Europe and Russia must take a more concerted approach to their energy partnership.
When Russia cut off the flow of natural gas to Ukraine, in January 2006, it set off alarm bells throughout the European Union, reviving concerns about Russia's reliability as an energy partner. The European Union responded with calls to diversify its energy sources and began mulling anew the virtues of coal and nuclear energy. Russia, for its part, suggested it might sell its natural gas to China instead of Europe.
Despite the apparent differences between Russia and Europe, both sides need the other more than they care to admit. Europe has few economical alternatives for its energy needs. Coal generates too much carbon dioxide. New nuclear power is controversial and wouldn't be on line for at least a decade, even if it became politically palatable. Alternative sources of gas, such as liquefied natural gas (LNG) from the Middle East and North Africa, would not only be prohibitively expensive but also force the EU to compete for supply against more lucrative gas markets, such as the United States. In fact, we estimate it would cost the European Union $40 billion to $60 billion (net present value) more to meet its energy needs from sources other than Russia.
As for Russia, we estimate that it would forgo $50 billion to $70 billion (NPV) if its western Siberian natural gas were to be sold elsewhere. Given Europe's proximity and ability to pay, it represents the most lucrative customer for Russian natural gas. Furthermore, if Europe's major energy companies were allowed to invest in Russia's upstream subsector, they could help ensure its development by contributing technical expertise and some of the billions of dollars of investment needed to build the production and transportation infrastructure in remote areas such as the offshore Shtokman field and the Yamal Peninsula of western Siberia.
Yet certain difficulties now stand in the way of increased gas flows from Russia to Europe. Companies on both sides of the equation hesitate to make the substantial investments needed to spur new production. Their caution arises from the real uncertainties that surround the European Union's future demand for gas, Russia's ability to supply it, which organizations will develop Russia's extensive energy assets, and the regulatory environment. What's more, there is one other red flag, at least for Europeans: wide-spread mistrust of Russia's willingness to follow the norms of international commerce. Both sides must cooperate to strengthen their energy relationship by moderating these considerable risks and uncertainties and thus ensure that the required investments occur in a timely way.
Broadly speaking, these goals call for action on three fronts. First, Russia and the EU must implement regulatory reforms to reduce risk and facilitate investment. Second, since risk can never be completely eliminated and many reforms will take years to bear fruit, businesses and governments must seek ways to manage the remaining risks by encouraging cross-border investment. Third, they must work together to create more transparency on a range of market factors.
Further reform
Policy makers in both the European Union and Russia must step up their reform efforts. While the former has come a long way on energy liberalization, some areas require further attention. Most important, the European Union must clarify the future of its carbon dioxide Emissions Trading Scheme (ETS) in order to spur new investments in energy generation. Carbon dioxide prices beyond 2007 are an open question, and so is the scheme's survival beyond 2012. To encourage electricity players to invest in gas instead of coal, the price of carbon dioxide must be set sufficiently high. (Gas emits half of coal's carbon dioxide per unit of energy.) And although new nuclear-power facilities are a long way off, over the next 15 years approximately 30 gigawatts of Europe's existing nuclear-generation capacity are due to be shut down. Deferring the phaseout will clearly reduce the requirement for new facilities, and decisions are required soon to help the sector respond appropriately. Until the European Union clarifies its ETS policies, demand for gas will remain highly uncertain, making it difficult for Europe's energy companies—and Gazprom—to commit themselves to the investments needed to bring new natural-gas production on stream.
Clear and consistent regulation across member countries must also be established for infrastructure such as cross-border pipelines and underground storage—the first to facilitate new imported sources of gas, the second to provide a local buffer, which is even more important when supplies are remote. Uncertainty about access arrangements and therefore the likely return on infrastructure assets hampers investment in them.
Furthermore, the European Union should consider building a strategic gas reserve (similar to the US strategic oil reserve) to temper price spikes and stabilize the market when supplies fall short. A reserve of this kind could mitigate Europe's current storage problems, such as those that struck in the winter of 2005, when stored gas could not be made available to cover supply shortfalls because it was fully committed under contract to other customers. In addition, some pragmatism is required regarding long-term oil-linked supply contracts. Although the European Union wants to move away from them, there may be no other way to underpin upstream investments, since no liquid market exists to replace such bilateral arrangements.
Meanwhile, Russia must undertake reforms that are equally crucial, however basic: for instance, it must not only bolster its courts and legal system but also demonstrate an increased willingness to keep politics and commerce distinct. These moves will help ensure the enforceability of long-term contracts, respect for ownership structures, and control over investments. Playing by the rules of world commerce will greatly enhance Russia's ability to attract the sizable investments it needs and will be essential for the country to develop its western Siberian fields, which must supply 40 percent of total production if it is to meet its 2020 output targets. This effort will require nearly $200 billion in investment and huge numbers of skilled workers in a harsh and remote environment.
Russia must also continue its ongoing domestic energy reforms by liberalizing the gas market and reducing price subsidies. One effect of these reforms will be to improve domestic energy efficiency—an important lever allowing Russia to increase its exports, since less gas would be needed at home.
Cross-border investments
Although these reforms will help the European Union and Russia go a considerable distance toward reducing uncertainty and risk in the energy sector, they will take time to produce results and won't eliminate risk entirely. The two sides can ensure that investments are made in the nearer term by fostering cross-border projects and tapping the capital markets to support each other's energy sectors. This approach would increase the flow of capital to where it's needed most as well as decrease the risk for energy companies by tying the fate of upstream and downstream players more closely together to overcome uncertain demand and shortcomings in the market's liquidity. Most likely, European companies would have to increase their investments in Russia's upstream subsector and acknowledge—and accept—Gazprom's downstream investment strategy by allowing it to invest in transportation and distribution facilities outside Russia's borders.
Some encouraging prototypes for cross-border investment already exist. Gazprom, for instance, has signaled its willingness to let Western oil companies invest in the Shtokman project to develop LNG for the United States. Another promising attempt to build energy security through cross-border partnerships is the North-European Gas Pipeline (NEGP), a collaboration between Gazprom and the German companies BASF and E.ON to build two 745-mile gas pipelines to transport gas from Russia. Much more is possible, however. Russia can and should extend upstream collaboration onshore. In return the European Union should not block Russia's downstream investments.
Increasing transparency
Finally, a lack of transparency regarding supply, infrastructure capacity, and changes in demand now compounds the atmosphere of uncertainty. Greater transparency about current production and infrastructure capacity, new developments in demand, and the timing and status of new upstream and infrastructure projects would facilitate investments and decision making. One tool that might promote increased transparency would be a European-Russian Gas Institute to undertake the role that the International Energy Agency (IEA) plays with oil.
Meeting these priorities will be a challenge. The temptation will be to allow the energy security relationship between Russia and Europe to go on evolving haphazardly. But the economics of the situation demand a more deliberate approach to energy collaboration if both sides are to come out ahead.
