Liberalizing Russian Gas Markets: An Economic Analysis.

• Author: Aune, Finn Roar
• Position: Report

1. INTRODUCTION

   Russia is the biggest supplier of natural gas to the European market--it is accounting for 25-30% of total gas use in the European Union. Hence, changes in the highly regulated Russian gas market can potentially have substantial effects on the European gas market. It is therefore of vital interest for European stakeholders to gain knowledge about developments in the Russian gas market, and derived potential impacts on the European market.

   In this paper we examine regulatory changes on the demand side of the Russian gas market. This market has been characterized by very low regulated prices to end users, see Section 2, but over the last 20 years plans to raise domestic gas prices have been announced. For example, in 2007 the Russian government authorized a plan to reach a European netback price--the European price minus costs of transportation and duties between Russia and the European market--by 2011. However, a few years later the plan was postponed to 2018. Other--less ambitious--attempts to raise domestic prices have been more successful: the current Russian price is way higher than 20 years ago. Still, prices are significantly below total (long-run) marginal costs of producing and delivering natural gas. This is considered as a problem by Gazprom--the major Russian gas company--which enjoys a monopoly right to transport and export natural gas by pipeline in exchange of ensuring secure supply to most domestic consumers at the regulated prices. The future level of domestic Russian gas prices is therefore highly uncertain.

   As pointed out in Goldthau (2008) and IEA (2011), higher gas prices in Russia would likely lead to reduced gas consumption among domestic users of natural gas, thereby making more gas available for export, either to the traditional export market in Europe or to emerging Asian markets. (1) In this paper we examine the impact of higher domestic gas prices in Russia, how the derived reduction in domestic consumption may affect Russia's gas export to Europe and the subsequent effects in the European natural gas market. We also look into the effects in the other energy markets in Russia.

   In order to study these issues we employ a detailed numerical model of the European and Russian energy markets--LIBEMOD. This model provides a detailed description of a number of energy goods, including natural gas, see Section 3. LIBEMOD endogenizes all main activities in the energy market; investment, extraction, production, trade and consumption of energy, along with a consistent set of equilibrium prices. Demand for energy is modeled separately for five user groups in more than 30 countries. Pipeline and transmission capacities between pair of European countries are endogenously determined. The model is run for a specific future year, here 2020, and the solution of the model can be interpreted as the long-run market equilibrium of this year.

   LIBEMOD has previously been used to analyze a number of energy-related questions for the European market, for example, price and welfare effects of emission quota allocation rules, see Golombek, Kittelsen and Rosendahl (2013), and the impact of liberalization of different parts of the European energy industry, see Golombek, Brekke and Kittelsen (2013). For this paper the model has been extended to include a detailed modeling of the Russian energy markets, separating this huge country into three regions: West-, Mid- and East-Russia. Because of Russia's large market share in the European natural gas market, we assume that Gazprom is not a price taker but takes into consideration that a higher export quantity will lower the price obtained in the European market.

   In LIBEMOD the description of domestic natural gas markets differs: European natural gas markets are assumed to be competitive, whereas in Russia there are large implicit subsidies to natural gas to mimic the regulated low prices. By lowering these subsidies, we can study the impact of higher domestic Russian gas prices.

   We make three contributions to the literature. First, we offer a unified, detailed modeling of both the Russian energy markets and the European energy markets, covering activities from extraction to consumption. We are not aware of any other model of the European and Russian energy markets with such details.

   Second, we contribute to the small economics literature that applies numerical (equilibrium) models to examine impacts of regulatory changes in the Russian gas market. Sagen and Tsygankova (2008) used a combination of analytical tools and a stylized numerical model to examine the effects of higher gas prices in Russia. They found that higher Russian gas prices may not lead to a substantial increase in export to Europe, partly because increased exports reduce the European gas price, which is not in the interest of Russia. However, because the numerical model in the Sagen and Tsygankova study is quite stylized, for example, there is only one gas user in Europe and one gas user in Russia, and other energy goods are disregarded, our study should be a significant improvement with respect to both modeling tool and calibration strategy.

   Finally, our study adds to the literature on Russian export behavior and export capacity between Russia and the EU. Paltsev (2014), employing the global CGE model EPPA, concludes that additional pipeline capacities from Russia to Europe are not needed unless Russia should want to route its gas via other countries than Ukraine and Belarus. However, many of the existing pipelines are old and their capacities may substantially decline unless they are upgraded or replaced. In the present paper we study the impact of accelerated pipeline depreciation on the incentives to build new pipeline capacity and on the export volumes from Russia to the EU. We also look into the potential benefits from having a pipe running directly from Russia to Turkey and South Eastern Europe, such as the Turkish Stream pipeline, which was announced in the spring of 2015. Furthermore, Russia currently has a gross tax on gas export, which reduces Gazprom's profitability of exporting gas. We examine possible consequences of removing this tax. Lastly, we look into hypothetical effects of a shift towards competitive Russian gas exports, which could be relevant if Gazprom's export monopoly were removed. Similar issues have previously been studied by Tsygankova (2010, 2012), using theoretical and stylized numerical models.

   There exist several other numerical modeling studies of Russian gas exports that are also relevant to our paper. Richter and Holz (2014) use the Global Gas Model (GGM) to assess implications of Russian gas disruptions for EU member states. Hirschhausen et al. (2005) analyze a game between Russia and Ukraine, where Russia decides gas volumes transported through Ukraine to Europe, and Ukraine decides the transit fee. The importance of transit options through Belarus for the outcome of the game is highlighted. Hartley and Medlock (2009) have a global perspective, examining Russia's ability to influence the world natural gas market by simulating their global gas market model RWGTM. Grimsrud et al. (2015) use a stylized dynamic model to investigate how increased shale gas supply may affect current and future market shares of Russia in the European gas market. Other relevant studies of Russian gas export are IEA (2011a, 2014) and Goldthau (2008).

   The rest of the paper is structured as follows. In Section 2 we present features of the Russian gas market--from the breakdown of the Soviet Union to the current situation--in order to understand the main characteristics of the Russian gas industry as well as to assess the politically realistic changes in the years ahead. Sections 3 gives a non-technical description of the energy market model LIBEMOD, and Section 4 provides a documentation of data used to calibrate the Russian block of the LIBEMOD model. The modeling results of increased domestic Russian gas prices are presented and discussed in Section 5. Finally, Section 6 summarizes the main findings and points at policy implications of these results.

2. THE RUSSIAN GAS INDUSTRY

   The Heritage from the Soviet Period

   The current Russian gas industry is tightly related to the Soviet gas industry structure as it evolved in the 1970s and 1980s. It was characterized by exploitation of huge deposits and long distances between production sites and consumption centers, which required construction of a comprehensive trunk pipeline network. These characteristics lent themselves to economies of scale and--in line with Soviet thinking--a unified industry structure intended to minimize costs of extraction and transportation of natural gas, see Kryukov and Moe (2013).

   In the centrally planned economy gas was prioritized in electricity and heat production, thereby making more oil available for highly profitable export. The regulated domestic price of natural gas was very low. Natural gas was distributed according to priorities in the centrally planned economy. Consumption of various users--power stations, industrial burners and cooking in vast apartment complexes--was usually not measured but estimated according to technical standards of energy needs. The prioritization of natural gas in electricity and heat generation is clearly evident in the consumption structure today; use of gas in the power sector amounts to 40 percent of total gas consumption in Russia.

   Gazprom

   In the 1970s and 1980s extraction and transportation of gas were organized within the Soviet Ministry of the Gas Industry. Then in 1989 a new entity, Gazprom, was established. It got control of the entire Soviet unified gas supply system and was also given a regulatory role. This type of agency was something new--an entity outside the ministry structure--although it was state owned.

   When the economic reforms in Russia started for real in 1992, an important element was the creation of new industry organizations. Notably...