Russia's energy policy: politics or economics?

Dieter Helm
16 October 2006

Russia's combative "resource nationalism" is a reaction to the frontier capitalism of the 1990s. The west should look, learn and reform, says Dieter Helm.

Western oil companies are reeling from a series of setbacks in Russia. Welcomed in under Boris Yeltsin, offering a new frontier for exploration and production, the likes of BP and Shell saw a chance to build up their reserves. BP saw Russia as a next step in its history - after Iran (it was the Anglo-Persian Oil Company originally), then Alaska, and then the North Sea. For Shell, Sakhalin offered a bright new future with United States and far-eastern partners. Now they are all in retreat, as the national champions Gazprom and Rosneft muscle in, with the Russian state as their driving force.

The companies' business predicament is matched by western governments' political one. As European Union heads of state and government prepare to meet their Russian counterparts at a special energy summit in Lahti (near Helsinki) on 20 October 2006, the west's foreign offices and media have settled into a view of these setbacks as fitting into a pattern of Russian politics that identifies a return to the "old" ways of nationalism.

Indeed, Putin himself has written of the need to use Russia's vast natural resources to rebuild its world status and prestige, which he personally witnessed collapsing around him when he worked for the KGB in Dresden at the end of the 1980s. Because the recent developments in the oil and gas sectors are seen in these political rather than economic terms, the easy conclusion is drawn that it will all end in tears, since it is readily assumed that only western oil companies can deliver, and to do this they must be able to buy up Russian reserves.

The rationale for what Putin, Gazprom and other state companies have been up to is a complex one. It is true that there have been erosions of civil liberties and major setbacks for democracy, and that the political elite is entrenching itself within the "oil and gas industrial complex" (replacing the military one of the Soviet years). None of this augurs well for the efficiency of its energy sector.

Dieter Helm is a fellow in Economics at New College, Oxford. See www.dieterhelm.co.uk for his articles on energy policy

Also by Dieter Helm in openDemocracy:

"GM and the intensification of farming"
(11 June 2003)

"Russian gas, Ukraine and Europe's energy security"
(20 January 2006)

The Putin effect

But after the Yeltsin dash-for-capitalism, there was bound to be a reaction. Under Yeltsin, the oligarchs gained their fortunes in a kind of frontier capitalism, which paid little attention to property rights, as indeed did their forerunners in the American west in the nineteenth century. Whether they stole the assets is hard to say, since - again like the American west - the existing property rights were hard to define. Just who owned oil and gas reserves after the Soviet Union collapsed and whether the loans-for-shares schemes were even legal was (and remains) unclear. They were often "ill-gotten", and it is hard to see that the consequences did much to benefit ordinary Russians.

So when Yukos's founder, Mikhail Khodorkovsky, moved on from business to the politics of pipelines to China and Japan, and its founder started to use its wealth to back individual political objectives, a newly elected Putin was likely to react. At the famous meeting with the oligarchs in January 2001, in the early days of his presidency, he pointedly advised them to keep politics and business separate. But then he did more, and the controversy began.

He wanted to claw back their gains. Some quickly buckled, others held out. Putin the lawyer turned to the law to give him leverage - tax law and now environmental law - to change the laws, particularly on natural resource ownership. The tactics were often questionable; the abuses of legal procedures and independence outrageous; and the role of the security services harked back to the Soviet days. But they worked.

This battle with the oligarchs inevitably homed in on energy, and Putin had a particular view about the role of the state in the energy sector. In his view, oil and gas reserves should belong to the state, not the private sector, and the state should develop these resources for the national interest, not those of private oil and gas companies. The part left for international companies is to provide the technology and the capital, to be service-providers and financiers to enable the state to maximise the benefits of the reserves for itself.

It is for the state to decide how quickly reserves are developed and who they are sold to, to dictate the pipelines and the markets, and to do the sort of governmental deals which provide the frameworks for exports. Thus Putin favours Germany as the core partner in Europe, and the Baltic pipeline over those through the Ukraine and eastern Europe. The state too decides (for example) who are the beneficiaries of Sakhalin, and whether the enormous potential of Shtokman, in northern Russia's Barents Sea, goes to Europe or the United States.

These arguments are very familiar and certainly not unique to Russia or Putin. Since the Opec crises of the 1970s, the nationalisation of the world's oil and gas reserves has been a dominant theme. Nationally-owned oil companies now control over 90% of the world's proven oil reserves, and they control depletion policy. Whilst western energy importers lambast the lack of access for their companies, is this really the wrong approach? Compare what happened when it has been left to the companies - in the middle east in the 1950s and 1960s, for example. It is not an era which the local populations would want to return to.

Although there are better ways - for governments to define clear energy policy frameworks, and depletion policies to match, and then for the private sector to do the work - such approaches rely on well-developed legal frameworks, the absence of corruption, and appropriate and enforced tax regimes. Most countries with large reserves lack these, and even those that do not - like the United Kingdom - have followed very questionable depletion policies, such as the rapid exploitation of North Sea oil and gas to fund tax cuts and public expenditure. Perhaps only Norway stands out as an example of how this mixed approach should work - but then it has a very small population as well as active state participation.

Given the situation in which Russia finds itself, nationalisation of reserves is not therefore such a bad policy. It enables it to ratchet up its market power, dictate terms for exports, and manage the development of new production. In the importing countries, the clamour is for more output to meet demand, but it is not at all obvious that Russia should oblige. The reserves may well be worth more tomorrow than they are now - as indeed would have been the North Sea's oil and gas had the UK husbanded them a bit better.

The challenge for Europe

Rather than keep berating Russia for its approach to the energy sector, it might be better to recognise that below the ugly politics lies a deeper rationale. Europeans in particular will have to learn to live with the new reality, and western oil and gas companies recognise that they will have to accommodate to Gazprom, Rosneft and the other Russian companies if they wish to carry on doing business there. So far, neither European governments (except possibly Germany) nor the major companies appear to have come to terms with this new reality.

In Europe, the mainstream approach has been to advocate the "British model" of an unbundled, competitive and liberalised energy market, with open access to pipelines and networks. Long-term contracts, which underpin long-term, upstream investments, have been attacked, and in the UK those for gas have been broken up. The Energy Charter framework (which includes the transit protocol, requiring Gazprom to permit third-party access to its export pipeline network), has been the main vehicle through which the Europeans have tried to get Gazprom to open up both its contracts and its networks to the same kind of regime.

Not surprisingly, to date it has been almost completely unsuccessful: Gazprom insists on long-term contracts, using Ruhrgas as its preferred partner, and rejects any attempt to open up its pipelines to third parties. The Germans - first Gerhard Schröder and now Angela Merkel - understand this. That is why, whilst the European Commission is getting nowhere in its negotiations with Russia, Merkel and Putin are getting on with building a political framework around the contracts and the Baltic pipeline; it is also why Germany will be a major beneficiary of the decision (announced on 9 October) to exclude foreign companies from Shtokman, with Gazprom choosing to send the output via the Baltic pipeline, rather than (as originally intended) via LNG to the United States.

What needs to be done? Europe's energy policy legacy of the 1990s will obviously not do. Liberalisation in Europe has had its benefits, and should not be abandoned. But competition has resulted in the concentration of the European energy sector into the hands of a small number of large companies - in electricity, E.ON, RWE, and EDF. The commission has simply allowed this to happen, so that there are now very few competitors to have a competition.

But the European energy policy green paper, published in March 2006, begins a more positive process. The EU needs to look to its own security and negotiating position. Completing the physical energy market, with the European grid, greatly increases the resilience to shocks. Diversifying away from fossil fuels helps too. And in gas, requiring a strategic storage regime would limit the scope for short-term opportunism, like that witnessed in Ukraine in January 2006.

None of these are steps the companies enthusiastically support: greater physical interconnection increases competition, since competing energy comes down the pipes and wires, and can therefore threaten existing assets. Diversity is not something private companies promote: on the contrary, left to themselves they would overwhelmingly opt for gas as the fuel of choice. Moreover, strategic gas storage takes out the peakiness of short-term markets, thereby lowering profits.

Russia's energy policies may be disturbing, but they are not wholly irrational. The oligarchs could not simply be left in charge, the reserves could not be simply handed out to foreign companies and Russia could not sensibly open up its networks and contracts to the dictates of the British model. Russia needs western expertise and capital - but it does not have to cede ownership of its reserves to achieve this. Western oil companies can help develop the fields but not necessarily own the reserves.

What has been done has often been questionable, but the Russian energy sector probably better serves the Russian people now than it did five years ago. What Europe and the west need to do is to sort out their own energy policy frameworks in a way that takes this new reality into account, rather than simply lecturing Russia about how the country should run its energy markets.

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