*3.2. Hold-Up Mitigation*

Gas supply disruptions negatively impact households and businesses. Any future disruptions of the supply of Russian gas to Europe would have a significant impact on the economies of Eastern Europe, and a moderate effect on Western Europe [4,53]. This is because Eastern Europe depends more heavily on the supplies of Russian gas. Hence, mitigation of future hold-up is crucial. Three strategies may effectively mitigate the hold-up problem when three parties—exporter, transit country, importer—are involved in trade dependent on asset-specific investments coupled with volatile markets.

The three strategies discussed below are (1) resolving disputes through an international organisation; (2) designing contracts with price mechanisms that might reduce the possibility of disputes; (3) reducing the number of parties involved in the trade. Political issues have often led to gas supply disruptions multiple times. One strategy to mitigate the hold-up problem is to set up an international organisation that can help avoid or resolve the disputes. The Energy Charter Treaty (ECT) was created to facilitate energy flows from east to west in Europe. The ECT covers four main dispute areas: trade, investment, transit and settlement [54].

The Treaty promotes the principles of freedom of transit and non-discrimination, includes an obligation to provide national treatment for energy in transit, and prohibits interruption of flows and the placing of obstacles to the construction of new energy transportation facilities. It also contains a specific conciliation procedure for disputes over energy transit. The ECT requires that, in case of a dispute, the transit country shall not interrupt or reduce the existing flow of energy materials and products prior to the conclusion of the conciliation mechanism. The flow can only be stopped if it was allowed by the original contract or by the conciliator.

The ECT experience so far shows that the hold-up potential has not been eliminated, as parties can simply renege on the agreements. The ability of an international organisation to resolve disputes thus needs further improvement. Before the 2009 gas dispute between Russia and Ukraine, the Energy Charter Secretariat warned that Ukraine had to ensure non-interruption of transit [2]. However, the ECT could not prevent or effectively alleviate the dispute. The ECT (which had been signed and ratified by Ukraine) did not stop Ukraine from interrupting the transit. However, Russia has not ratified the Treaty, stating that it is biased towards consumers. Hence, for the ECT or any future similar organisation to effectively prevent and resolve disputes, it must have some enforcement mechanism.

One such enforcement mechanism is reputation, which has been used relatively successfully by the WTO (World Trade Organisation). The DSB (Dispute Settlement Body) of the WTO has at times been successful at resolving political hold-up problems by providing transparency and reputation damages for violators [55]. Another example of an enforcement mechanism derives from Klein's [9] self-enforcing range: the parties could post substantial collateral forfeitable upon non-compliance.

Price disputes have also led to gas supply disruptions multiple times. Hence, a second strategy to mitigate the hold-up problem is to design contracts with price mechanisms that might reduce the possibility of disputes as a result of market changes. Current pricing in long-term gas contracts indexes the gas price to trailing averages of fuel oil derivatives prices in Europe [56] and of crude oil prices in Asia [52]. Temporarily large deviations of current price from longer-term averages might lead to disputes. Additionally, eliminating seasonality by indexing contract prices to longer-term average prices might lead to suboptimal gas consumption or require additional costly gas storage. Although designing a better pricing mechanism than indexing gas prices to average fuel prices is difficult, perhaps accounting for seasonal changes in demand is beneficial.

The gas wars between Russia and Ukraine show that eliminating the need for a transit country can reduce hold-up potential significantly. Hence, a third strategy to mitigate the hold-up problem is to reduce the number of parties involved. This is what Russia is trying to achieve with its new gas pipeline projects, such as Nord Stream and Blue Stream. These pipelines connect Russia with its European customers while avoiding the territories of former Soviet republics (Belarus, Estonia, Latvia, Lithuania, Moldova, Ukraine). The drawback of this strategy is its cost; and delaying investment into expensive alternative routes might also serve as a deterrent [6].

Nord Stream is an offshore pipeline connecting Russia directly with Germany via the Baltic Sea. This pipeline has two lines, opening in 2011 and 2012, with a total capacity of 55 million m3. The capacity is being expanded with Nord Stream 2; which is expected to be completed in the third quarter of 2021 [57]. The cost of the pipeline is over \$15 billion (onshore and offshore sections). Russian and German officials stated that this pipeline reduces costs due to the elimination of transit fees and increased pipeline pressure (eliminating the need for midway compressors) [58].

Blue Stream is an offshore pipeline connecting Russia with Turkey via the Black Sea. This pipeline started commercial gas supplies in 2003, with a capacity of 16 billion m3 per year. The cost of the pipeline is over \$3.2 billion (onshore and offshore sections). Russian Gazprom stated that the significance of this pipeline is in bypassing transit countries (Bulgaria, Moldova, Romania, Ukraine) [59–62].

Russian investments in new multi-billion-dollar pipelines to avoid hold-up risks recognise the importance of hold-ups related to transit countries. Game-theoretic models show that potential investment in alternative transit routes shifts the bargaining power [7]. A broader understanding of transit-related hold-up problems and the development of mitigating strategies benefit from a clear account of historic cases of opportunistic behaviour. Hence, this study might be useful for academics in energy economics, for practitioners involved in international energy trade, and for policymakers at the highest state levels.
