Record-high oil prices in the recent years brought an illusion with Russian oil and gas companies that their easy profits would continue forever. The financial crisis and the subsequent recession have taught them a harsh but useful lesson: even enormous hydrocarbon resources are not enough for prosperity.

Five Russian majors (Rosneft, LUKoil, TNK-BP, Surgutneftegaz and Gazprom-Oil) have more energy resources than the leading Western companies, while Gazprom is the world’s leader in natural gas resources. However, the Russian corporations are behind their major rivals in terms of capitalization and stable position on the market. Owing to their diversified investment structure, international oil and gas companies influence the formation of the norms that provide stability both inside and beyond individual countries. Even their occasional performance setbacks in underdeveloped countries do not undermine their reputation as successful global players. Stability in the market helps them counteract the volatility of oil prices.

When oil prices were high, Russian companies could easily attract financial capital. Short-term profits earned them stable credit ratings and encouraged them to take long-term loans for large investments. However, the liquidity crisis froze many long-term investment projects. Even such major Russian companies as Gazprom, Rosneft and LUKoil, which increased their profits by 30 to 40 percent over the last year, have not achieved an island of stability in the ocean of financial turmoil. The loss of capitalization and overall profits only complicates their investment prospects, which, in turn, will have a long-term effect on their future development.

Russian corporations that made profits only by raising prices ignored the need for onward development and diversification of investment activities. Meanwhile, the latter measure must be used to develop and improve the resource base and enter new sales markets – especially as global economic recessions are always accompanied by a growth of protectionism and its political manifestations. This is why transnational energy companies usually abide by – and help consolidate – the international practice that protects their investments in other countries.

Moscow, however, only responds to actions of the West.

The situation for Gazprom is complicated by its long-term commitments, whose fulfillment requires stable gas supply from extraction sites to the European Union’s borders.

In view of the abovementioned changes in the world energy system it is natural to ask a question: Does Russia really need an international investment regime?

RECESSION AND POLITICIZATION OF THE ECONOMIC SECURITY ISSUE

The financial crisis has already caused countries to toughen their economic security measures. State interference in the economy, expropriations and forced sales of assets have become common practice even in such liberal states as Britain.

The revision of liberal economic values was also behind the new measures taken by the EU Energy Council for the EU internal market. On October 10, 2008, the Council proposed allowing all EU states to take protective measures with regard to investment in transport facilities. National governments will be able to restrict access to investment in gas transport networks for non-European companies; in other words, protectionist actions by EU member-states will be legalized. Of course, the Council’s conclusions are not tantamount to barring access to investment, yet they justify introduction of economic security measures.

In this context, diversification of investment by Russia must be carried out within the frameworks of a political strategy for protecting its investments abroad. Yet the international political context weakens Russia’s positions – Russian actors have to operate outside of Russia in an atmosphere of mistrust and absence of protection means against investment risks, as well as absence of stable relations with neighboring states, which are becoming systemic factors of the global energy system.

The development of a long-term investment strategy in foreign markets is a vital need, but legal mechanisms for protecting energy investments are not always backed with foreign-policy moves. In addition, Moscow’s demands – made with an injured air – that the West revise its approach to Russian energy companies rarely come home to its Western partners. Moreover, the decisions by the EU Energy Council emphasize potential risks involved in the economic security policy in EU countries.

THE POLITICAL PROBLEM IS NOTHING NEW

According to Immanuel Wallerstein, the bifurcation of international relations began with changes in the rules that regulated cross-border political and economic ties.

The global economy is now witnessing two opposite trends. On the one hand, the increasing politicization of the economic security issue undermines the liberal market norms. On the other hand, this causes a pressing need for international legal protection of investments against possible discrimination.

The liberalization of EU gas markets is a graphic illustration of these two opposite trends on the way towards a common market. The closure of the doors before outside investors acquired a pan-European dimension in September 2007 when the European Commission approved the Third Energy Package to restrict non-European investment in EU transport facilities. This document became part of a logical chain of the development of a common liberalized EU energy market.

Making energy markets open to competition has always met with political opposition. The first fights over this issue began in 1989, when the EU discussed the possibility of introducing the successful experience of the UK in liberalizing electricity and gas markets was. Seven years of negotiations were crowned with the adoption of a directive of the European Council and the European Parliament, which endorsed the main principles for opening markets. The principles include separating transportation from production and supply; working out transparency rules that would facilitate access to transportation for all competing suppliers; and opening wholesale markets for companies competing for sales networks.

However, the process of opening up the gas market has been delayed because gas transport networks belong to suppliers, which deny access to them for competitors. The European Commission’s proposal, made in the autumn of 2007, was intended to increase competition among gas suppliers. To this end, suppliers needed to be separated from their transport networks, thus removing barriers to markets for suppliers that do not have pipelines of their own.

The Third Energy Package, in its original wording, was blocked by the European Council which bowed to the demands of some of the EU states and their companies that showed strong opposition to this initiative. Nevertheless, the European Commission turned to the EU competition law in order to legitimize –through legal action – complete separation of transport companies and suppliers in terms of property. On October 10, 2008, the EU member states sealed a compromise based on a consensus on the exclusion of non-European investments if this is required by security considerations. At the same time, attempts have been made to lobby for establishing a unified European gas transport company, where investment limitations would be introduced. A unified gas transport system would create real prerequisites for the emergence of a single gas market, where networks and supplies would belong to different owners.

The adoption of such measures to protect Europe against “unwanted” capital should not be surprising, considering the EU’s efforts to strengthen its economic security.

The politicization of the energy security issue began after the events of January 2006, when a Russian-Ukrainian gas price conflict interrupted gas transit to Europe for some time. Russian gas supplies began to be viewed through the prism of security and geopolitics. Subsequent agreements between Moscow and Kyiv have not removed the threat of a crisis recurrence, which happened three years later. In 2009, gas transit to Europe was halted on a much larger scale; this time the termination of supply was initiated by Russia, which has given additional arguments to those who advocate the politicization of energy relations with Moscow and those who propose establishing a unified gas transport company in Europe, with ensuing protectionist measures.

The EU poses as the only effective international regime for cross-border investment in the energy sector, which it believes justifies its moves to restrict access to its market. Thus, the European Union distances itself from other international investment regimes, such as the Energy Charter.

INVESTMENT RISKS IN SAFE EUROPE

Russian oil and gas companies look at investment risks in the European Union through rose-colored glasses. Indeed, the EU economic space is more predictable and transparent than most of the other regions in the world. Nevertheless, real and latent investment risks in the EU do exist. Today they concern Gazprom, and tomorrow they may affect Russian oil companies as well.

First, there is a risk of actual expropriation of assets after the introduction of forced competition and restricted access for foreign capital. The discussion of the Third Energy Package makes this risk more tangible. In addition, pursuant to the EU competition provisions, the European Commission is taking steps to initiate legal proceedings against suppliers that have transport assets. This may directly affect the investment already made by Gazprom in gas transport networks, which are particularly ramified in the Baltic States and Eastern Europe.

Second, investment may also be limited for ecological reasons, and, at worst, assets may be expropriated. Many energy investments have come under the pressure of standards of the Kyoto Protocol and the EU directive on emission reductions. Russian investments in oil refineries may be affected by this pressure as well.

Third, it is not ruled out that investors from Russia will be barred – for security reasons – already at the pre-investment stage. Such cases are many, and the best known of them involves Britain’s Centrica. Calls to restrict Russian investments are heard even from such friendly countries as Germany.

Fourth, risks emerge when partners fail to fulfill their contractual obligations. For example, Russian gas suppliers conclude a contract to supply gas to a distribution market at a certain price, while local authorities amend the price according to their political favors. Such conflicts may happen in the Baltic States where Gazprom has a large share in heat power distribution. It should be noted that failure to comply with one’s contractual obligations does not entail the application of security provisions of the Energy Charter Treaty (ECT).

Apart from the European Union, which remains the largest source of revenues for the Russian oil and gas sector, the restrictions may also be applied in the Balkans and Turkey. Russian investors view that region as an alternative to the EU, but EU legislation applies to Balkan countries, as well as they are parties to the 2005 Energy Community Treaty.

Combining competition legislation with energy security issues is becoming a long-term tendency of the EU internal market. This situation is not in Gazprom’s favor, although the latter has been making great efforts, struggling against complete division according to property. Gazprom is trying to influence the European Council through the lobbies of its European partners. But these efforts will it bring nothing – either in what concerns European competition legislation or limitations on investment in the EU – as the Russian gas giant has to rely on companies that are its rivals in EU distribution markets.

What political and legal mechanisms are needed to protect investors in the European Union?

NEW EU RULES VERSUS ECONOMIC LIBERALISM

The international investment regime has traditionally been regulated by bilateral investment agreements providing for international arbitration. However, these agreements do not always clearly specified rules for resolving conflicts. In addition, agreements of this kind are very sensitive to political changes in the signatory countries.

During the years of the rapid development of energy markets, an attempt was made to streamline the protection of private investment within the framework of the Energy Charter Treaty (ECT). This was the first document in economic history to include multilateral provisions for protecting investors against discrimination and illegitimate expropriation. In addition, the ECT mechanisms for settling disputes allow one to initiate legal proceedings directly against the European Community.

However, the treaty has lost its legitimacy after Moscow’s refused to ratify it, which was the result of Gazprom’s lobbying efforts. The corporation has objections against transit provisions of the ECT and against its Transit Protocol, which is still the subject of international negotiations.

In June 2006, experts of the Gazekonomika Research Institute, which is close to Gazprom, pointed to the absence in the ECT of provisions that would ensure pre-investment protection against discrimination. They failed to take into account the fact that investment arbitration rules make no distinction between pre- and post-investment stages. Yet, the criticism by Gazekonomika was justified because non-discrimination at the pre-investment stage increasingly depends on relations of reciprocity, bypassing provisions of the international treaty. These rules of reciprocity serve as a pretext for the European Union to restrict investment in transport facilities.

In light of these restrictions, one can assume that if the negotiations on the ECT were held today, the treaty would not be signed even by the EU member states themselves. But the treaty has been in force for ten years now, while the interest of European energy companies in it further grew after the emergence of the Third Energy Package. These companies view the Charter’s investment provisions as a legal guarantee against property division and as protection against the expropriation of energy property.

Russian experts from the Russian Gas Society and the Institute for Energy and Finance Foundation contrast European law with constitutional rights of the EU member countries concerning the protection of property at the national level. But their reasoning does not take into account legal monism, by which the majority of European countries abide: international law is integrated into national legislation through the ratification of any treaty. The monism means that national legislation cannot oppose decisions of a European court or laws of the European Union. At the same time, the ECT prevails over EU legislation, because the European Community is a party to the Charter.

At the same time, the European Commission has grounds to deny Gazprom non-discrimination, using the security provisions in the ECT and those adopted by the Council. The proponents of the EC’s position argue that the monopoly on gas exports in Russia, which lacks economic grounds and which even Norway has given up, is the main and only argument for justifying the security measures.

The situation with investments in the oil industry is simpler: arbitration is possible there within the ECT frameworks, as there is no oil exporting monopoly company in Russia.

In addition, the January 2009 crisis has confirmed that the transit mechanisms, provided for by the ECT, can prove necessary in situations when transit to Europe is halted. During the conflict with Ukraine, after Russia resumed gas supply to the EU but Ukraine did not resume gas transit yet, the Russian leadership and Gazprom urged Kyiv to comply with ECT transit provisions. However, Moscow refrained from resorting to the ECT legal mechanisms against violator countries. Meanwhile, using international mechanisms for settling disputes would have been less painful politically than proving to be an unreliable gas supplier to consumers in the EU.

This conflict may have consequences for direct access to European markets for Gazprom. After the January 2009 events, the Europeans will find it difficult to give it direct access to investment after it has proven to be an unreliable gas supplier unable to find a political solution to the conflict with a transit country without halting gas supply to its clients. And on the contrary, the settlement of the crisis using intermediary mechanisms within the ECT frameworks would have let Russia save face and accuse Ukraine of violating the transit provisions.

But can the Russian state and Russian companies use legal mechanisms of the ECT which has not been ratified yet? This question remains open and requires careful analysis of various political and legal options.

RUSSIA AND THE ENERGY CHARTER TREATY

Russia has not ratified the ECT and applies it on a temporary basis (that is, its provisions remain in force if they are not at variance with Russian legislation and the Constitution). Therefore, there arises a possibility of using its investment provisions to oppose restrictions in the EU. Such an approach to the treaty is practiced for the first time in international practices. According to the Vienna Convention on Treaties, provisional application ceases after a treaty enters into force. In case with the ECT, this already happened in 1998.

 According to the Vienna Convention, a state can choose either to start full application of a treaty, or revoke its signature from it. Russia has chosen a “golden mean” of its own – it has refrained from the full application of the ECT, yet it has not withdrawn its signature. Thus, Moscow’s application of the ECT to protect Russian oil companies in Europe, for example, becomes the subject matter of an international arbitration proceeding, without Moscow’s consent. Russia does not relish the prospect of being ranked among Latin American regimes, such as Bolivia, so it does not contest international arbitral awards. In particular, it signed and ratified the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards even when it was part of the Soviet Union.

The situation has been exacerbated by the application of the ECT against Russia by YUKOS shareholders, who argue that Moscow has violated the ECT expropriation provisions, using them in a discriminatory manner against their company. YUKOS is seeking an arbitral award precisely over the provisional application of the Energy Charter Treaty by Russia. An arbitration proceeding is yet to begin but the case has already been forgotten by the public opinion both in Russia and the West. A hypothetical decision by an arbitrator in favor of or against YUKOS would not mean that Russian oil companies would automatically have a similar right to defend their interests in Europe.

Russia’s uncertain position on the ECT may backfire on the Russian state (if an arbitral award is made in favor of YUKOS) and on Russian oil companies (if they are denied the right to use ECT provisions against the EU). Meanwhile, Russia recognizes arbitration decisions, even though it does not participate in drawing up norms and rules.

The absurdity of the situation with the provisional application of the ECT makes one ponder what system, apart from the EU legal system, Russian investors can turn to if problems with the EU arise.

Moscow will have to formulate its position and choose one of the following options:

• Withdraw from the ECT, leaving its economic players to the mercy of EU legislation and renouncing high posts in that organization, which would limit Moscow’s influence. As a result, political mistrust of Russia would grow, and the spiral of security problems would continue to unwind. The European Union would have every reason to use restrictive measures not only towards Gazprom but also towards the Russian oil industry;
• Accept the ECT in its present wording, renouncing its provisional application and reaching a compromise with the EU, particularly on transit issues. Difficulties may arise, above all, for Gazprom due to its legal monopoly on gas export and due to limited access to networks for other gas producers. The gas giant is not ready for changes that could remove conflicts between Russian legislation and the Energy Charter Treaty. Russia may ratify the ECT with a reservation that its provisions shall not apply to the gas industry. However, considering the importance of gas for the EU, it is unlikely that Brussels will consider such ratification sufficient. In addition, it would be difficult for Moscow to demand that Ukraine comply with provisions that Russia itself has declined to observe;
• Offer a clear alternative that would be acceptable both to Russia and the European Union. It could be a new document based on the ECT or a possible Russian-EU Agreement, which would contain clear-cut provisions on non-discrimination at the pre-investment stage and specify mechanisms for settling transit disputes. Regular gas conflicts with Ukraine require a new approach for settling them. However, this approach involves a risk of losing new negotiations, whose results would have to be renounced. This is what happened, for example, to the Transit Protocol, which was initially supported and partly initiated by Moscow.

Obviously, Russia avoids making a decision for the time being. A wait-and-see position makes sense if there is a clear political strategy behind it. In this case, the Russian position is based on expectations of high oil prices and on the liberal investment regime in the EU countries. However, protectionist sentiments in Europe are growing, while a further decline in oil prices may weaken Russia’s positions at negotiations with the EU.

WHAT TO DO?

Russian companies have overestimated their own strength and have been affected by the financial crisis more than their Western partners. The dependence on European markets, finance and technologies requires drawing up a detailed economic strategy aimed at diversification and innovation. Only in this way can Russia move from a policy of “protecting the weak” to the “stimulation of the strong” and clearly formulate its position on investment and the international investment protection system. Otherwise, Russian actors will have to abide only by the European rules of the game in their relations with the EU.

When entering the international investment market, Russian companies and the Russian state must become sources for developing international energy law. So far, Russia’s participation in this process has been passive. Russian corporations underestimate investment risks in the European Union, while the Russian energy strategy lacks understanding of how this country should build its relations with international arbitration institutions.

The conflict between EU legislation and traditional liberal norms calls into question the possibility of protecting investment in the EU on the basis of EU laws. The present vacuum of international rules and regulations on investment movements gives Russia a chance to offer an alternative of its own – a new international investment agreement based on the ECT. It could be concluded starting with the oil industry, which needs investment security most. Such an agreement would also be good for the power industry, where the liberalization process is already well under way.

As regards the gas industry, it first needs to be depoliticized by both Russia and the European Union. This is impossible unless regular conflicts between Russia and Ukraine are stopped. The transit conflicts only confirm the need for universally accepted rules, rather than annul it. One can draw an analogy with the law of the sea: the existence of pirates does not call into question the Treaty’s validity but it requires additional political efforts to combat anomalies.

To this end, Russia should start a political dialogue with various states and regional groups in Europe, similar to the existing German-Russian energy dialogue. But above all, this requires a political decision by Russia to move towards an international Energy Treaty.