A state of mutually assured energy dependence exists between Russia and the European Union. Understandably, both parties worry about energy security. European policy-makers worry about relying too much on one supplier. Russian policy-makers worry about relying too much on one market. Both are likely to take action to limit that mutual dependence. Meanwhile, both Russia and the EU face practical problems in energy production and delivery on which they could usefully cooperate more than they do.

The mutual dependence is simple: Europeans want the oil and gas; Russians want the money they can get from that oil and gas. The European Union of 27 states currently obtains around a quarter of its total consumption of hydrocarbons from Russia. Russia, in turn, is delivering to the EU more than half its oil production and just under a quarter of its output of gas (though part of that export flow is balanced by imports of Central Asian gas). Russia has lately been deriving almost half of its federal-budget revenue from taxes on oil and gas – natural-resource extraction tax plus export duties plus profits tax. It is true that by no means all that tax revenue depends on sales to Europe. But European sales contribute more than their share of the volumes involved, because the prices (including export duties) in those sales are substantially above the prices paid by domestic and CIS customers.

The worries, on both sides, are primarily about gas, with some secondary concern about electricity. Exports of crude oil and oil products in 2006 brought in about three-and-a-half times as much revenue for Russia as gas, and were a larger contributor to European energy balances than Russian gas exports were; but oil markets are comparatively open and flexible. It is over long-term, bilateral gas supply arrangements, mainly through pipelines, that the worries arise. Will the customer commit himself to a ‘take or pay’ deal large enough and for long enough to justify the supplier’s investment in extraction and transport? Will the supplier “turn off the tap” to extract some political concession?

Russia exports some, but so far very little, electricity. But gas is a comparatively clean and attractive fuel for electricity generation, and Gazprom has been interested in downstream investment in Europe in electricity as well as in gas distribution; therefore some questions have been raised about Russian involvement in European generation and distribution of electricity as well.
Two recent developments shed light on the practical problems in the relationship.

One is the publication of the draft outline (kontseptsiya) of the new Russian government energy strategy up to 2030. The strategy document is due to be finalized in 2008, when it will replace the existing strategy for the period to 2020. The draft indicates a real problem: that Russian production capacity in gas may be insufficient to meet growing domestic and European demand for Russian gas.

The second development is the proposal by the EU competition commissioner, Neelie Kroes, to liberalize energy markets in EU countries, opening up gas and electricity, in particular, to more competition from new market entrants. This would entail “unbundling” companies in the two industries to separate production from distribution. That cannot be a purely internal EU matter. It would be absurd to prohibit EU-based companies from controlling both distribution networks and production assets while allowing foreign companies that controlled production and distribution in countries outside the EU to acquire distribution networks inside the EU. And, of course, the foreign company that is usually mentioned in this connection is – you guessed it – Gazprom.
These two documents – the Russian energy draft strategy and the European commission energy market proposal – were not intended by their authors to be primarily about EU-Russia cooperation. They do however suggest an agenda for cooperation.

THE PROSPECTS FOR RUSSIAN ENERGY SUPPLIES TO EUROPE

For those in Europe who fret about the security of Europe’s supplies of Russian gas, the Russian draft – from the Ministry of Industry and Energy (Minpromenergo) Energy Strategy Institute – identifies what should be the main worry: not Russia’s willingness, but its capacity to supply increasing amounts of gas to Europe.

The likelihood of Moscow manipulating gas supplies to Europe in order to win political concessions has been greatly exaggerated. For Moscow deliberately to “turn off the gas tap” with the intention of depriving Germany, France, Austria or Italy of gas, there would have to be a state of tension not far short of war. Such a situation is conceivable but not at all likely. If it did arise, it would not have arisen without warning; that would enable the potential target countries to take at least some protective measures. Short of this state of affairs, Moscow has too much revenue at stake to consider any such action.

The flurry of alarm about gas supplies to Europe in January 2006 was, in my judgement, a reaction to collateral damage sustained by Europe from a conflict between Russia and Ukraine. That conflict was at least partly commercial. Moscow’s management of it was clumsy, and the collateral damage should not have been allowed to occur. But it was probably an unintended consequence, all the same.

The prospect of Russia being unable to supply appreciably more gas to Europe than at present is a more serious worry. It emerges clearly in the draft new energy strategy. The authors of the 2030 Energy Strategy draft (ES2030 henceforth) assume that not only Russian but world production of hydrocarbons will soon ‘stabilize’ – that is, be close to stagnating. Partly for that reason, the draft does not even explore the possibility of any large and long-lasting fall in oil prices. It offers two scenarios, Conservative and Favorable. The latter is the one put forward as the basis for policy. In both scenarios Russian output of both gas and oil never falls. Many energy analysts would see that as unduly optimistic, but let us leave that to one side. The most striking aspect of the projections, from a European perspective, is that even the Favorable scenario has Russian gas production and exports growing very slowly.

That looks, on the face of it, like a reduction in aggregate export supplies to the CIS, Turkey and Europe. Moreover, non-Asia-Pacific exports by 2030 would include any liquefied natural gas (LNG) deliveries from the Shtokman field to the East Coast of the U.S. that might be developed during this period. So the prospects for Europe (including Turkey) do not look at all encouraging. Even if sales to CIS countries fall still further in response to price increases, deliveries to Europe would probably be, on the face of it, flat, at best. Yet EU27 aggregate consumption of natural gas is not flat: it rose at 1.7 percent p.a. in 2000-2006. What is still more worrying is that these export figures, modest though they are, rest partly on success in substituting coal and nuclear power for gas in Russian electricity generation, thus releasing gas from domestic consumption for export. That plan requires a huge growth in nuclear capacity. The nuclear power-station building program must be achievable; it is rather doubtful, however, whether it can be achieved as quickly as the planners are counting on.

Moreover, this is the favorable scenario, and that scenario rests on Russia achieving a turn-around in energy-sector investment and a sustained improvement in energy use domestically. If these improvements did not take place, the situation for Europe would be still more unpromising.

The draft sets out clearly the problems that hamper hydrocarbons output growth and energy saving in Russia. The authors note that the rules governing state involvement in the sector need to be clarified soon; that taxation of the oil industry is probably too high; that decisions need to be made soon on future domestic prices for gas and electricity; that the rules governing relations with international energy companies need to be clarified; and that by these and other means investment in hydrocarbons and in electricity needs to be raised substantially.

The shortfall in energy sector investment in the first five years of the existing Energy Strategy (2000-2020) is striking.

Moreover, if one takes the annual figures on investment by branch of the energy sector, given in current prices for 2002-05 in ES2030, and deflates them with the Rosstat producer price index to get a rough-and-ready measure of real investment, the trends over time are extraordinary. Real fixed investment in oil extraction rises by a healthy 23 percent between 2002 and 2003, and then falls, reaching 78 percent of the 2002 level in 2005. Real investment in gas extraction also rises in 2003, by 13 percent, edges up marginally in 2004 and then falls precipitately in 2005 to a mere 45 percent of the 2002 level.

Some of the likely reasons for this shortfall in investment have been widely discussed: the disturbing effect of the YUKOS affair and the subsequent diversion of Gazprom and Rosneft finance to the acquisition of existing assets in the sector, at the expense of the creation of new assets, for a start. But price controls and tax policies also play a role. As long as gas and electricity prices to Russian customers (residential and commercial) remain below long-run marginal cost, producers lack both the finance and the incentive to invest in their core business. Gazprom makes large profits from its exports, and has borrowed extensively, but is often criticized in Russia for putting so much of its investment into activities other than gas extraction. At the same time, consumers have a much weaker incentive to economize on energy usage than they would have if gas and electricity prices reflected real scarcities. The authors of ES2030 estimate that 75-80 percent of the drop actually achieved lately in energy-intensity of production is the result of structural change in the economy – in other words, the shift from industry to services and the shift within industry toward consumer goods. These structural shifts cannot continue indefinitely; they are likely to slow down soon.

The current state of affairs and the prospects set out in the new draft outline of the Russian energy strategy are therefore disturbing for European customers. What does that imply for possible cooperation?

The first step should be to review the ES2030 projections to explain more clearly what is expected to happen to Russian westwards export of oil and gas. Is the interpretation of the ES2030 numbers given here somehow misleading with respect to future levels of non-Asia-Pacific exports, particularly of gas? Ideally, that might be done by Russian specialists in close consultation with Western colleagues, both from international energy companies and from independent think-tanks.

Then, if all grounds for concern in Europe have not been disposed of, there should be more consultation with Western companies and analysts about the institutional barriers to adequate investment in the energy sector – including, sooner rather than later, a clarification of the rules of engagement for foreign energy companies in Russia. There is no question that Western capital and technology would help, but on what basis will that happen? President Putin sought in spring 2005 to provide early clarification. He called on Russian ministries to prepare legislation on strategic industries and strategic natural-resource deposits by autumn 2005. Neither is now expected before some point in 2008 – at best.

This is not a call for an end to the re-nationalization of the Russian oil industry and for a fully open door for Western investors, desirable though (in my view) those would be. It is a call merely for more consultation and more clarity soon about the rules of the game.

ENERGY MARKET LIBERALIZATION IN EUROPE

The European Competition Commissioner’s proposals for making the EU energy market more competitive have been received by many Russian commentators as calling for action against Gazprom in Europe. The “reciprocity” element in the proposals is a recommendation that companies from outside the EU be refused control of EU energy distribution networks if such access is not granted in their country of origin to EU-based companies. That would indeed be inimical to some of Gazprom’s reported plans. But, again, more consultation and clarification would be helpful.

The proposal to liberalize gas and electricity markets in the EU is not aimed at, and is not primarily about, Russian interests. It is about extending the kind of energy-market liberalization that has worked well in the UK and a few other countries to the EU as a whole. Vertically integrated energy companies with strong market power – E.ON Ruhrgas, Gaz de France, Eni, etc – derive substantial profits from the distribution end of their businesses. When distribution networks are opened to competition from new market entrants, the gap between retail and wholesale energy prices falls. That gap is far larger, for example, in Germany than in the UK. Lobbies of energy-using industries naturally support the change, and the benefit to residential consumers is clear.

The real struggle in the EU over this is between reformers like the Competition Commissioner and energy users, on the one hand, and vertically-integrated national monopolists or oligopolists and their political allies, on the other. Gazprom, though based outside the EU, is aligned with the latter camp. This is hardly surprising. German, French, Italian and Austrian ‘national champions’ have worked closely with Gazprom for a long time and they share joint ventures and other assets.

Either the competition proposals do not go through – in which case Gazprom cooperation with E.ON and others continues much as before – or it does not. In the latter case, there is still much to be clarified. Could Gazprom, for example, retain substantial minority stakes in European distribution companies?

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The issues raised here lend themselves to detailed assessment by specialists. This could be done in consultation ahead of the periodic EU-Russia summits. One of the many difficulties in relations between the European Union and Russia is that Russian policymakers see their own state as meriting, by its size, resources, history and location, a right to be consulted on EU policies and not treated simply as one of many neighbors or potential members. When so much of the business between the two entities is to do with energy, closer consultation on policies in precisely that sphere makes sense. That should work both ways: over Russian policies as well as EU policies.