The gas-price dispute that erupted in early 2006 has sobering lessons for all the parties involved, says Dieter Helm.

When Gazprom turned down the gas supply to the Ukraine in early January 2006, there was a sense of panic in Europe, as the full extent of dependency on Russian supplies dawned, both inside and outside the old Soviet boundaries. Some saw this as a wake-up call, which would usher in a dash-for-nuclear. Others saw a blatant bit of power politics as Vladimir Putin wreaked revenge on the orange revolution in the Ukraine. And many simply concluded that the west was deluded to think Russia had embraced competitive markets in energy, rather than a more familiar Opec game.

Almost all of these initial responses were misguided, and for reasons which have quite deep historical and political roots. The history of Russian energy policy towards eastern Europe is a strange combination of hard-nosed economics and political expediency. In the Soviet days, being able to turn the lights out was a deliberate part of a strategy of control, and electricity transmission systems and fossil fuel supplies were designed with this in mind. In return, the satellite countries got cheap energy – as indeed did the Russians themselves – designed to give industry a competitive advantage and to keep the population happy.

Dieter Helm is a fellow in Economics at New College, Oxford. See www.dieterhelm.co.uk for recent articles on energy policy. Comments welcome to [email protected]

Among his recent publications are:

A New British Energy Policy (Social Market Foundation, November 2005)

European Energy Policy (prepared for the UK presidency of the European Union, October 2005, pdf)

Carbon Contracts and Energy Policy: An Outline Proposal (October 2005)

This deal has been coming unstuck since at least the collapse of the Berlin wall in November 1989, but it took the gradual ramping up of oil (and gas) prices on world markets since 2000 to undermine it. As the Putin regime gained in political power with the new oil revenues, so too did its desire to control and exploit its oil and gas reserves. It became less and less tenable to subsidise Ukraine and all the rest of the former client states. World prices simply made the subsidies prohibitively expensive against the market value of the oil and gas. Why anyone expected these countries to remain immune from the oil shock after 2000 is a mystery.

There were however three complications. The first was the politics of the Ukraine, and the defeat of the Russian faction of eastern Ukraine in the controversial presidential elections of October-November 2004 which precipitated the orange revolution. If Russia had felt a national sympathy for the Ukraine regime before the revolution, it had less incentive to subsidise it afterwards.

The second complication came with the question of the pipeline, its control, ownership and transit fees. This is a prize that Gazprom wanted, and since Gazprom is very much now a Putin-controlled company through its effective renationalisation, the company's strategy of controlling transit to western Europe simply got muddled up in the immediate gas-price dispute.

But it was the third complication which caused the furore – the implications for all the countries downstream of Ukraine. Here the reactions have been very muddled. Far from demonstrating the dependency of Europe on Russian gas, what actually was revealed was how dependent Russia is on European markets. Howls of protest (including from the United States) called into question Russia's application to the World Trade Organisation, and even its fitness to be in the G8, where its membership is in recognition of its oil and gas, not the size of its economy. And crucially, the Russians caved in very quickly. The result is that Russian supplies are probably more secure today than they were a few months ago.

The real lessons for European security of supplies is that after decades of cheap and abundant fossil fuels, with the North Sea at the core, basic storage and pipelines have been neglected. Asset-sweating, not investment, has been the dominant theme with a benign neglect of energy policy. What Europe needs to learn from this episode is the urgent priority to get its own energy policy in order, and invest in its infrastructure, increase interconnections and build substantial more storage capacity – all things it needed to do anyway long before the Ukraine crisis erupted. And in eastern Europe, the lesson is a similar one, except with the added proviso that the ability of Russia to threaten their supplies depends upon how isolated and bilateral their supply lines are. Again interconnection and storage is what counts.

Also in openDemocracy on the Ukraine/Russia gas dispute:

Alexander Motyl, "Ukraine vs Russia: the politics of an energy crisis" (January 2006)

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The benefits of change

The creation of an energy-policy framework to address security of supply will not however be easy. The preoccupation of the European Commission has been with completing liberalisation, unbundling large energy companies and breaking up long-term contracts. Whilst Russia has consolidated enormous power in the hands of Gazprom and the state, European policy has moved in the opposite direction.

Liberalisation has much to offer, and should not be abandoned, but it will not be sufficient to solve security-of-supply problems. The private market will not, on its own, build in the system-wide connectivity and storage necessary to meet the public interest. The private sector will do some of this, but not enough, because profits are not maximised through spare capacity. Interconnections, in particular, bring competition as well as security, and hence powerful incumbents are sometimes reluctant to make investments which benefit the system rather than themselves. Energy policy needs to incentivise this urgently needed investment.

But Ukraine and those who have had the benefit of subsidised energy will also have to come to terms with market prices. This is painful, but in the longer term it should wean them off the inefficiencies that such subsidies have caused and speed the process towards modernising their economies. And, of course, there will be enormous benefits to the environment. More expensive oil and gas are usually husbanded better, used more efficiently and as a result carbon and other emissions will fall.

If Europe responds with better energy policies, if the Ukraine starts to use energy more efficiently and if Russia has learnt a salutary lesson about the weakness of the threats to interrupt supplies, the net effects of this little episode will in fact turn out to be rather benign – unless of course Russia makes the mistake of thinking energy is a serious weapon in a new nationalistic foreign policy, rather than a valuable economic source.