Stepping on the Gas

It has long been known that subsidising fossil-fuel consumption has the unwanted side effect of leading to wasteful consumption, not to mention to increased negative impacts on the environment. Currently, a whopping 548 billion dollars are burned annually this way worldwide. Many countries, from Argentina through Bahrain and Kuwait to Uzbekistan, are currently engaged in efforts to dismantle such subsidies. Russia is not, not really.

Why should it matter? What Russia does with its own gas is its own business, isn't it? Yes, except that a good chunk of that gas, around 30%, gets consumed in Europe. It is worth the effort, then, to examine what would happen, in Russia and abroad, if the Russian government were to remove its subsidies on fossil-fuel consumption, which at present amount to a bit more than one-fifth of the full cost of supply.

A group of Norwegian researchers around CESifo Fellows Rolf Golombek and Knut Einar Rosendahl undertook just that effort. They report their findings in a new CESifo Working Paper.

The Evolution of Domestic Gas Prices in Russia

After the fall of the Soviet Union, a new type of state-owned agency was created that not only took over the entire Soviet unified gas supply system, but acquired a regulatory role as well. The agency was named Gazprom. In the early 1990s, the company became partly privatised and generally independent, but with the state retaining key control.

The new company not only obtained ownership of all the major physical assets of the Russian gas industry for free; it also claimed roles that had previously been outside the purview of the ministry responsible for gas, such as investment planning and output targets, distribution to final consumers, and gas exports. In sum, the gas industry became even more centralised and monopolised than under the Soviet system.

But Gazprom also inherited obligations, such as supplying gas domestically at very low prices. The volume of domestic supplies was about four times higher than exports to Europe, but the latter provided most of the profits. Unsurprisingly, after Russia emerged from its economic crisis in the early 2000s, Gazprom started to exert pressure for domestic gas prices to be raised. The Russian government acquiesced and reduced subsidies and allowed some price increases, but by the end of 2003 the regulated average gas price was still very low, around 24 dollars per 1,000 cubic meters, against a European netback price (i.e. net of transportation costs and transit fees) of 145 dollars per cubic meter. Reaching parity between the domestic and netback prices was the stated goal, and it should be reached by 2011.

The netback price, however, kept increasing, since the price of gas was linked to that of oil. The government duly postponed the goal for attaining parity to 2014 and then 2018, in order to avoid negative internal repercussions. The plan now calls for reaching 70 percent of the netback price by 2030. Gazprom is not amused. On top of that, it must now face competition from other domestic producers. What would happen if Gazprom got its way and convinced the government to let gas prices reach the netback price?

This is where our authors come in. Using a detailed numerical model of the European and Russian energy markets, covering everything from extraction to consumption, they examine the impact of higher domestic gas prices in Russia, how the resulting reduction in domestic consumption may affect Russia's gas exports to Europe, and the effects this would have on the European natural gas market, simulating the model for the year 2020. They also examine the effects of accelerated depreciation on existing pipelines between Russia, and Europe and what it would mean in terms of incentives to build new pipelines, the potential effects of the proposed Turk Stream pipeline running through Turkey to South-eastern Europe, the elimination of the Russian tax on gas exports, and the elimination of the Gazprom monopoly.

They find that removing the gas subsidies would significantly reduce consumption in Russia. Gas production would shrink as a result, but a larger portion would be available for export, facilitated by the fact that current pipeline capacity from Russia to the EU is sufficiently large to permit significant export growth without having to build new pipelines. Removing the subsidies would have positive welfare effects for Russia as a whole, despite the fact that consumers would be negatively affected.

In Europe, gas prices would come down, imported volumes would go up, and more gas-fired power plants would go on stream profitably. If pipeline capacity were to be expanded, export prices would be further reduced.

But other factors may also be at play. The costs of extraction may increase over time, as they have done from the 40 dollars per 1000 cubic meters of 2001 to the 140 dollars per 1,000 cubic meters of 2013. This higher cost may depress production volumes and hence export volumes as well. Russia could, on the other hand, improve the efficiency with which it uses its gas, which is fairly low. According to a recent study by the IFC/World Bank, the theoretical saving could be as much as 240 billion cubic meters per year. Tellingly, one of the quickest ways to attain this level of efficiency would be to reduce gas price subsidies.

But of course, the situation being as it is, politics also plays a role. The "pivot" of Russia towards China and other Asian nations as its main export markets, together with the conflict with Ukraine and the attendant tension with the EU, may reduce Russian gas on offer to the EU market, despite the higher volumes available for export. The EU, in turn, may seek to reduce its reliance on Russian gas. It is, after all, a volatile market.

But leaving aside geopolitical considerations, the authors find that, bottom line, liberalising the Russian gas market, under all the scenarios they considered, would lead to a drop in Russian welfare, due to lower export prices.

Guess Russia will continue to be the exception in terms of subsidy removal for a while yet.

Finn Roar Aune, Rolf Golombek, Hilde Hallre, Arild Moe, Knut Einar Rosendahl Liberalizing Russian Gas Markets – An Economic Analysis, CESifo Working Paper No. 5387

Other CESifo Working Papers by Rolf Golombek
Other CESifo Working Papers by Knut Einar Rosendahl