastal states have certain rights in relation to their EEZ, these are limited to “the purpose of exploring and exploiting, conserving and managing the natural resources… and with regard to other activities for the  economic exploitation and exploration of the zone” (Article 56). To the extent that EU law may seek to impose rules beyond the EU’s territory, in the EEZ (and continental shelf) of member states, this would be restricted to rules of this nature. Given that sovereignty is significantly more limited in relation to the EEZ, the remaining offshore pipeline of Nord Stream 2 comprising around 950 km of pipeline in the EEZ of each of Germany, Denmark, Sweden and Finland, would therefore not be subject to EU energy law.

As mentioned above, at present, the Gas Directive, and other EU legislation applicable to pipelines, is not framed to apply to external pipelines from third countries. It is concerned solely with the rules for the EU’s internal natural gas market. Indeed, the TEP and the Gas Directive have not been applied to any other pipelines from third countries, such as the Transmed, Medgas and Greenstream pipelines. The EU has taken a number of steps recently to change the situation.

Steps Taken by the EU
On November 13, 2017, in order to address concerns about Nord Stream 2, the European Commission issued a proposal to amend the Gas Directive to extend its application to natural gas pipelines running between the EU and third countries. This proposal includes broadening the definition of “interconnector” which currently applies only to internal pipeline systems, to “a transmission line which crosses or spans a border between Member States or between member States and third countries up to the border of Union jurisdiction.” Such an amendment would enable the EU’s rules on unbundling, transparency, third party access and regulated tariffs to apply in the territorial sea and to the sections of Nord Stream 2 prior to it connecting with the EU’s internal transmission systems.

At a meeting of the Working Party on Energy on January 11, 2018, the Council Legal Service was asked to issue an opinion on whether application of its proposal to the EEZ of EU member states was compatible with UNCLOS. On 1 March 2018, the Council Legal Service issued its opinion which, in a set-back for the EU, said that internal energy market rules could not legally extend to the EEZ (see Opinion of the Legal Service 6738/18) on the basis of UNCLOS, Articles 56 and 58, by which the coastal state does not have full sovereign powers in the EEZ.Accordingly, EU energy regulations cannot apply there.

Against this view, the EU Commission has argued that Article 79(4) of UNCLOS provides support for the its position that the Gas Directive can be extended the EEZ (see Euractiv.com). However, this is a misapplication of the provision. Article 79(4) does not confer any additional rights or powers on a coastal state but, rather, refers to its existing rights under the convention. It does not explicitly permit the EU to extend the rules of the Gas Directive to the EEZ.

Finally, a subsequent opinion issued by the Council Legal Service on March 26, 2018 finds that the EU regulatory framework may be extended to apply to parts of a pipeline up to the border of “Union jurisdiction” provided that, in the legislator’s assessment, the security of energy supply is enhanced by a regulated framework for third country interconnectors. If the legislator is satisfied that this is the case, then the there is an additional requirement to apply the principle of proportionality to achieve the intended purpose (an issue which will be determined by the EU Council) (see Opinion of the Legal Service 7502/18). This view is on an assumption that the EU Commission’s proposal to extend the Gas Directive and related legislation to third country interconnectors “falls within the scope of the establishment and functioning of the internal market in gas.” In such circumstances, the EU’s rules on unbundling, transparency, third party access and regulated tariffs would apply.

Inter-Governmental Agreement Between the EU and Russia
As noted above, different legal regimes apply to Nord Stream 2, depending upon the area through which the pipeline is passing, namely EU law, Russian law, and international law in the areas in which no single state has full sovereign rights. However, the pipeline as a whole is connected and regulations on the operation of one part of the pipeline necessarily affect operations on the rest of the pipeline. Once the Gas Directive and related legislation is extended to apply to pipelines carrying natural gas from third countries into the EU, any applicable EU rules would need to be applied to the rest of Nord Stream 2 outside the EU’s jurisdiction, resulting in a territorial extension of EU law. However, Russia is unlikely to consent to such an extension and a conflict would arise between the rules applicable to the pipeline.

In addressing this issue in its latest opinion of March 28, 2018, the Council Legal Service states that the EU and the third country would have to conclude an inter-governmental agreement for the operation of the pipeline to resolve any contradiction in their respective rules. This is what the EU Commission previously proposed in relation to Nord Stream 2. In particular, on June 12, 2017, the Directorate General for Energy of the European Commission submitted a draft recommendation to the EU Council for a decision authorizing the negotiation of an agreement between the EU and Russia “on the operation of Nord Stream 2 to ensure a coherent regulatory framework contributing to market functioning and security of supply in the Union.” However, this request was rejected when the Council’s Legal Service issued an opinion that the Gas Directive did not apply to Nord Stream 2.

The latest opinion nonetheless holds that, upon the adoption of the Commission’s proposals (which the Council Legal Service supports), an intergovernmental agreement will be needed. The irony is that such a conflict arises as a result of the EU’s proposals to extend the application of EU energy
law, and not on the basis of the law as it currently stands. Any international agreement necessitated by a conflict would fall within the exclusive competence of the EU. As a consequence, member states would not be entitled to enter into international commitments which would affect the EU’s common rules on unbundling, third party access, regulated tariffs and transparency and would be obliged to take appropriate steps to terminate such existing agreements with third countries.

The opinion provides sufficient support for the Commission’s proposals for the EU to move forward with its agenda concerning Nord Stream 2, although the opinion has a narrow scope and does not address all the relevant legal issues.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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