Russia’s invasion of Ukraine profoundly impacted the global economy, immediately sending shockwaves across the globe. The attack of a country that was once a major energy supplier to Europe on the country which was one of the top food exporters in the world, sent food and fuel prices spiralling, causing major energy shortages and the prospect of protracted recession in the United States and the European Union.
The unprovoked and brutal aggression resulted in nearly universal condemnation and widespread sanctions placed on Russia by the United States, the EU, and other Western allies. Financial sanctions were perhaps the most unexpected and significant with the potential for immediate impact on Russia’s neighbours, including those that did not formally join the sanctions regime. In addition to sanctions, the major consequence of the war was mass migration waves, particularly from Ukraine, but also from Russia and Belarus to neighbouring countries.
At the start of the war, it was expected that the Georgian economy would be severely and negatively impacted for the following reasons:
- First, as a former Soviet republic, Georgia historically maintained close economic trade ties with both Russia and Ukraine. The ties with Russia have weakened considerably in the wake of the 2008 Russo-Georgian war but remained significant. Russia was the primary market for imports of staple foods into Georgia, such as wheat flour, maize, buckwheat, edible oils, etc. Russia and Ukraine were both important export markets for Georgia. Russia was absorbing about 60 percent of Georgian wine exports and 47 percent of mineral water exports, while Ukraine was one of the leading importers of alcohol and spirits from Georgia (46 percent of Georgia’s exports). Tourism and remittances are other areas where Georgia is significantly tied to Russia and somewhat weaker to Ukraine. Before the pandemic, in 2019 Russia accounted for 24 percent of all tourism revenues, while Ukraine for 6 percent. Remittances from Russia accounted for 16.5 percent of total incoming transfers in 2021.
- Second, while the Georgian government chose to largely keep a neutral stance on the war (announcing at one point that they would not join or impose sanctions against Russia), the main financial and trade international sanctions were still in effect in Georgia due to international obligations and close business ties with the West. These factors were reinforced by strong support for Ukraine among the Georgian population, where the memory of the Russian invasion of Georgia in 2008 remains uppermost.
- In addition, Georgia is a net energy importer, and while the dependence on energy imports from Russia is not significant, the rising prices would have affected Georgia profoundly.
Original publication: This policy paper was originally published in the ISET Policy Institute Policy Briefs section by Yaroslava Babych, Lead Economist of ISET Policy Institute. To read the full policy paper, please visit the website of ISET-PI.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
The recent record-high gas prices have triggered legitimate concerns regarding the EU’s energy security, especially with dependence on natural gas from Russia. This brief discusses the historical and current risks associated with Russian gas imports. We argue that decreasing the reliance on Russian gas may not be feasible in the short-to-mid-run, especially with the EU’s goals of green transition and the electrification of the economy. To ensure the security of natural gas supply from Russia, the EU has to adopt the (long-proclaimed) coordinated energy policy strategy.
In the last six months, Europe has been hit by a natural gas crisis with a severe surge in prices. Politicians, industry representatives, and end-energy users voiced their discontent after a more than seven-fold price increase between May and December 2021 (see Figure 1). Even if gas prices somewhat stabilized this month (partly due to unusually warm weather), today, gas is four times as expensive as it was a year ago. This has already translated into an increase in electricity prices, and as a result, is also likely to have dramatic consequences for the cost and price of manufacturing goods.
Figure 1. Evolution of EU gas prices since Oct 2020.
These ever-high gas prices have triggered legitimate concerns regarding the security of gas supply to Europe, specifically, driven by the dependency on Russian gas imports. Around 90% of EU natural gas is imported from outside the EU, and Russia is the largest supplier. In 2020, Russia provided nearly 44% of all EU gas imports, more than twice the second-largest supplier, Norway (19.9%, see Eurostat). The concern about Russian gas dependency was exacerbated by the new underwater gas route project connecting Russia and the EU – Nord Stream 2. The opponents to this new route argued that it will not only increase the EU’s gas dependency but also Russia’s political influence in the EU and its bargaining power against Ukraine (see, e.g., FT). Former President of the European Council Donald Tusk stated that “from the perspective of EU interests, Nord Stream 2 is a bad project.”.
However, neither dependency nor controversial gas route projects are a new phenomenon, and the EU has implemented some measures to tackle these issues in the past. This brief looks at the current security of Russian gas supply through the lens of these historical developments. We provide a snapshot of the risks associated with Russian gas imports faced by the EU a decade ago. We then discuss whether different factors affecting the EU gas supply security have changed since (and to which extent it may have contributed to the current situation) and if decreasing dependence on Russian gas is feasible and cost-effective. We conclude by addressing the policy implications.
Security of Russian Gas Supply to the EU, an Old Problem Difficult to Tackle
Russia has been the main gas provider to the EU for a few decades, and for a while, this dependency has triggered concerns about gas supply security (see, e.g., Stern, 2002 or Lewis, New York Times, 1982). However, the problem with the security of Russian gas supplies was extending beyond the dependency on Russian gas per se. It was driven by a range of risk factors such as insufficient diversification of gas suppliers, low fungibility of natural gas supplies with a prevalence of pipeline gas delivery, or use of gas exports/transit as means to solve geopolitical problems.
This last point became especially prominent in the mid-to-late-2000s, during the “gas wars” between Russia and the gas transit countries Ukraine and Belarus. These wars led to shortages and even a complete halt of Russian gas delivery to some EU countries, showing how weak the security of the Russian gas supply to the EU was at that time.
Reacting to these “gas wars”, the EU attempted to tackle the issue with a revival of the “common energy policy” based on the “solidarity” and “speaking in one voice” principles. The EU wanted to adopt a “coherent approach in the energy relations with third countries and an internal coordination so that the EU and its Member States act together” (see, e.g., EC, 2011). However, this idea turned out to be challenging to implement, primarily because of one crucial contributor to the problem with the security of Russian gas supply – the sizable disbalance in Russian gas supply risk among the individual EU Member States.
Indeed, EU Member States had a different share of natural gas in their total energy consumption, highly uneven diversification of gas suppliers, and varying exposure to Russian gas. Several Eastern-European EU states (such as Bulgaria, Estonia, or Czech Republic) were importing their gas almost entirely from Russia; other EU Member States (such as Germany, Italy, or Belgium) had a diversified gas import portfolio; and a few EU states (e.g., Spain or Portugal) were not consuming any Russian gas at all. Russian natural gas was delivered via several routes (see Figure 2), and member states were using different transit routes and facing different transit-associated risks. These differences naturally led to misalignment of energy policy preferences across EU states, creating policy tensions and making it difficult to implement a common energy policy with “speaking in one voice” (see more on this issue in Le Coq and Paltseva, 2009 and 2012).
Figure 2. Gas pipeline in Europe.
The introduction of Nord Stream 1 in 2011 is an excellent example of the problem’s complexity. This new gas transit route from Russia increased the reliability of Russian gas supply for EU countries connected to this route (like Germany or France), as they were able to better diversify the transit of their imports from Russia and be less exposed to transit risks. The “Nord Stream” countries (i.e., countries connected to this route) were then willing to push politically and economically for this new project. Le Coq and Paltseva (2012) show, however, that countries unconnected to this new route while simultaneously sharing existing, “older” routes with “Nord Stream” countries would experience a decrease in their gas supply security. The reason for this is that the “directly connected” countries would now be less interested in exerting “common” political pressure to secure gas supplies along the “old” routes.
This is not to say that the EU did not learn from the above lessons. While the “speaking in one voice” energy policy initiative was not entirely successful, the EU has implemented a range of actions to cope with the risks of the security of gas supply from Russia. The next section explains how the situation is has changed since, outlining both the progress made by the EU and the newly arising risk factors.
Security of Russian Gas Supply to the EU, a Current Problem Partially Addressed
Since the end of the 2000s, the EU implemented a few changes that have positively affected the security of gas supply from Russia.
First, the EU put a significant effort into developing the internal gas market, altering both the physical infrastructure and the gas market organization. The EU updated and extended the internal gas network and introduced the wide-scale possibility of utilizing reverse flow, effectively allowing gas pipelines to be bi- rather than uni-directional. These actions improved the gas interconnections between the EU states (and other countries), thereby making potential disruptions along a particular gas transit route less damaging and diminishing the asymmetry of exposure to route-specific gas transit risks among the EU members. Ukraine’s gas import situation is a good illustration of the effect of reverse flow. Ukraine does not directly import Russian gas since 2016, mainly from Slovakia (64%), Hungary (26%), and Poland (10%) (see https://www.enerdata.net/publications/daily-energy-news/ukraine-launches-virtual-gas-reverse-flow-slovakia.html). The transformation of the gas market organization brought about the implementation of a natural gas hub in Europe and change in the mechanism of gas price formation. It is now possible to buy and sell natural gas via long-term contracts and on the spot market. With the gas market becoming more liquid, it became easier to prevent the gas supply disruption threat.
Second, Europe has made certain progress in diversifying its gas exports. According to Komlev (2021), the concentration of EU gas imports from outside of the EU (excluding Norway), as measured by the Herfindahl-Hirschman index, has decreased by around 25% between 2016 and 2020. While the imports are still highly concentrated, with the HHI equal to 3120 in 2020, this is a significant achievement. A large part of this diversification effort is the dramatic increase in the share of liquified natural gas (i.e., LNG) in its gas imports – in 2020, a fair quarter of the EU gas imports came in the form of LNG. An expanded capacity for LNG liquefaction and better fungibility of LNG would facilitate backup opportunities in the case of Russian gas supply risks and improve the diversification of the EU gas imports, thereby increasing the security of natural gas supply.
However, the above developments also have certain disadvantages, which became especially prominent during the ongoing gas crisis. For example, the fungibility of LNG has a reverse side: LNG supplies respond to variations in gas market prices across the world. This change has intensified the competition on the demand side – Europe and Asia might now compete for the same LNG. This is likely to make a secure supply of LNG – e.g., as a backup in the case of a gas supply default or as a diversification device – a costly option.
In turn, new mechanisms of gas price formation in Europe included decoupling the oil and gas prices and changing the format of long-term gas contracts. The percentage of oil-linked contracts in gas imports to the EU dropped from 47% in 2016 to 26% in 2020. In particular, 87% of Gazprom’s long-term contracts in 2020 were linked to spot and forward gas prices and only around 13% to oil prices (Komlev, 2021). This gas-on-gas linking may have contributed to the current gas crisis: Indeed, it undermined the economic incentives of Gazprom to supply more gas to the EU spot market in the current high-price market. Shipping more gas would lower spot prices and prices of hub-linked longer-term contracts for Gazprom. In that sense, the ongoing decline in Russian gas supplies to the EU may reflect not (only) geopolitical considerations but economic optimization.
Similarly, this new mechanism also finds reflection in the ongoing situation with the EU gas storage. The current EU storage capacity is 117 bcm, or almost 20% of its yearly consumption, and thus, can in principle be effective in managing the short-term volume and price shocks. However, the current gas crisis has shown that this option might be far from sufficient in the case of a gas shortage (see, e.g., Zachmann et al., 2021). One of the reasons for this insufficiency can be Gazprom controlling a sizable share of this storage capacity (see https://www.europarl.europa.eu/doceo/document/E-9-2021-004781_EN.html). For example, Gazprom owns (directly and indirectly) almost one-third of all gas storage in Germany, Austria, and the Netherlands. Combining this storage market position with a long-term gas contract structure may also lead to strategic behavior for economic (on top of potential political) purposes.
Last but not least, the EU gas market is likely to be characterized by increased demand due to the green transition agenda (see Olofsgård and Strömberg, 2022). Being the least carbon-intensive fossil fuel, natural gas has an important role in facilitating green transition and increasing the electrification of the economy. For example, Le Coq et al. (2018) argues that gas capacity should be around 3 to 4 times the current capacity by 2050 for full electrification of transport and heating in France, Germany, or the Netherlands. In such circumstances, the EU is not likely to have the luxury to diminish reliance on Russian gas.
Conclusions and Policy Implications
Keeping the above discussion in mind, should the EU try to diminish its dependence on Russian gas to improve its energy security? This may be true in theory, but in practice, this might be too costly, at least in the short-to-medium run.
The current situation on the EU gas market suggests that simply cutting gas imports from Russia is likely to lead to high prices both in the energy sector and, later, in other sectors of the economy due to spillovers. Substituting gas imports from Russia with gas from other sources, such as LNG, is likely to be very costly and not necessarily very reliable. Alternative measures, e.g., improving interconnections between the EU Member States or controlling transit issues via the use of reverse flow technology, are effective but have limited impact. Simply cutting down gas demand is not a viable strategy. Indeed, with the EU pushing for a green transition and the electrification of the economy, the EU’s gas imports may have to increase. Russian gas may play an important role in this process.
As a result, we believe that the solution to keep the security issue of Russian gas supply at bay lies in the area of common energy policy. It is essential that the EU implements and effectively manages a coordinated approach in dealing with Russian gas supplies. The EU is the largest buyer of Russian gas, and given Russian dependency on hydrocarbon exports, such a synchronized approach would give the EU the possibility to exploit its “large buyer” power. While the asymmetry in exposure to Russian gas supply risks among the EU Member States is still sizable, the improvements in the functioning of the internal gas market and gas transportation within the EU make their preferences more aligned, and a common policy vector more feasible. Furthermore, recent EU initiatives on creating “strategic gas reserves” by making the Member States share their gas storage with one another would further facilitate such coordination. Implementing the “speaking in one voice” gas import policy will allow the EU to fully utilize its bargaining power vis-à-vis Gazprom and spread the benefits of new gas routes from Russia – such as Nord Stream 2 – across its Member States.
- European Commission, 2011, “Speaking with one voice – the key to securing our energy interests abroad“, press release, https://ec.europa.eu/commission/presscorner/detail/en/IP_11_1005
- Komlev, S. 2021, “Evolution of Russian Gas Supple to Europe: Contracts and Prices”, Presentation at 34th WS2 GAC, https://minenergo.gov.ru/system/download/14146/158148
- Le Coq C. and E. Paltseva (2020), Covid-19: News for Europe’s Energy Security, FREE Policy brief. https://freepolicybriefs.org/2020/05/07/covid-19-energy-security-europe/
- Le Coq C., J. Morega, M. Mulder, S Schwenen (2018) Gas and the electrification of heating & transport: scenarios for 2050, CERRE report.
- Le Coq C. and E. Paltseva (2013) EU and Russia Gas Relationship at a Crossroads, in Russian Energy and Security up to 2030, Oxenstierna and Tynkkynen (Eds), Routledge.
- Le Coq C. and E. Paltseva (2012) Assessing Gas Transit Risks: Russia vs. the EU, Energy Policy (4).
- Le Coq C. and E. Paltseva (2009) Measuring the Security of External Energy Supply in the European Union, Energy Policy (37).
- Lewis, Paul, “Gas pipeline is producing lots of steam among allies“, New York Times, Feb. 14, 1982, https://www.nytimes.com/1982/02/14/weekinreview/gas-pipeline-is-producing-lots-of-steam-among-allies.html
- Olofsgård A., and S. Strömberg (2022) Environmental Policy in Eastern Europe | SITE Development Day 202, FREE Policy Brief, https://freepolicybriefs.org/2022/01/10/environmental-policy-in-eastern-europe-site-development-day-2021/
- Stern, J., 2002. Security of European Natural Gas Supplies—The Impact of Import Dependence and Liberalization, Royal Institute of International Affairs, available at: 〈http://www.chathamhouse.org.uk/files/3035_sec_of_euro_gas_jul02.pdf〉
- Zachmann, G., B. McWilliams and G.Sgaravatti, 2021, How serious is Europe’s natural gas storage shortfall? https://www.bruegel.org/2021/12/how-serious-is-europes-natural-gas-storage-shortfall/
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
This brief is based on a study that investigates how Ukraine’s integration into the EU Digital Single Market (DSM) could affect EU-Ukraine bilateral trade as well as Ukraine’s GDP growth. The major benefits of integration are expected to come from 1) reduction of cross-border regulatory barriers and restrictions to EU-Ukraine digital trade 2) acceleration of the development of Ukraine’s digital economy in line with EU standards. According to the results, enhanced regulatory and digital connectivity between Ukraine and the EU is expected to increase Ukraine’s exports of goods and services to the EU by 11.8-17% and 7.6-12.2% respectively. At the same time, the acceleration of the digital transformation of the Ukrainian economy and society will produce a positive effect on its productivity and economic growth – a 1%-increase in the digitalization of the Ukrainian economy and society may lead to an increase in its GDP by 0.42%.
Integration into the EU has been one of the key topics on Ukraine’s political agenda for a number of years. Recently, more emphasis has been put on an essential component of issue – integration into the EU’s Digital Single Market (DSM). The DSM is a strategy aimed at uniting and enhancing digital markets and applying common approaches and standards in the digital sphere across the EU. The Ukraine-EU Summit, held on October 6, 2020, stressed the paramount importance of the digital sector in boosting its economic integration and regulatory approximation under the EU-Ukraine Association Agreement. Implementation of the provisions of this agreement, in particular the updated Annex XVII-3, would introduce the latest EU standards in the field of electronic communications in Ukraine. The country is also gradually approximating its regulations with regard to other components of the EU DSM – electronic identification, electronic payments and e-payment systems, e-commerce, protection of intellectual property rights on the Internet, cybersecurity, protection of personal data, e-government, postal services, etc. These steps will, in turn, ensure Ukraine’s gradual integration into the EU’s Digital Single Market, which will facilitate digital transformations within the country and open a new window of opportunity for individuals and businesses.
This brief summarizes the results of our recent work (Iavorskyi, P., et al., 2020), in which we estimate the effect that Ukraine’s integration into DSM could have on EU-Ukraine bilateral trade as well as Ukraine’s GDP growth.
Benefits of Integration into the EU DSM
The EU DSM strategy comprises three pillars: (1) better access for consumers and businesses to digital goods and services across Europe; (2) creating the right conditions and a level playing field for digital networks and innovative services to flourish; (3) maximizing the growth potential of the digital economy (EC, 2021).
These goals suggest that the major benefits of Ukraine’s integration into the DSM are likely to come from 1) reduction of cross-border regulatory barriers and restrictions to EU-Ukraine trade, 2) acceleration of the development of Ukraine’s digital economy in line with EU standards.
Indeed, the trade of goods and services is increasingly becoming “digital” – i.e., involving “digitally enabled transactions in goods and services that can be either digitally or physically delivered” (OECD, 2019). Trade digitalization (e.g., electronic contracts, electronic payments, e-customs, etc.) simplifies export and import procedures, reduces trade costs for exporters, and creates new opportunities for trade with the EU, in particular for SMEs. Therefore, the reduction of regulatory restrictions on cross-border digital trade reduces the overall level of restrictiveness of trade in goods and services.
Thus, digitalization is expected to facilitate and intensify the total EU-Ukraine trade in goods and services. It is also anticipated to increase the productivity of Ukraine’s economy which will have a positive impact on the country’s economic growth.
Major benefits include lower prices and greater access to EU online markets for Ukrainian consumers and business, digital innovative products and services, greater online consumer protection, lower transaction costs for businesses, improved quality and transparency of public digital services and e-government as well as an intensification of innovation development in Ukraine.
At the same time, Ukraine’s integration into the DSM entails several obligations: to align national legislation and standards with EU legislation and standards; to ensure institutional and technical capacity as well as interoperability of digital systems. For businesses in Ukraine, this means facing new EU requirements aimed at improving consumer and personal data protection, as well as increased competition from European companies in digital markets. However, these changes are necessary if the country wants to build a common economic space with the EU, especially given the growing impact of digital technologies on international trade and economy.
Ukraine in International Digital Rankings
Many international digital development rankings show that Ukraine lags behind EU countries, including its neighbors that recently joined the EU.
According to the UN e-Government Development Index (EGDI) for 2020, Ukraine ranks 69th among 193 countries and is included in the group of countries with high levels of e-government development. It received the lowest scores for Telecommunications Infrastructure and Online Services, and the highest for Human Capital. Nevertheless, Ukraine is lagging behind its neighboring EU members, – Poland, Hungary, Slovakia, Romania, Bulgaria, Lithuania, etc., – which belong to the group of countries with very high levels of e-government development (UN, 2020).
In the Network Readiness Index (NRI) ranking for 2019, Ukraine ranked 67th among 121 countries. As for the components of the index, Ukraine ranks worst in the following indicators: Future technologies (82nd out of 121), ICT Use by Government and Online Government Services (87th), and Regulatory Environment (72nd). Neighboring EU countries have higher rankings (Poland – 37, Latvia – 39, Czech Republic – 30, Croatia – 44). Other neighboring countries do somewhat better than Ukraine (Turkey is ranked 51st, Russia – 48th) or occupy positions close to Ukraine (Belarus – 61, Moldova – 66, Georgia – 68) (Portulans Institute, 2019).
In 2019, the country ranked 60th among 63 countries included in the World Digital Competitiveness Ranking (WDCR) rating. Just as in the other rankings, Ukraine scored well in the Knowledge component (40th among 63 countries), while in terms of Technology and Future Readiness it was at the bottom (61st and 62nd position respectively) (IMD, 2019).
Hence, it is primarily the technological and regulatory issues, that need to be addressed in order to improve Ukraine’s digital position in the region and the world.
Measuring Ukraine’s Digitalization level
In order to estimate the impact of digitalization, a Composite Digitalization Index is calculated for Ukraine, the EU, and other countries included in the model. This index is based on 11 digital indicators, combined into five components that characterize different areas of the digital economy and society – Connectivity, Use of the Internet by citizens, Human capital, Integration of digital technology by businesses, and Digital public services.
Our results confirm that the level of digital development in Ukraine is far below the EU average. It also lags behind the new EU Member States, which have a lower level of digital development compared to the other EU countries. As of 2018, the widest gaps between Ukraine and the EU average are found in Digital Public Services, Connectivity and Use of Internet by citizens. At the same time, Ukraine performed better in Human Capital and Integration of digital technology by businesses.
Measuring Digital Services Trade Restrictiveness in Ukraine
To assess the impact of digital regulatory barriers on trade, we use the Digital Services Trade Restrictiveness Index (Digital STRI) (OECD, 2020). It quantifies the regulatory barriers in five different policy areas (communication infrastructure, electronic transactions, electronic payments, intellectual property, other restrictions) that affect trade in digital services (Ferencz, J., 2019). OECD calculates Digital STRI for OECD countries and some non-OECD countries. As Ukraine is not included in this index, we estimate it for 2016-2018 using the OECD methodology.
Our estimations show that the level of digital services trade restrictiveness in Ukraine is much higher than the EU average. The regulatory differences in the digital sphere between Ukraine and the EU increase the cost of cross-border digital transactions between countries.
For Ukraine, most barriers are related to cross-border electronic payments and settlements, protection of intellectual property rights on the internet, cross-border electronic transactions (for example, the divergence of the national requirements for foreign trade agreements, including electronic ones, from international practices and standards, lack of practical mechanisms for the application of the electronic digital signature in foreign trade contracts, lack of mutual recognition of electronic identification and electronic trust services between Ukraine and major trading partners, etc.), other barriers (requirements for the use of local software and cryptography, etc.). These regulatory restrictions significantly hinder the development of cross-border cooperation and Ukraine’s integration into the European and global digital space.
Ukraine’s integration scenarios
In the event of Ukraine’s integration into the EU DSM, the country’s regulatory environment and digital development are expected to gradually approach the EU averages. We model it through assuming that the regulatory differences between Ukraine and the EU (captured by the Digital STRI Heterogeneity Indices – see OECD, 2020) will be decreasing, and level of digitalization in the country (captured by the Digitalization Index – OECD, 2020) will converge towards that of EU-DSM members.
We considered three integration scenarios that imply high, medium, and low levels of Ukraine’s approximation to the regulatory environment and digital development of the EU. For instance, the high scenario implies the highest level of Ukraine’s digital development and the lowest level of regulatory differences between Ukraine and the EU.
We study the effect of reduced regulatory differences in the digital sphere on Ukraine-EU trade using a gravity model – one of the traditional approaches in the international trade literature. A gravity model predicts bilateral trade flows based on the size of the economy and trade costs between countries (affected by distance, cultural differences, FTAs, tariffs, etc.)
The study uses the following specification of the model for exports of goods and services in 2016-2018:
• Dependent variable – the total export flow of goods and services from country into country j (all possible pairs of countries).
• Independent variables – distance between countries and common characteristics (borders, language, law), existence of a free trade agreement, level of tariff protection (for goods), level of regulatory heterogeneity in the digital sphere between the two countries, and a set of fixed effects for each country.
We also estimate how digital development affects technical modernization, productivity, and economic growth. Technically, we use a Cobb-Douglas production function to describe each country’s output and model its total factor productivity component as a function of digital development (captured by the Digitalization index).
The results suggest that Ukraine’s integration into the EU DSM will be beneficial for both Ukraine and the EU. Under all integration scenarios, bilateral trade between Ukraine and the EU is expected to intensify considerably due to enhanced regulatory and digital connectivity between the two.
Ukraine’s total exports of goods and services to the EU are estimated to grow by 11.8-17% ($2.4-3.4 billion) and 7.6-12.2% ($302.5-485.5 million), respectively – a cumulative increase throughout the period of implementation of reforms aimed at regulatory and digital approximation of Ukraine to the EU.
Figure 1. The impact of Ukraine’s integration into the EU’s DSM on the exports of services from Ukraine to the EU*: three integration scenarios
Figure 2. The impact of Ukraine’s integration into the EU’s DSM on exports of goods from Ukraine to the EU*: three integration scenarios
The EU would increase its exports of goods and services to Ukraine by 17.7-21.7% ($4.1-5 billion) and 5.7-9.1% ($191-305 million), respectively.
The acceleration of Ukraine’s digital development will bring productivity gains that would transform into higher GDP growth. It is estimated that a 1% increase in Ukraine’s digitalization level is expected to raise its GDP by 0.42%. As a result, the country’s gradual approximation to EU levels of digitalization would result in additional Ukraines GDP growth of 2.4-12.1% ($3.1-15.8 billion), depending on the scenario.
Figure 3. Impact of digitalization on Ukraine’s GDP growth: three digitalization increase scenarios
According to our estimations, improved digitalization and reduction of regulatory barriers in the digital sphere between Ukraine and the EU will have a positive effect on trade for both Ukraine and the EU. There is also a significant potential for economic growth to be attained in Ukraine by increasing digitalization and productivity of various spheres of the economy and society.
Realization of this potential would, however, require a substantial regulatory approximation on the Ukrainian side to achieve alignment with the EU DSM. The main emphasis needs to be put on electronic identification and transactions, payment systems and electronic payments, protection of intellectual property rights on the internet, cybersecurity, and personal data protection.
- European Commission, 3.02.2021. Shaping the Digital Single Market.
- Ferencz, J., 2019. The OECD Digital Services Trade Restrictiveness Index, OECD Trade Policy Papers, No. 221, OECD Publishing, Paris.
- Iavorskyi, P., et al., 2020. Ukraine’s integration into the EU’s Digital Single Market: potential economic benefits
- IMD, 2019. World Digital Competitiveness Ranking 2019.
- Marcus, J., Petropoulos, G., and Yeung, T., 2019. Contribution to Growth: The European Digital Single Market Delivering economic benefits for citizens and businesses. CEPS Special Report.
- OECD, 2020. Digital Services Trade Restrictiveness Index and Digital STRI Heterogeneity Indices.
- OECD, 2019. Digital trade. Trade policy brief.
- Official Journal of the European Union, 2014. “EU-Ukraine Association Agreement.
- Portulans Institute, 2019. Network Readiness Index 2019, Washington D.C., USA.
- UN, 2020. E-Government Development Index (EGDI) 2020.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
The member states of the European Union coordinate on many policy areas. The joint implementation of public good type projects, however, has stalled. Centralized fiscal spending in the European Union remains small and there exists an overwhelming perception that the available funds are inefficiently allocated. Too little commitment, frequent rounds of renegotiation and unanimous decision rules can explain this pattern.
Currently, the EU allocates only about 0.4% of its aggregate GDP to centralized public goods spending (European Commission (2014)). This is surprising given the fiscal federalism literature’s classic predictions of efficiency gains from coordinated public goods provision (see for example Oates (1972) and the more recent contributions of Lockwood (2002) and Besley and Coate (2003) for a discussion). Yet, recent proposals to expand centralized fiscal spending in the EU have been met with skepticism if not outright rejection. The most frequently cited argument claims existing funds are already being allocated inefficiently and any expansion of centralized spending would turn the EU into a mere transfer union (Dellmuth and Stoffel (2012) provide a review).
Centralized fiscal spending in the EU is provided through the “Structural and Cohesion Funds”, which are part of the EU’s so called “Regional Policy” and were initially instituted in 1957 by the Treaty of Rome for the union to “develop and pursue its actions leading to the strengthening of its economic, social and territorial cohesion” (TFEU (1957), Article 174). At that point, the six founding members agreed it was important to “strengthen the unity of their economies and to ensure their harmonious development by reducing the difference existing between the various regions and the backwardness of the less favoured regions” (stated in the preamble of the same treaty). A reform in 1988 has further emphasized this goal by explicitly naming cohesion and convergence as the main objectives of regional policy in the EU.
Today, actual fiscal spending in the EU is far from achieving this goal. The initially agreed upon contribution schemes are often reduced by nation specific discounts and special provisions as the most recent budget negotiations for the 2014-2020 spending cycle showed yet again. Moreover, the perception is that available funds are being spent inefficiently (see for example Sala-i-Martin (1996) and Boldrin and Canova (2001)).Figure 1. 2011 EU Structural and Cohesion Funds
Figure 1 shows the national contributions to the structural funds as well as EU spending from that same budget in each member nation in per capita terms (data published by the European Commission). If fiscal spending was efficiently structured to achieve the above mentioned goal of convergence, one would observe a strong negative correlation between contributions and spending. The data shows, however, that while some redistribution is clearly implemented, rich nations still receive large amounts of the funds meant to alleviate inequality in the union (see Swidlicki et al. (2012) for a detailed analysis of this pattern for the contributions to and spending of structural funds in the UK).
What prevents a group of sovereign nations from effectively conducting the basic fiscal task of raising and allocating a budget to achieve an agreed upon common goal? In a recent paper, we theoretically examine the structure of the bargaining and allocation process employed by the EU (Simon and Valasek (2013)). Our analysis suggests that efficiency both in terms of raising contributions and allocating fiscal spending cannot be expected under the current institutional setting. While poorly performing local governments, low human capital in recipient regions, and corruption might all play a role in creating inefficiency (see for example Pisani-Ferry et al. (2011) for a discussion of the Greek case), improving upon those will only solve part of the problem.
We demonstrate that the inefficiency of EU spending in promoting the goal of convergence can be explained by the underlying institutional structure of the EU, where sovereign nations bargain over outcomes in the shadow of veto. Specifically, we model the outcome of the frequent negotiation rounds employed by the EU as the so-called Nash bargaining solution, explicitly taking into account the possibility for each member nation to veto and to withdraw its contribution (as the UK threatened in the most recent budget negotiations). It turns out that it is precisely the combination of voluntary participation, unanimity decision rule and the lack of a binding commitment to contribute to the joint budget that generally prevents efficient fiscal spending. In such a supranational setting, the distribution of relative bargaining power arises endogenously from countries’ contributions and their preferences over different joint projects. This creates a link between contributions to and allocation of the budget that is absent in federations, where contributions to the federal budget cannot simply be withdrawn and spending vetoed. Since the EU members lack such commitment, this link will necessarily lead to an inefficient outcome.
Why Does the EU Have These Institutions?
If the currently employed bargaining process cannot lead to an efficient outcome, why then did the EU member nations not institute a different allocation process right from the start? Of course, agreeing on a binding contract without the possibility for individual veto is politically difficult. More complicated bargaining processes may also be much more costly in terms of administration than is relying on informal negotiations and mutual agreement. Our analysis suggests another alternative: If the potential members of the union are homogeneous with respect to their income and the social usefulness (or spillovers) of the projects they propose to be implemented in the union, then Nash bargaining will actually lead to the budget being raised and allocated efficiently. The intuition behind this result is simple: If all countries have the same endowment, their opportunity costs of contributing to the joint budget are the same. Moreover, symmetric spillovers do not give one country a higher incentive to participate in the union than the other. Consequently, all countries have the exact same bargaining position. Thus, equilibrium in the bargaining game must produce equal surpluses for all nations. At the same time, with incomes and spillovers perfectly symmetric, the efficient allocation also produces the same surplus for each nation, so that it coincides with the Nash bargaining solution. It is important to notice, though, that symmetric income and spillovers do not imply homogeneous preferences: Each nation can still prefer its “own” project to the others. Instead, symmetry leads to a perfectly uniform distribution of bargaining power in equilibrium. Moreover, our analysis shows that efficiency is achieved if the union budget is small relative to domestic consumption and member countries have similar incomes.
This resonates well with the history of the European Union. In fact, the disparities between the founding members were not large, so that the current bargaining institutions could reasonably have been expected to yield efficiency. Only the inclusion of Greece, Ireland, Portugal and Spain created a more economically diverse community (European Movement (2010)). Our model shows that as the asymmetries between member countries or the importance of the union relative to domestic consumption grow, Nash bargaining leads to increasingly inefficient outcomes. Figure 2 shows this effect for a union of two nations. Keeping aggregate income constant and assuming symmetric spillovers between the two nations’ preferred projects, we vary asymmetry in their domestic incomes. The graphs show the Nash bargaining outcome (marked with superscript NB) compared to the generally efficient solution. As country A’s income increases, so does its outside option (i.e. all else equal, the higher the income, the less a country would lose if the joint projects were not implemented). Thus, country A’s bargaining position relative to country B increases in equilibrium, leading to an inefficient outcome. The allocation of funds to the union projects (upper right panel) depicts this channel very clearly: While the efficient allocation is independent from the distribution of national incomes, the Nash bargaining solution reflects the changing distribution of power. Nation A is able to tilt the allocation more toward its own preferred project the higher its income. Moreover, it is able to negotiate a “discount” for its contribution. While its contribution (labeled xa) does increase with its income (labeled ya), country A still pays less than would be budgetary efficient given its higher income (upper left panel). As a result of the inefficiencies introduced by the bargaining process, aggregate welfare in the union declines as asymmetry grows. Again, it is worth noting, that the loss in aggregate welfare is relatively small when asymmetry is small, but grows more than proportionally as the countries become more and more unequal (lower right panel).Figure 2. The Effect of a Union of Two Countries
This has troubling implications for the EU, as income asymmetry has increased with every subsequent round of expansion while the bargaining procedure for the fiscal funds has essentially stayed the same. It is not surprising then that a larger and more asymmetric EU has resulted in supranational spending that is increasingly inefficient.
The EU as a “Transfer Union”
We go on to show that the level of redistribution inherent in the Nash bargaining solution depends crucially on the overall size of the budget the union intends to raise. Increasing the EU’s budget for centralized fiscal spending would indeed lead to more “transfers” to low income members (in terms of net contributions), bringing the EU closer to the original goal of convergence. In fact, the EU could pick a budget such that inequality in terms of total welfare between member nations is completely alleviated. Such an outcome necessarily implies that the net gain from being part of the union for high-income nations is lower (albeit still positive) than for low-income members. However, this in turn has consequences for the endogenous distribution of bargaining power: Richer nations would be able to assert even more power and push even further for their own preferred projects, rendering the allocation of funds across projects less efficient. This trade-off between equality and efficiency implies that complete convergence is not necessarily socially desirable.
Arguably, this trade-off might be more important for a transition period than in the long run. If fiscal spending does not only lead to convergence in instantaneous welfare, but also has a positive effect on long-run performance and GDP growth, income asymmetries across countries will decrease even if the allocation of spending across projects is not entirely efficient. Less inequality in turn will lead to a more efficient allocation process in the future and endogenously reduce the level of necessary transfers. However, whether the growth effect of the EU’s structural funds is indeed positive remains a much-debated empirical question (see for example Becker et al. (2012)).
Institutions Fit for a Diverse Union
As the EU has expanded from the original six nations to the current 27, there has been a concurrent evolution of decision-making rules. A qualified majority rule is now used in many areas of competency. We show that the allocation of fiscal spending could also benefit from the implementation of a majority rule. Efficiency would be improved as long as the low-income member nations endogenously select into the majority coalition while their contributions to the budget remain relatively low. In connection to this, the EU might benefit from enforcing rules specifying contributions as a function of national income (such rules exist, but are easily and often circumvented), forcing wealthier member nations to pay more. An exogenous tax rule without the possibility to negotiate a discount, for example, may indeed improve overall efficiency.
It is important to note, however, that a unanimous approval of such a change is unlikely. The institutional mechanism of Nash bargaining is an “absorbing state” after the constitution stage, in the sense that not all member nations can be made better off by switching to an alternative institution. Therefore, the discussion of alternative institutions and decision making processes is particularly relevant when considering new mechanisms that increase fiscal spending at the union level, such as the proposed EU growth pact. If the same bargaining process remains to be employed even for new initiatives, even though a majority rule is preferable and implementable relative to the status quo, the opportunity for the EU to achieve efficiency in its fiscal spending is lost.
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