Professor Alan Riley: German Energy Policy & Russia

Guest Post from Professor Alan Riley from City University in London, UK.

In an article I wrote, published today by the Financial Times Deutschland, I argue that the impending third Putin Presidency in Russia is a perfect time for Germany’s policy makers to take a close look at their energy requirements and Russia’s domestic energy capabilities. Given the flows of incoming LNG and the prospect of shale gas, Germany's dependence on Russia is less than often feared. The very existence of LNG and shale both create alternatives and push the newly elected President Putin in the direction of reform. All of these developments improve German and European energy security. The article is below.

German Energy Policy & Russia: A good moment in time

by Alan Riley
21.03.12

The energy turnaround comes at a good moment in time. Thanks to shale gas and LNG the dependence on Russia is smaller than feared

The German energy turnaround is also based on the hope that – in addition to the expansion of renewables – the phasing out of nuclear energy can be compensated with gas-fired power plants. That is why the Russian gas shortages in Germany this winter put a chill into German bones. Will the dependency on Russian become a mortgage that will burden the energy turnaround?

That chill deepens amongst some observers at the prospect of a third Putin Presidency. However, there are compelling reasons for believing that during his Third Presidency Vladimir Putin will take steps to reform the Russian gas market. It is likely that President Putin, faced with the twin pressures of a dysfunctional Russian gas market and the prospect of new gas competitors; thus, he is likely to take steps to fundamentally reform and liberalise the Russian market. And that would be a good thing for Germany.

This winter’s gas shortages, although they did not have the media drama of the 2009 supply cut off to Ukraine, will have generated greater alarm amongst policymakers in Berlin, Paris and London. Because this was a supply shortage. Worse still gas demand because of the mild European winter and the recession reduced demand for Russian gas which suggests that Gazprom’s ability to deliver gas to both domestic and European markets is really being stretched. For Germany particularly with gas playing a key transition role in the move away from nuclear power the Russian supply failure was particularly alarming.

It is of course true that the Russian Federation has the world’s largest proven resources of gas at 47 trillion cubic metres. However, the Russian gas market on which so many Germans and other Europeans depend is not run like any modern Western gas market. Gazprom is dominant at the exploration, production, wholesale and retail levels of the supply chain. The company has both a pipeline and an export monopoly. This market dominance reduces efficiency and incentives to ensure gas supply in the longer term. In addition low fixed Russian domestic gas prices further reduces incentives for Gazprom to invest in new infrastructure, as most of gas production is sold in Russia.

Meanwhile, the ageing Nadym Pur Taz supergiant fields remain the principal source of Russian gas to Europe. Although one major new field is being brought on stream soon it is open to question whether the investment that is being made in new gas fields is sufficient given the prospective depletion of the Nadym Pur Taz fields and the demands of European and Russian consumers. Gazprom is also coming under additional pressure from both the shale gas revolution in the United States and the growth in global liquid natural gas production. This massive increase in US gas production with more gas resources coming on stream has damaged Gazprom in a number of ways. Gazprom can no longer contemplate selling LNG into the US market as it had planned. LNG destined for the US has been dumped on to the European spot market reducing demand for Russian gas. Worse still: in addition, a major US project the Global Shale Gas Initiative (GSGI) is seeing technology transfer and knowhow of shale gas production being spread across the globe.

Although European sales only represent one third of production they represent two thirds of revenue. Hence any major alternative source of supply is disturbing for Moscow. Gazprom is not taking much comfort out of the fact that LNG dumping in the European market has slackened as a result of Japanese demand following Fukushima and the lack of LNG carriers. It is understood in Moscow that this is a temporary phenomena. The real fear is an upswing in LNG imports into Europe in the next couple of years followed by some commercial level of shale gas production in Europe in three or four years from now.

Viewed from the Kremlin at the beginning of his third term President Putin, who has an encyclopedic knowledge and understanding of the global gas market, recognizes the threats facing Russia’s external gas markets. On the one hand there is a real threat to supply from the dysfunctional nature of the Russian market. On the other hand there are new competitors entering the European market who could take market share away from Gazprom.

The traditional view is that the Russian state will only take limited steps to ‘reform’ the gas market. However, the twin pressures of market dysfunctionality leading to lack of investment and potential new competitors who can take Gazprom’s foreign markets provides a powerful incentive to change. The major argument in favour of the traditional view is that any major reform of the gas market would involve ownership unbundling something the Kremlin could never contemplate.

However, to liberalization in sensitive state sectors there is a way forward: Margaret Thatcher’s administration in the 1980s adopted so called ‘golden shares’ which gave the state a series of rights to call and control otherwise liberalized companies. There is no reason why President Putin could not adopt this ‘golden share’ model to liberalise the Russian gas market while retaining a significant level of state control.

To accompany liberalization, the Russian Federation will need to recognize the need for foreign investor protection rules. A major signal of a change of direction would be for Russia to fully adhere to the Energy Charter Treaty with its multilateral investor protection rules. Liberalisation is not enough if foreign capital and knowhow at scale cannot be tempted into the Russian gas market.

Germany should take some comfort from the pressures on President-Elect Putin to reform the Russian gas market. Either the Russian gas market is reformed and gas continues to flow into Germany. Or the market is not reformed and increasing amounts of LNG and shale gas flow into the German market. If market reform takes hold in Russia then Germany will have a greater diversity of gas sources to help manage the transition away from nuclear power and toward renewables. Greater diversity should also mean lower gas prices which will benefit German consumers and industry. Gas can then take its key transition role as a direct fuel and a back up fuel for wind and solar power before the next generation of renewables come on stream.