02.03.2008
Russia and Europe Are Doomed to Cooperate
№1 2008 January/March

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?

* * *

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.