Russia’s unsustainable energy model

http://georgiandaily.com/index.php?option=com_content&task=view&id=15285&Itemid=132

October 18, 2009

By David Clark

Russia has taken a significant step in its bid to become a dominant international energy supplier, one that has important implications for its relations with the European Union and its prospects of returning quickly to the high growth rates that have underpinned its national recovery in recent years.

Monday marks the end of the 60-day notification period after which Russia’s provisional application of the energy charter treaty (ECT) will formally come to an end. Announced in August as Europeans headed for the beach, Russia’s repudiation of the ECT should be read as a clear signal of strategic intent. The Kremlin’s statist and highly politicised approach to the use of energy resources is here to stay and any lingering European hope that Russia might be persuaded to accept an energy relationship based on commercial logic and multilateral rules can now be forgotten. Henceforth European energy security policy will have to take account of that fact.

The ECT was drawn up in the early 1990s to protect the property rights of foreign energy investors in the former Soviet Union, guarantee transit rights to third-country suppliers and establish arbitration mechanisms to resolve bilateral disputes. It was already becoming clear towards the end of Vladimir Putin’s first presidential term that Russia was departing radically from these norms. Mr Putin talked explicitly about using Russia’s natural resources to further the country’s geopolitical interests in the post-Soviet space and beyond. The energy sector was to be integrated within a strengthened “power vertical” under Kremlin control. Russia’s largest private energy company, Yukos, was forcibly dismantled and foreign investors, Shell and BP, were strong-armed into selling investments to the state at well below market price.

The model established by Mr Putin envisages Russia as an energy superpower able to convert its natural endowments of oil and gas into diplomatic leverage – if necessary by coercive means. There is no room in this vision for the niceties of international law or respect for property rights. Indeed, the possibility of a negative ruling by an arbitration tribunal looking into the Yukos case is widely believed to have prompted Russia’s withdrawal from the ECT – a futile gesture that merely confirms Russia’s provisional application of the treaty at the time of Yukos’s seizure. In its place, President Dmitry Medvedev has proposed a new international energy treaty notable for its lack of binding commitments or enforceable rules.

This presents an obvious dilemma for European policymakers. Although existing European investments in the Russian energy sector will remain covered by the ECT for another 20 years, new investors will have to rely on the goodwill of a Russian state that has already demonstrated a considerable appetite for expropriation. At the same time, Russian investors in the EU market will continue to enjoy the safeguards and legal protections extended to all commercial operators under European law. Can the EU tolerate this double-standard? Should it not use market access to insist on some measure of reciprocity or has European energy dependence tipped the scales too far in Russia’s favour?

In fact, what appears to be a problem for the EU could turn out to be more of a problem for Russia in the long term. If rejecting a major international treaty was intended as a demonstration of unilateral Russian power, it may instead backfire and expose the underlying fragility of Russia’s national revival. As Mr Medvedev himself acknowledged last month, in what was taken as an oblique criticism of his predecessor, the Russian economy remains dangerously lopsided in its dependence on energy export revenues. Without the record energy prices of the past decade, Russia would have remained mired in post-Soviet decline. Yet even if prices now rebound as the world economy recovers it is by no means certain that Russia will be able to pick up from where it left off. A combination of internal and external factors is rendering the Putin model unsustainable.

Within Russia itself, the failure of the cumbersome, state-centred energy sector to invest in new production is beginning to bite as existing fields reach exhaustion and replacements are not yet ready to be brought on stream. This problem is especially acute in the more strategically important gas sector. Russia possesses huge reserves of oil and gas, but according to the government’s own assessment needs investments to the tune of $2,000bn over the next 20 years in order to access them and sustain current production. The already heavily indebted state energy companies, Gazprom and Rosneft, cannot generate the required funds, nor do they have the technology needed to drill in the icy waters and permafrost of the Arctic north where the future of Russian energy production lies. For this they need foreign investment and know-how, and plenty of it.

In a tight energy market in which there is nowhere else to turn, it is just possible that investors might accept the rising political risks involved in dealing with the Russian government and part with the cash and technology required to gain a subordinate role in a major Russian energy project. But the market for gas, in particular, is undergoing important changes that are likely to undercut Russia’s apparently dominant position. Some of this is a consequence of the EU’s drive to liberalise its energy market by forcing a separation of production and supply activities and building the interconnectors needed to switch energy supplies rapidly across Europe. Properly implemented, these measures will neutralise Russian strategies of vertical integration and market segmentation while encouraging new suppliers to enter the market.

Just as important in this respect is the revolution taking place in the production of unconventional gas, the term applied to gas locked up in difficult geological formations such as shale rock and coal. Until recently considered unobtainable at economic cost, advances in extraction technology and rising gas prices have made it an increasingly attractive option. Unconventional sources now account for half of US gas production and rising. This in itself is leading to a drop in US demand for imports of liquefied natural gas, thereby increasing European supply options. The global base of unconventional gas is vast, and although not all of it will be recoverable, even a small proportion of it brought to market would transform the energy equation. The EU’s potential alone is equivalent to more than two-thirds of current known reserves of Russian conventional gas, and it falls well behind Africa, Asia and the Americas.

In its zeal to recover lost global status, Russia has over-played the energy card in a way that threatens to destroy demand for its own primary export. The second gas war with Ukraine earlier this year forced a widespread rethink about the level of European dependency on Russian supplies and accelerated the search for alternatives. After Russia’s rejection of the guarantees contained in the ECT, investors may now follow suit and look for less risky options for a return on their capital. If so, Russia’s potential as an energy superpower will remain unrealised and it will pay a heavy economic penalty in lost revenues and flagging growth. The Putin model is broken and sooner or later Russia will have to prove its worth as a reliable energy partner by signing up once again to the ECT or something very much like it.

The writer is chair of the Russia Foundation. From 1997 to 2001 he was special adviser to Robin Cook and the Foreign and Commonwealth Office specialising in European affairs