Russia in Global Affairs

Several unprecedented global events have awakened international
interest in Russia as the world’s major energy exporter. The high
political risks involved in world energy supplies following
September 11, 2001, the Iraqi campaign, structural changes in
energy consumption (especially as coal tends to be replaced by
natural gas), integration inside Europe and the ex-Soviet Union are
influential developments which place greater emphasis on the energy
question. Major consumers of energy resources — the EU, the United
States, Japan and China — may even turn out competitors for future
supplies of Russian gas and oil, as well as the right to engage in
the development of Russia’s export infrastructure.

The European Union was the first to begin an in-depth energy
dialog with Moscow when economic growth slowed in the developed
countries and competition intensified on the world markets. By the
fall of 2000, after a decade of decline, Russia had gained
political stability and was beginning to show high growth rates.
Nevertheless, it took the economically developed countries two more
years to recognize Russia as a market economy state. In the fall of
2002, a new, reformed Russia became an integral part of the global
community once again.

The energy market is a mixed bag of interests: countries, energy
firms and producers of energy-intensive products are all vying for
position. The complexity of the situation demands that Russian
policymakers make well-balanced and responsible decisions which
conform with the country’s long-term interests. In its relations
with the EU, Moscow cannot maneuver between positions of various
countries. Its sole negotiating partner in Europe is the European
Commission, the EU’s executive body which expresses the collective
will of the 15 member countries, whose number will soon grow to 30
nations. This collective will is the result of a complex process of
harmonizing many diverse interests: governments of various
countries (budgets), the European Commission’s directorates (for
energy and transport, and for competition), consumers, major
wholesalers of energy resources, and European energy producers. It
would be unwise to indulge in illusions with Russia’s trading
partner — the European Commission will show maximum tenacity and
assume a hard stance in its desire to safeguard European interests.
Russia’s dialog with a united Europe will only prove successful if
the various interests inside Russia (those interests would cover
the budget, exporters of energy resources, exporters of
energy-intensive goods, and the economy in general as a target for
re-investing export revenues) reach a solid consensus defining
exactly what its national interests are inside the energy
sphere.

Europe And Russia In Close Interdependence

Russia’s energy dialog with the EU started during the Paris
summit in October 2000, while the very idea of integrating Russia
into the European economic and social space was outlined in the
EU’s collective strategy on June 4, 1999. These steps followed the
Partnership and Cooperation Agreement (PCA) between the EU and
Russia, which took effect in December 1997, but failed to yield any
substantial results. In May 2001 and May 2002, under the aegis of
Russia’s Deputy Prime Minister Victor Khristenko and Franоois
Lamoureux, EC Director General for Energy and Transport, two
synthesis reports were published. The EU’s main goals in the energy
dialog are securing stable energy supplies to the continent amid
toughening environmental requirements, and enhancing European
industry’s competitive ability.

In the coming years, there will emerge a unified market in
direct proximity to Russia’s borders, which will potentially
embrace 30 countries. (Throughout this article estimates are given
for 30 member countries of the future EU — 15 current member
countries, 12 applicants in Central and Eastern Europe, the Baltics
and the Mediterranean, as well as Turkey, Norway and Switzerland —
since Russia must build its policy for the long-term future.) This
vast area, with a population of 450 million (around 8 percent of
the world’s population in 2001), accounts for 22 percent of the
world’s GDP (proceeding from the purchasing power parity in 2001)
and imports the bulk of Russia’s exported energy resources. There
has arisen a situation when extremely important energy supplies to
Europe are delivered by a European country, but they are not
regulated by European rules. While the European Union can regard
oil and gas from Africa, the Middle East, etc. as imports from
remote sources, Russia’s proximity to the EU has prompted the
latter to view Russia as a partner of potential integration.

During the past 12 years, Russia’s reintegration into the global
economy, following the breakdown of the Communist bloc, has been
accompanied by shocking losses for Russian manufacturing
industries; Russia has maintained a competitive position only in
the arms market, and some other market niches.

Russia owes its success in overcoming the transitional crisis,
financing the country’s development and ensuring a favorable trade
balance to a small group of energy-intensive goods and energy
resources. Integration into the European economic space via energy
resources is important for Russia as an instrument of accelerating
its further development and modernization and — eventually —
reducing the heavy role of energy exports in the national
economy.

In the 1990s, a relatively stable model of Russia’s trade
relations with Europe took shape. Two groups of commodities prevail
in Russian exports: energy resources (mostly oil and gas) and
energy-intensive commodities, such as metals and chemical
products.

Graph 1. Russian exports to the EU and Central and
Eastern Europe in 2001, %

Russia’s imports from Europe include consumer goods, engineering
products, as well as popular and expensive travel services. The
migration of labor from Russia to Europe is insubstantial. Capital
is exported from Russia in various forms and imported into Russia
in the form of loans.

Russia and Europe are now economically more attached to each
other than ever before. For the first time, energy imports from
Russia have become vital for the European economy, and this
importance will continue growing in the future. As the share of
energy resources is extremely high in Russian exports (65 percent),
Russia has developed a new type of dependence as well. Head of the
Delegation of the European Commission in Russia, Richard Wright,
rightfully says that Russia has no choice but to gradually adapt
its legislation to that of the EU. But rapprochement with Europe
does not remove from the agenda the need for Russian businesses to
adjust to the realities of Asian markets, as well as those of other
regions, where the share of the manufacturing sector’s products in
Russian exports is substantially higher than those exports to
Europe.

To a great measure, Russia’s move toward aligning itself with
European legislation is prompted by its market reform and expected
accession to the World Trade Organization. However, it will hardly
be able to selectively borrow certain provisions from its European
neighbors, while remaining outside the system. But energy markets
are the least regulated in the WTO framework, which makes the
energy dialog a more innovative sphere than the others. Anticipated
growth in the demand for energy resources in Europe over the next
20 years requires capital investment by companies (no matter what
country they come from) which will have to sell their energy
resources in the enlarged European Union, while producing them
outside the Union. The more similar the investment environments,
the less the business development costs, and the European
Commission has provided for that in advance. Specifics of
investment, worth billions of dollars, in the production and
transportation of vast amounts of energy resources over thousands
of kilometers must provide for political factors, commercial risks,
the duration of construction, and competition among companies and
countries whose well-being depends upon energy exports.

It is impossible to understand the essence of the dialog with
Europe unless we take into account the real trends in demand for
various types of energy resources. These trends must be considered
for the future 30 member countries of the European Union. During
the past 25 years, Europe has rapidly shifted from the consumption
of traditional fuels, primarily coal and oil, to natural gas and,
to a lesser degree, nuclear energy. Between 1973 (the last year
when oil was cheap) and 2000, the share of coal in energy
consumption dropped from 25 to 14 percent, and oil from 60 to 42
percent, while the share of natural gas increased from 10.5 to 23
percent. The use of nuclear energy increased from 1.5 to more than
15 percent (hydroelectric power and other types of energy account
for the rest of energy consumption). In the 1990s, the European
shift away from coal to natural gas rapidly intensified due to
reasons concerning efficiency, as well as environmental
considerations.

In Europe, the only substantial energy producers to speak of are
the U.K., the Netherlands and Norway. In the Netherlands, the peak
production of gas has already passed. The U.K., while remaining an
oil exporter, is expected to become a net gas consumer by 2005, or
somewhat later. In Norway, oil production has tended to stabilize,
while there are prospects for stepping up its natural gas
output.

The figures are an expert judgment — data from
various sources for the past periods differs by 10-15 percent. The
new member countries are Bulgaria, Cyprus, the Czech Republic,
Estonia, Hungary, Latvia, Lithuania, Malta, Norway, Poland,
Romania, Slovakia, Slovenia, Switzerland, and Turkey.

While the world’s natural gas consumption has grown 20 percent
over the last decade, it has increased nearly 40 percent in Europe.
Although European nations seek to develop their own renewable
resources (wind energy, biomass, solar energy), this will not solve
their energy problems in the foreseeable future. There have
appeared theories seeking to prove that growth is possible at
stable, non-increasing amounts of energy consumption. France and
Germany have achieved certain success in these efforts, but their
growth rates have been low; besides, they have had to increase
their consumption of natural gas. So, the demand for Russian gas is
likely to grow even if the overall energy consumption remains
stable.

Europe views an increase in the share of natural gas in its
energy balance as the solution to the main problems faced by its
energy sector: making EU products more competitive and minimizing
the negative impacts on the environment. This increase implies more
reliance on imports — by 2020, 60-70 percent of Europe’s natural
gas will be imported. One of the main sources of natural gas for
Europe is the imports from Russia and the Commonwealth of
Independent States.

Reform Of The European Energy Markets

European power and natural gas markets are undergoing reforms
initially described as deregulation and now known as
liberalization. Until recently, the economies of France and Italy
were dominated by state-backed national monopolies. In Germany,
where strict anti-monopoly legislation is in place, several major
companies held key positions. That creation of the natural gas
sector was due to the fact that this industry had been developed
with the state’s active involvement during the past 30 years (gas
began to be consumed on a large scale in Europe in the 1970s). Gas
was mostly imported under intergovernmental agreements. Powerful
infrastructure was created for gas delivery and consumption with
the help of all sorts of preferences. As a result, economic
mechanisms, long rejected in other industries, continued to be
applied to the gas sector.

Expensive energy resources are a serious drawback, reducing
Europe’s ability to compete in the market. Attempts to resolve the
problem have been made by reducing the number of intermediaries in
the energy supply line, liberalizing the market, etc. The
successful liberalization of the gas market has been accomplished
in Britain which has its own gas fields, and where the tax system
is not as complex as in continental Europe.

Another example is the liberalization of the EU’s power energy
market. In the past, each country used to rely on its own
potential: Germany relied on coal, Italy on fuel oil, etc. This
practice ran counter to the European Union’s fundamental principles
(unity of the markets, competition on a EU scale, etc.), and reform
in the energy production sector has been fast-moving during the
past years. Where energy flows are physically possible in
principle, countries producing more electricity than they required
began exporting it, which caused prices to decrease by
approximately 50 percent. Today, there is a power surplus
throughout Central and Northern Europe. Resulting low prices (for
example, U.S. $0.025 per kilowatt of electricity in Germany) only
reflect a variable component of costs and do not recoup new
construction costs. According to estimates, demand for new
investment in power engineering may emerge in the EU only after
2010, which may cause an increase in energy prices. This explains
why Europe has not been taking any serious steps aimed at
integrating Russia’s Unified Energy Systems into the common
European market. This aspect of the energy dialog remains in the
background today, but interest in it may increase when the EU faces
shortages of general energy capacities since the level of
investment is quite low now in this area. Importantly, the
liberalization of the EU electricity market has been accomplished
under conditions of surplus capacities, and on the basis of the
EU’s own generating capacities — this is an essential difference
from the situation in the natural gas market.

The EU’s directives aimed simultaneously at liberalizing and
unifying the European market (the directive for the power sector
was adopted in 1996, and for the gas market in 1998) will influence
the supplies of energy resources for many decades. In 2002, it was
decided that the liberalization process will be completed in 2005
(rather than in 2008, as the EU initially planned). Major companies
now combining both natural gas transport and natural gas marketing
functions will be split up and there will emerge two distinctly
different types of organizations.

The EU’s initiative was primarily political and the main goal
was to launch a program of liberalization; this approach failed to
address in detail, however, such issues as taxes, the behavior of
suppliers, and the like. It implied that consumers would have a
right to access transport capacities and to sign and extend any
contracts. But it turned out that the natural gas market hardly
fits into such schemes. It has always been founded on stable
long-term ties rather than on the spot contracts. The natural gas
trade is impossible without costly pipelines and therefore requires
long-term investment both in the production capacities and in the
construction and maintenance of the pipelines. By shifting from a
supplier’s market to a buyer’s market, the EU hopes to resolve two
problems at once: secure long-term supplies (and a probable growth
in imports) while reducing gas prices for major consumers (chemical
production and power generation) and households.

The liberalization initiative for the natural gas market has
been proceeding very slowly and with great difficulties. While in
the power energy sector the producers are powerful European
companies really able to compete in the common European market, the
natural gas sector is different. Here, European companies have been
reluctant to disrupt traditional ties, and gas suppliers are
companies based beyond the borders of the EU. Major purchasers of
natural gas, and its transportation intermediaries, have come to
realize that they are no longer guaranteed a comfortable position
within their national borders, and thus seek to secure a place in
the new market. But even the biggest companies, like Ruhrgas, are
not big enough to become pan-European players. Major restructuring
has been underway, with companies buying other companies or forming
alliances. The market has reacted to liberalization by the
reorganization and integration of companies, rather than head-on
competition and price reduction, which is the case in other
economic sectors. Importantly, this is the initial phase of a
dynamic process, rather than a complete system to which one has to
simply adjust. Suppliers find it difficult to compute the
efficiency of major long-term investments in gas production and
transportation, since the situation in the European market is
constantly changing.

The EU is now working on its second directive concerning natural
gas imports. The first directive was a difficult compromise between
individual countries. The second directive will place greater
emphasis on reciprocity (synchronization of transparency of
national energy markets with each other). This provision may
gradually become part of the EU’s internal regulatory legislation,
then an element of the common economic space (for example, for
Norway). Finally, the provision will become an important part of
the energy dialog between the EU and Russia.

One example of the EU’s position in the course of its internal
transformation is the Transit Protocol to the Energy Charter Treaty
which Russia signed in 1994 but has not ratified yet. Transit
regulation issues are rather complex: provisions concerning
available capacities, transit tariffs, the “right of first
refusal,” etc. In fact, the parties negotiated for the transparency
of gas supply procedures for Russian companies exporting gas to EU
member countries under long-term contracts — what actually can be
referred to as a “grandfather clause.”

The situation is different with regard to the applicability of
the Transit Protocol to EU member countries. This issue was raised
quite unexpectedly in the fall of 2001, when the European Union’s
delegation proposed adding to the Transit Protocol a provision on
its applicability to the EU as a single entity. In other words,
this provision interprets transit as the transportation of energy
resources across the EU as one single entity. Thus, the EU would
free itself from transit-related commitments with respect to
outside suppliers, as the transportation of natural gas would be
regulated by the EU’s internal legislation rather than by
international agreements. This interpretation of transit means that
with respect to natural gas exports from Russia it will only apply
to a limited number of cases — for example, transit across the EU
to Switzerland. Following the European Union’s expansion in 2004,
the Transit Protocol will only apply to Russian energy exports
flowing via Belarus, Moldova and Ukraine, and these issues can be
resolved on a bilateral basis. As for transportation of energy
resources across Russia from third countries, this situation would
be covered by the Transit Protocol in full measure, thus
effectively making it an international agreement on transit across
Russia.

The attempts of suppliers to retain long-term gas contracts and
other attractive prospects are similar to the wishes of Western
investors who search to find an absolutely stable investment
environment in Russia. Alternatively, they may demand to insert a
“grandfather clause” into their major contracts, or provide for
production sharing contracts. Difficult negotiations concerning the
future regime of the natural gas trade with the EU have been going
on for several years. In the long run, the EU — in the Second
Progress Report, presented by Victor Khristenko and Franоois
Lamoureux — has confirmed, however reluctantly, the enduring
significance of long-term contracts: “The Commission has made it
clear that long-term take-or-pay gas contracts are indispensable.”
(Still, it is not clear if it is the European Commission’s final
position, as the view of the antitrust directorate is
different.)

As distinct from the oil market, the gas market is characterized
by a very high share of transportation costs. In the past, the
balance of interests between the suppliers and consumers was based
on the fact that gas producers were guaranteed sales for many years
and could reasonably hope for a payback on their investment. There
remained risks for the suppliers, because gas prices were, and
still are, pegged to the price of a barrel of oil, thus making it
impossible to accurately predict profits. Yet, gas suppliers were
spared the need to think about retail sales. Now, the companies
which transport gas will have to go through a difficult
transitional period, while the number of intermediaries will be
reduced. In the future, Russian suppliers will be able to compete
with each other for consumers, but the risks of this approach will
grow. The new environment will require high management efficiency,
new approaches, and access to local infrastructure. In principle,
suppliers may turn out to be the actual winners, but one cannot be
absolutely sure about this. Renunciation of long-term contracts and
a shift to a spot market and short-term deals are among the main
goals of the liberalization. Although the need for long-term
contracts was confirmed during the discussions, future prices that
are based on short-term deals — like in the oil spot market — could
shift the risks on to producers. In this case, the transportation
company will charge its tariff, while the margin between the spot
price and the tariff will go to the gas producer. In the future,
producer profits may vary wildly, like oil prices. If this is the
EU’s goal in liberalization, a surplus of gas supply would be
desirable in the main regional markets. The price of gas delivered
to Germany ($115 per 1,000 cubic meters), while oil prices are high
($23 a barrel), would guarantee relatively high profits. But if the
price of oil drops to $16 a barrel, the price of gas will decrease
to $80. With transportation costs subtracted, this leaves $10-$15
in profits — no production project can survive this rate of return.
And the associated high risks inevitably reduce the suppliersХ
willingness to invest.

The future for investment in supplies to the developed and
rapidly developing nations, where demand is particularly high for
natural gas rather than oil, is being defined today. The European
economic space is an attempt to pool efforts needed to improve
Europe’s ability to compete with Southeast Asia (including China)
and NAFTA. Liberalized markets and competition among market players
are the principles Europe has adopted. But high gas prices for end
consumers in Europe are the result of the European distribution
system and high taxes, rather than expensive imports.

Natural gas which is exported to central Europe at approximately
$100 per 1,000 cubic meters, reaches end consumers along the supply
chain at $120-$150 for major consumers, and $300-$350 for remote
and smaller consumers. The margin between supply prices of energy
resources and end prices paid by consumers is predetermined by tax
deductions and social policies. Taxes collected on energy resources
partially mitigate various social problems, and help make capital
investment in next-generation energy sources, even though the
mismatching tax systems of various EU member countries are a clear
obstacle to trade in energy resources. In a sense, those profits
and tax revenues are being used to finance Europe’s modernization
program. Russia should learn from this experience for its own
development, and make it an object of discussion in the energy
dialog.

Protection of Europe’s economic interests should provide for the
balanced protection of all the players in the common economic
space; this would be an important consideration for Russia once it
has decided to become a member. The pace of internal changes in the
EU is growing, requiring a deeper analysis of potential effects of
these changes on Russia and its companies in order to clearly
understand the state of Russia’s main gas market for the next
generation.

Russia’s Interests And Prospects

Clear answers have yet to be provided to a number of key
questions. For example, what are the goals of Russia’s energy
policy in Europe? What is the scale of Russia’s involvement in EU
energy supplies? What are the limitations and risks involved? And
how can export revenues be best used for the country’s development?
There are few people in Russia who could doubt that the goal of
trade in energy resources is receiving and re-investing stable
revenues in the long term (20-30 years), rather than maximizing
export volumes of some or other type of energy resources.
Initially, Russia’s position was simple: as an integral part of
Europe, the Russian Federation assumes its share of responsibility
for guaranteeing Europe’s ongoing energy security. For that reason,
it has entered into an energy dialog with the EU and is prepared to
consider stepping up energy supplies on certain terms:

* additional supplies of power energy should be
accompanied with investment and transfer of technologies to
Russia;

particular attention should be paid to energy-saving
technologies, which may be regarded as an independent source in the
expansion of supplies;

* free transit for all Russian energy resources to the
EU-15 via Eastern Europe (which is now being integrated into the
EU);

* the expansion of energy supplies should embrace, along
with primary energy resources, power energy (including that
generated by nuclear power plants), nuclear fuel, energy-intensive
goods (fertilizer and metals), oil products, etc.

Many private Russian companies compete in the European oil and
coal markets, and are seeking to gain a firm foothold in Eastern
Europe before it has joined the EU. The countries of the ex-Soviet
Union account for about 37 percent of European oil imports.
Considering projects for Russian oil exports to the U.S. and
Chinese markets, this figure will grow, mostly due to the export of
oil from Kazakhstan. Russian companies will likely step up their
supplies of oil products, although not necessarily from oil
refineries based in Russia. In that sense, the integration of
Russian businesses into the European economic space is proceeding
in full swing.

In the field of power energy, Russia is interested in building
bridges to Europe in order to add stability to its energy supply
systems. It is also interested in being able to maneuver resources,
while ensuring access to the European markets for probable surplus
capacities, which may result from basic reforms in the power
sector. A program for the construction of nuclear power plants in
Russia may also contain an export orientation. The situation
concerning nuclear fuel is a separate issue, of course, since all
such purchases require licensing, thus artificially limiting
Russian exports (even though this runs counter to Article 22 of the
PCA). Eventually, Russia will have to formulate its priorities
concerning its various forms of exportable energy resources.

As for Russia’s domestic interests concerning electricity and
gas tariffs, it needs to avoid a serious conflict between the metal
and fertilizer exporters, on the one hand, and energy exporters and
the budget, on the other. The existing price formation system of
Russia’s gas sector dates from the 1970s-1980s when the Soviet
infrastructure was created at the state’s expense, as well as to
the detriment of other social issues. Seeking to create an
export-oriented sector, the state stripped assets from other
sectors of the economy, not to mention from the population in
general, in order to proceed with its plan. Thus, the Soviet Union
was able to invest $10 billion-$12 billion per year in the gas
industry. The seemingly low tariffs today ignore the construction
costs of that vast infrastructure. Actually, the cheap domestic gas
supplies are not only the result of Russia’s natural advantages
(rich natural resources), but also a ХgiftХ from the Soviet people
— the natural gas infrastructure was financed with their latent
savings.

Recently, the European Commission set forth certain demands
related to Russia’s domestic gas prices as one of the preconditions
for Russia joining the WTO. The Russian newspaper Commersant quoted
EU Trade Commissioner Pascal Lamy as saying that Russia should
bring its energy prices into line with international rates, thus
eliminating the annual $5 billion hidden subsidy within its
industry. The current domestic prices, which constitute just
one-sixth of the world prices, let Russian producers export their
goods at unfoundedly low prices. The issue is too important for the
EU to ignore, Lamy said.

It seems rather obvious that the European Union wants Russia’s
energy-intensive goods to be more expensive. According to
unofficial estimates cited by the press, the EU would like to see
gas prices increase to $45-$60 per 1,000 cubic meters for Russian
industrial consumers. This would increase revenues for Russia’s
energy producers, thus providing for further investment in other
export projects. Also, it would make it easier for European
metallurgical and chemical industries to compete in the EU internal
market.

A steep gas price hike would be a one-time shock for the Russian
economy, for which it will be very important to reduce the
inflation rate in the coming years. Second, the effect of cross
subsidies provided to private consumers by Russian industries,
under conditions of extreme social inequality, is not being taken
into account. The difference between per capita GDP in the EU and
Russia ($21,000 against $2,500 in current prices) is too great to
be ignored in the context of the European economic space. Finally,
liberalization of the domestic gas and electricity markets is
important for Russia, as it will result in a natural growth of
tariffs to, potentially, $40 per 1,000 cubic meters from today’s
$21, according to an unpublished World Bank report cited by The
Financial Times.

Russia’s position is that low energy prices are a natural
advantage of a country rich in natural resources. Furthermore, the
Russian population, which for decades invested (via the planned
economy system) rather heavily in the development of the energy
sector, now has the right to enjoy lower energy rates.

Russia now mainly produces gas from the old Soviet network, but
new natural gas resources are being gradually commissioned. More
and more pipelines need repair, and from 2010, there will be the
need to implement large-scale projects, which will require the
development of new energy producing regions, as well as the
construction of new transportation networks. Given the current
prices (not only low domestic prices, but also export prices of,
say, $100 per 1,000 cubic meters), it is difficult to invest as
much funds toward a project as in the Soviet times as a substantial
share of new gas resources will only make up for depleted resources
rather than add to output growth.

Long-term planning will also require answers to many political
questions. For example, will the consortium in Ukraine work
efficiently? Will it be able to renovate the gas pipelines within a
reasonable time frame? Would it be worth laying a Baltic pipeline
in order to by-pass other countries altogether? This proposal would
increase the project’s initial costs rather significantly, but
would allow for the reduction of transit tariffs at the same time.
Will oil companies, and other energy producers, be offered
acceptable financial terms for gas production in Russia as a result
of reforms within the sector? The experience of the United States,
for example, indicates that in order to ensure reasonable long-term
utilization of energy resources, it is expedient to develop small
and mid-sized fields. New gas produced by oil companies, or
independents at smaller fields, would in the future allow balancing
gas supply and demand, as well as helping to free up export routes.
The nuclear power plant construction program also objectively
serves this purpose, as it will reduce the future demand for gas in
the European part of Russia.

Yet another separate question, this in connection with the EU’s
nuclear fuel policy: what share of its gas supplies is the EU
prepared to allow from any one source? Officially, there are no
restrictions on this amount, but it is recommended that not more
than 30 percent of gas imports should derive from one source, given
the dependency which the future EU members have for Russian gas.
Russia now accounts for 36 percent of natural gas supplies to
Greater Europe (Britain supplies 31 percent, Norway supplies 16
percent, and these are followed by Algeria, the Netherlands and
Nigeria), while the EU’s own gas output is unlikely to exceed 300
billion cubic meters in the foreseeable future. Russia’s exports
will stand at about 20 percent of all gas supplies in 2020, with
physical export volumes remaining unchanged. But if Russia wants to
retain its current share proportion (around 30 percent) in the
expanding European market, its supplies should increase from 130
billion cubic meters to 200-210 billion by 2010. This actually
means that three additional lines (with an annual capacity of 30
billion cubic meters, each) will have to be constructed to carry
the extra amount, given that demand will also gradually grow in
Russia and the CIS. In that case, Russia’s ability to
simultaneously supply other export markets will remain unclear.

A thorny issue is a ratio of supplies of Russia’s own energy
resources and transit supplies from other countries to Europe.
Russia will certainly allow transit supplies of energy resources
across its territory. The need to serve the old, ‘SovietХ capital
invested in the pipeline transport requires that tariffs should
include renovation costs, no matter what price formation models are
applied.

While anticipating the future situation in the EU-30, the
European Commission is trying to create a buyer’s market (with
supply exceeding demand) for gas in the foreseeable future by
attracting as much gas as possible from faraway regions: Iran,
Qatar, Nigeria and Central Asia. Excessive supply can be created
only by producing countries or supplier companies if they decide to
make long-term heavy investment in the European market now in the
hope of its fast growth. Suppliers can also go over to liquefied
gas production, which would let them supply the whole of the world
market, as oil exporters do. On the other hand, delivery costs are
high, and initial investment in the construction of liquefied gas
plants and terminals is comparable to the cost of laying new gas
pipelines. As vast investment is required, the cost of a mistake
would be enormous for the potential investors.

Russian exports to Europe have no alternative for either party
at the moment. It is necessary to define export priorities, routes,
project costs, sources of finance. So far, no detailed elaboration
has been made of specific plans, nor have there been indications of
major European investment in the Russian economy. Clearly, the
parties will have to make responsible political decisions
concerning cooperative strategies before the Russian judicial code
is brought into line with European standards. Either those
suppliers wishing to expand their exports will provide the
investments themselves, and subsequently undertake all risks in the
determination of a target market, or the investment will have to
derive from European sources after they receive guarantees that the
produced energy resources will be supplied to the EU. The more
uncertainty there is about the terms of future sales in Europe, the
harder it will be to accumulate financial resources for such vast
projects.

Along with other basic commitments, Russia’s operation in the
common economic space should provide it with certain privileges.
For example, EU Хinfrastructure grantsХ for the development of poor
regions could become part of joint financing of Russia’s
development. This investment in energy production would involve
allocations for environmental protection, together with the
development of basic infrastructure.

We proceed from the assumption that in the coming decade the EU
and Russia will move toward the formation of a common economic
space and a higher level of integration. But differences will
remain, and the parties will complement each other in the energy
market in particular. Russia has certain inviolable rights to know
more about the future of Europe’s gas market since it has always С
even during the grave political and economic crises of the 1990s С
remained an absolutely reliable provider of energy supplies to
Europe.

The issue of investment in the production and export of energy
resources brings us back to the goals of Russia’s Energy Strategy.
Most countries, when they consider their long-term strategies, need
to take account of a smaller number of factors. These are one or,
at most, two energy industries, the manufacturing sector (fuel
prices), and the interests of the population (tariffs) and the
state (taxes). In Russia, there are four full-scale energy
industries (electricity, oil, gas, and coal), and their interests
coincide in some respects and clash in others. The companies
operating in these industries are privately and state-owned.

The matter at issue is vital interests of the population,
therefore, Russia needs a long-term energy policy and a development
strategy that takes into account international aspects of the
economy, including the Russia-EU Energy Dialog. In the long run,
the state, concerned about Russia’s economic modernization in
general, will be interested not in physical export volumes, or even
in the value of exports, but rather in export revenues being
re-invested in the further development of the Russian economy.