James Sherr. The International Spectator. Volume 45, Issue 2, 2010.
To the liberal mindset that still prevails in much of Europe, it is ironic that the most interdependent dimension of the Europe-Russia relationship should be characterised by discord and apprehension. Yet from the time of Rousseau, if not before, other traditions of thought have associated interdependence with rivalry and tension. Interdependence has always been a political as well as an economic relationship. The sources of our current difficulties in this political-economic domain are historical, cultural and institutional. Over the mid-to-long term, political pressure, economic necessity and technological possibility are more likely to stimulate change than rational argument and conventional methods of “building trust”. The global economic crisis has accelerated some of these trends with consequences that could prove at least as disorientating for the Russian supplier as for the European consumer.
Policy recommendations must take account of reality, despite the obvious fact that they are usually designed to change it. When it comes to energy, as on broader and more traditional terrains, we are unlikely to establish “common security” in future if we do not first understand why current approaches to security are so divergent.
Problems of conceptualisation and practice
Even before the Russia-Ukraine gas crisis of 2005-06, the geopolitical, as opposed to the commercial basis of Russia’s energy policy was the subject of much discussion. This is not surprising. Russia’s economic revival has been the basis of its political revival. Geo-economics—the use of economic instruments for political gain—has been a leitmotif of the Putin era. The first paragraph of the (2003) Energy Strategy of Russia in the Period to 2020 states that Russia’s “mighty energy sector” is “an instrument for the conduct of internal and external policy” and that “the role of the country in world energy markets to a large extent determines its geopolitical influence”.
Yet the geopolitical prism is distorting in two respects. First, it ignores the fact that the primary purpose for re-establishing the dominance of the state in this domain was internal. From the time of glasnost and perestroika, if not before, real power had steadily devolved from Party-state authority (the structures of “command-administration”) to the illicit “shadow structures” that had come to exercise de facto control over resources and their distribution. Under Boris Yeltsin, the process of nomenklatura privatisation consummated this mutation. During much of the 1990s, Russia functioned less as a state than as an arena upon which very powerful interests competed for power and wealth, often at Russia’s expense. Although the international impetus was always present, the primary purpose of Putin’s restoration of the state was to restore order. By the same token, the fuel and energy complex has become integral to the cohesiveness of a state congenitally distrustful of decentralisation, beset by demographic crisis and increasingly conscious of China’s power. The state-dominated energy sector literally binds the country together. For this reason, it is likely to remain “an instrument of internal policy” until the diseconomies associated with state dominance render the model untenable.
Second, the geopolitical prism filters out the entire spectrum of issues associated with economic self-interest. As Philip Hanson has noted:
A case can be made, even for the oil industry, that what has been going on is not so much the pursuit of a policy of nationalisation as the development of a network of firms controlled by the political leadership, sometimes as state concerns and sometimes as the nominally private business of cronies.
Whereas in the mid-1990s, 50 percent of Russia’s GDP was controlled by seven relatively independent bankers, by 2007 five senior Kremlin officials chaired companies that produced 33 percent of national wealth. This reversal of the relationship between business and the state has not diminished the difficulties in distinguishing between personal and state interests, on the one hand, and financial and geopolitical interests, on the other. Whilst there are times when one or the other imperative becomes visible and dominant, each dimension—commercial, geopolitical and “subjective” (personal/clan/institutional)—has to be seen as a primary colour that must be combined if it is to be seen properly.
The sociological aspect of these realities is of crucial importance. Whereas in most mature democracies, property rights and sanctity of contract have well-established moral, normative and legal underpinnings, their foundations in Russia and many other former Soviet countries are weak or absent. So is entrepreneurship, which in a Western context implies business activity independent of the state, rather than in collusion with it. In much of the former USSR, “understandings” matter more than rules, deals count for more than contracts, and the shifting power relationships between interests and networks tend to render deals provisional. These differences make the distinction between “state” and “private” business in Russia less significant than these terms imply—and the comparison between Russian and European state energy companies misleading. Despite improvements in recent years, divergent models of corporate governance reinforce these differences. So does the direction of operational activity. Gazprom’s determined acquisition of downstream facilities and neglect of domestic infrastructure, its acceptance of any diseconomy that expands control, its indifference to gargantuan levels of waste and its willingness to forego core revenue in order to change long-term market conditions (q.v. the 2008-09 Russia-Ukraine gas crisis) distinguish it not only from commercially orientated business in the West, but from virtually any European state monopoly.
An equally crucial area of divergence is on the surface semantic, but it points to deep divergences in models of economics and economic security. To Russia’s mega-economic actors, “markets” exist wherever money-commodity relations exist, however unbalanced, inequitable or monopolistic. But from the perspective of the European Commission, monopoly is the antithesis of markets, which, in principle, mean choice for buyer and seller. To Alexei Miller, CEO of Gazprom, “energy security” is guaranteed by a strong “vertical” of integration and control: “the regulation from a single centre of regimes of extraction, transport, underground storage and sales”. From the Commission’s perspective, it is guaranteed by an impartial and effective regulatory framework and by “diversity with regard to source, supplier, transport route and transport method”. Russian practice points not only to the importance of protecting this model but extending it to “control of the entire value chain” and hence, as far as possible, the evolution of the market itself. Whatever the intent behind this policy, its success has risked rendering Europe unusually dependent on what the Russian authorities do or fail to do to address the looming supply problem and the imbalances and diseconomies of a highly monopolised system. Almost 70 percent of Russia’s gas production is consumed domestically, equivalent to the total consumption of Japan, Italy, the UK and India, which have a combined GDP 13 times greater than that of Russia.
The final problematic element is the transnational, as opposed to purely international, aspect of the energy relationship inside as well as outside the former USSR. The transnational dimension is felt in the attempt to extend to Europe the “system of understandings” linking the state and business in Russia. By means of such “network diplomacy” (and intelligence methods of business), official executive and regulatory mechanisms risk being bypassed. Allegations of such “understandings” between local political leaders, Russian business and the Russian political leadership are growing in central and southeastern Europe. The transnational dimension can also be seen in the fluid and bewildering complexity of business structures and intermediary companies that have come to characterise the gas business. Untraceable ownership, shareholders, assets and corporate history have added to the burdens of national and EU regulation. Finally, it can be seen in the increasingly aggressive use of lobbying structures and litigation to stifle investigation, debate and criticism.
Despite the regulatory powers of the European Commission, in this domain the EU is still uncomfortably dependent on the adequacy of national systems of monitoring, regulation and law enforcement. In several new member states, the starting point must be the inadequacy rather than the adequacy of these institutions. Even though such inadequacies are not confined to “new Europe”, the fact is that countries only recently part of the integrated Soviet energy system are now vulnerable components of our own.
This fact alone makes the status quo precarious, but not everyone in Europe is prepared in practice to accept the Commission’s conclusion that we cannot continue “business as usual”. Whilst some member states are unduly dependent on Russian energy, and a few alarmingly so, the EU as a whole does not suffer from excessive dependency upon Russia. In 2007, natural gas accounted for 24 percent of overall EU energy consumption, and Russian deliveries accounted for 29 percent of that. Some EU member states suffer from an unwelcome dependency on other countries and regions. When Italy increases its supply of Russian gas, it is not “deepening its dependency upon Russia”, it is diminishing a dependency on North Africa. In other words, it is diversifying supply.
The Russia-Ukraine relationship is another factor that makes the status quo precarious, but in part for the reasons just cited, it also brings to the surface Europe’s sharpest divisions. Ukraine’s gas transportation system (GTS) plays a cardinal and neuralgic part in the energy security of Europe and Russia, not to say Ukraine itself. It represents, at one and the same time, an essential attribute of Ukraine’s independence and (in President Medvedev’s words) the “rupture” [razryv] of a “unified system of gas transport”, as well as “well established economic relations” and “principles of friendship”. The gas crises of January 2006 and January 2009 have played a singular role in focusing the EU’s attention on the security of its own energy supply, future energy sources and “a real Internal Energy Market”, whose creation it described in January 2007 as a precondition of “meaningful external policy”.
At the same time, these crises have exposed the role that political issues play not only in Russian calculations but in Europe’s. One year after the “Orange Revolution”, most of Europe was predisposed to view Ukraine as the victim rather than culprit in the dispute, and EU pressure on Moscow (still suffering the effects of post-Orange Revolution disorientation) played a decisive role in bringing the crisis to a swift conclusion. Three years after the Orange Revolution (and widespread disillusionment with it), images were largely reversed, Moscow (five months after the Georgia war) was indignantly self-confident, and the EU was even-handed to the point of detachment. It was not a prime minister from “old Europe”, but Mirek Topolanek of the Czech Republic, which was then holding the EU presidency, who insisted that the EU should not involve itself in a “business dispute” and a “bilateral matter”. That conclusion was not reversed until the crisis escalated out of all proportion to its cause. Yet the pretences that commercial disputes between Russia and Ukraine will remain commercial—and that the Russia-Ukraine gas relationship can be separated from the Russia-Ukraine-EU gas relationship—remain matters of principle to many who realise that they are in reality absurd. Less absurd is the hope that “diversity with regard to source, supplier, transport route and transport method” will insulate the EU from the disharmonies of the Russia-Ukraine relationship and the dysfunctionalities of the gas transportation system. Yet this is only partially true, and the European Commission has made the point itself.
Reaping what you have sown
The global financial crisis is having a profoundly paradoxical impact upon Russia. On the one hand, this impact is insufficiently severe to transform power relationships, alter the conservatism of society or change models of how the economy and political system should function. It has put the regime under pressure, but not under threat. Nevertheless, it has been severe enough to transform the outlook of the country’s energy sector: the very part of the economy most widely linked with Russia’s prosperity and revived international influence. This is a paradox that calls for explanation. It also calls for a re-examination of conventional wisdom.
One pillar of conventional wisdom, shared by a distinguished corps of experts in Russia, is borne out by the crisis. Russia’s leaders failed to use the boom years—ten years of 7 percent annual economic growth—to reform the economy and modernise its infrastructure. The strategy of commodity-led growth has ignored and repressed structural flaws that are now assuming malignant proportions: monopolisation (which explains why prices rise even when income falls), cronyism, the suborning of regulatory structures by “groups of influence”, the proliferation of bureaucracy, chronic underinvestment in the domestic energy market and a level of corruption not seen even in the Yeltsin era. These trends, which germinated after the Yukos affair of 2003, along with the relaxation of financial disciplines explain why problems arose in the economy months before the collapse of global markets. But the emergence and persistence of these trends also follow naturally from two systemic needs. First, as Pekka Sutela notes, “stability and sovereignty are [the regime’s] overriding goals”—which explains, inter alia, why “a major part of the windfall revenues” has not been used for infrastructural investment, but “for repaying foreign debt and accumulating reserves”. Second, those who run the country for all intents and purposes own it. If money bought power in the 1990s, today power buys money—or, more concretely, the businesses and assets of those who are in disfavour or not powerful or well-connected enough to resist. As Evsei Gurvich wrote in 2008, “the authorities went from building a market economy (in Putin’s first term) to building a business”. Modernisation might be the universally acknowledged imperative in Russia, but the priority remains control.
A second and even greater pillar of conventional wisdom—the linkage between commodity prices and Russian economic performance—has all the unsoundness of a literal truth. It is a truth that disguises the real sources of growth and weakness in the economy. One readily forgets that 7 percent growth rates emerged not in the five years after the secular rise in oil prices began in 2003, but in the four preceding years (1999-2002). As Sutela has argued, this growth reflected: the massive devaluation of the rouble after 1998, the growth of international liquidity in the 1990s, ample spare manufacturing capacity and, most important, a shift of resources from the inefficient industrial core of the Soviet economy to the production of goods and services that Soviet citizens had never had. The low tax and de-regulatory impetus displayed in much of Putin’s first term—or, more accurately, the impetus established under the influence of Kasyanov, Gref, Illarionov and Chubais—reinforced positive, qualitative changes that emerged in the decade that Putin, for reasons of ideology, political interest and temperament, portrays as a period of chaos.
These changes included rising production, productivity and investment in Russia’s energy sector. Liberalisation of the oil sector followed, rather than preceded the collapse of production between 1989-93, and the growth that emerged after 1999 was led by private oil companies, who increased production by 150 percent in five years. The gradual return after 2003 to state dominance, the overruling of proposals to restructure Gazprom, growing concentration of vertically integrated entities, the absorption of independent companies, prohibition of private pipelines and restriction on foreign investment has blunted market signals and incentives and reversed these trends. As Vladimir Milov, former Deputy Minister of Energy and later president of the Institute of Energy Policy, prophetically warned in 2006, “if oil prices drop, Gazprom drowns”. In this highly fatalistic sense, the second pillar of conventional wisdom is correct, but only because of the model that Russia has chosen. This model fosters the illusion that the return of even moderate oil prices will revive Russia’s economic performance and international influence. But that, as we shall see, is somewhat questionable.
The third and most debatable pillar of conventional wisdom is that President Medvedev represents an alternative to the status quo. To be sure, this is true in part. Several of his advisors in the Institute for Contemporary Development believe that the country’s present model of development is unsustainable. As Arkadiy Dvorkovich said at his meeting with the Valdai Club in September 2009, unless Russia moves from an economy dominated by dozens of people to one dominated by hundreds of people, it will not advance into modernity. Medvedev’s 10 September 2009 manifesto, “Russia, Forward!” reads like a clarion call not only to those who believe this, but to a still wider group who believe that “Russia must become a country whose prosperity is ensured not so much by raw materials as by intellectual resources”. Nevertheless, the document’s omissions and inconsistencies command as much attention as its boldness. “Russia, Forward!” is a call for modernising the economy by enlightened state action. It is not a manifesto for liberalising the economy by limiting the powers of the state. Medvedev’s annual Address to the Federal Assembly on 12 November reinforced this message in a traditionally uninspired manner. The more high key September article is long on “humanistic values”, but short on liberties. It expresses a quaintly Soviet faith in the connection between the quality of technology and the quality of life. It also expresses a decided ambivalence about political change. Finally, whilst emphatic about the need to overcome dependency on the energy and raw materials sectors, the article says nothing about how these sectors are owned and managed or how, if at all, they are to be reformed. As previous chairman of Gazprom’s board of directors (2000-01, 2002-08), Medvedev might well find this a difficult subject. Can he restructure Gazprom today without accepting responsibility for its unreformed state before? If he was uninterested in its reform before, why? If he, as chairman, had the interest but not the authority to reform it, why? Does he, as president, have the authority today?
A revolutionary turn?
In terms of energy, the world is a different place than it was before July 2008. It is likely to remain different even after economic recovery takes place. Gazprom’s sales on the European market shrank 39 percent in the first half of 2009. Although Russia’s Ministry of Energy (Minenergo) reported a rebound in the second half of 26.4 percent above the figure for the second half of 2008, that is less cheerful news than it appears. European industrial consumption in the fourth quarter of 2008 was deeply depressed, and in any event, a large part of the increase represents Russian enforcement of take-or-pay contracts, which Gazprom has since been forced to relax. JP Morgan reports 2009 exports at 145.6 billion cubic metres (bcm), down 13 percent from 2008. But the possibility of a “revolution” arises less because of depressed demand (which can be expected to recover) than because of a new development: the emergence of a genuine gas market. Up to the present day, gas supply has been tied to highly expensive, fixed infrastructure, and this has led both to monopolisation and excessively tight interdependence. This fact has made the pipeline gas business fundamentally different from the trade in oil. With pipeline gas, the trading element is diminished. Without alternative infrastructure, alternative supplies do not diversify choices for the consumer; because pipelines run to fixed destinations, alternative markets do not necessarily diversify choices for the producer. For these reasons, both the owners of infrastructure and consumers of gas have traditionally sought long-term contracts with stable pricing frameworks (hence, the emergence of the Baumgarten formula) to maintain investments and a baseline of economic predictability. By early 2006, three factors—the Russia-Ukraine gas crisis, the wider politicisation of energy relationships and anxiety about Gazprom’s longer-term production capacity—were creating a security problem in the eyes of the European consumer.
Today new factors are creating a security problem in the eyes of the Russian supplier: the expansion of LNG imports into Europe and even greater expansion of LNG capacity, predominantly outside Russia, the emergence of new gas shale fields in North America (which have greatly set back Russia’s own LNG ambitions), and the breaking of Russia’s near-monopsony on Turkmen gas by China, which in turn not only threatens Russia’s control of over 45-50 bcm per annum of Turkmen gas, but Russia’s energy model and possibly its geopolitical model as well. At present, there is the beginning of a spot market in Europe, and the supply glut has pushed the spot price down 60 percent from June 2008 levels. These developments are occurring in a context in which the structural problems of Russia’s energy sector are finally coming home to roost. During the first half of 2009, Gazprom’s production and transmission costs rose 33 percent and 36 percent respectively (partially due to inflation, partially to structural inefficiency), and the company has only begun to recover from the 76 percent drop in the value of its shares. Facing the inevitable, Valeriy Golubev, Deputy CEO of Gazprom, announced in April (the same month as the curtailment of imports from Turkmenistan) that production of gas would drop in 2009 by 10 percent, most likely for a five-year period. For good measure, he also predicted that Gazprom’s position in European markets would decline by 2020. Given the strength of this trend, Gazprom has had to cede ground on its enforcement of take-or-pay contracts with European consumers.
Given these developments, the prospect that South Stream will be built becomes ever more remote, and if for some reason it is built, it will be filled with virtual gas, as no sources for supplying it have been identified. Whilst Nord Stream’s construction is considerably more likely, especially after Finland and Sweden cleared the way for the project on 5 November 2009, there is at least a finite risk that it will become Europe’s white elephant. Gazprom’s decision, first announced in 2006 by its CEO Alexei Miller, to reorient new production to the Far East is no longer a presumptive threat to Europe. But is it a solution for Gazprom? Unlike the EU, China is a unified energy market, which in the exhortatory words of the European Commission, speaks with “a single voice”. In that market, the Baumgarten formula is a non-starter. When ExxonMobil demonstrated a readiness to sell gas to China from Sakhalin-1 at $100/1000 cubic metres (tcm) in August 2007, it was ordered by Gazprom without any trace of irony to charge the “market price”. In October 2009, little more than two years later, Prime Minister Putin implicitly acknowledged that China would pay a genuine market price according to a new, so-called “Asian oil basket” that is bound to trim profit margins for Gazprom. Back in 2007 it was widely predicted that Gazprom would become the dominant factor in European markets by 2020. Today, more are willing to wager that it will become an energy appendage of China.
Not surprisingly, there were signs at the end of 2009 that the contours of the Russia-Ukraine gas relationship might change for the better. According to JP Morgan, Ukraine imported 26.6 bcm of Russian gas in 2009, set against a contractual requirement to purchase 40: a development reflecting not only the parlous economic crisis in the country, but a fair measure of industrial modernisation since the initial gas shocks of 2006. Moreover, Ukraine has 25 bcm of gas in storage, almost as great a volume as the entire EU. Although Russia enjoys a powerful economic advantage relative to Ukraine, for the moment, Putin has decided not to press it. In his joint press conference with Prime Minister (and then presidential candidate) Yulia Tymoshenko on 19 November 2009, Putin announced that Russia would suspend enforcement of the harsh take-or-pay provisions in the gas contract concluded by the same two prime ministers on 19 January 2009 and also announced that Ukraine’s transit fees would rise 60 percent. True to form, on the same occasion, he announced that the ten-year contract, with all of its provisions, remained binding and unalterable. Yet only six days after affirming that principle, Gazprom and its Ukrainian counterpart, Naftohaz Ukrainiy, signed amendments altering it. The amendments formalise the suspension of take-or-pay provisions for the first ten months of 2010. In contrast to the January 2009 provisions, which obliged Ukraine to take 50 bcm of deliveries from Gazprom every year to 2019, the amendments also reduce Ukraine’s import commitment for 2010 to 33.75 bcm with leeway to consume 20 percent below that figure.
The enlightened interpretation of these events is that Russia’s diminished position in Europe will no longer enable it to withstand a major gas crisis. Prior to the Ukrainian presidential elections of January 2010 Putin hoped that even Tymoshenko, if elected president, would be amenable to a gas deal that would shift Ukraine from Yushchenko’s pro-NATO policies and, despite the (as yet unfinanced) EU-Ukraine March gas transit modernisation initiative, pull Ukraine more closely into Russia’s orbit. Yanukovych’s electoral victory on 31 January will certainly increase his optimism. The problematic question, even under a Yanukovych presidency however, is whether the agreements will actually lessen Ukraine’s vulnerability to Russian pressure. Ukraine will lose its 20 percent discount in 2010, precisely at the time when gas prices are set to rise again. Although the 60 percent rise in transit fees will partially offset these sums, it will not match them. Once again, Ukraine might be unable to pay. So whilst Ukraine and Russia will, in Putin’s words, “greet the New Year without shocks”, an assault on the Gas Transit System in 2010 remains entirely possible. Whilst Yanukovych has already tried to pre-empt such pressure by reviving the stillborn 2002 project of a gas consortium, he is tying this concession, most unrealistically, to a return to gas subsidies, which Russia has no inclination to accept and which it can no longer afford. Hence, despite the change of power in Ukraine, the gas relationship promises to remain stressful and problematic for both parties.
Breathing space for Europe
The financial crisis has placed a dark cloud over almost every EU aspiration and priority, and that of course applies to the needs and ambitions of its member states. Enhanced energy security might be this cloud’s one silver lining. The crisis has not only widened the cracks in the edifice of Russia’s “mighty energy sector”, it is threatening it with decomposition. That threat could prove highly advantageous to Russia if difficult choices are grasped and even more difficult decisions taken. Russia can only benefit from an “unbundled”, responsive and competitive energy sector, largely in private hands and underpinned by the legal safeguards that make market relations humane and enriching. So would everybody else. Such a transformation would make EU-Russia partnership a meaningful term.
The financial crisis also brings tomorrow’s energy solutions closer to today’s Europe. It is reviving the elementary truth that monopoly is not only a source of insecurity but expense, that costly investment in cheaper technologies is a wise economy and that interdependence has no value if you are locked into it. It not only provides the incentive to take up the challenges of the EU’s March 2007 Action Plan—and its more detailed and less contentious Energy Security and Solidarity Action Plan of November 2008—it gives it the time to do so.
“Business as usual”—which is at the top of the Commission’s list of sins—will melt this time away, just as it has done in the past. Without a strategic and coordinated approach, it is still likely that a few of the more promising changes outlined here will gather momentum. But it is most unlikely that the momentum will be sufficient to overcome Europe’s security dilemma: too many member states with too unhealthy a dependency on Russian controlled pipeline gas. Thanks to the current crisis, the EU is in a promising position to influence Russia and, despite the change of power, Ukraine. But if it continues to define itself by its divisions, it will not be able to use the influence it has gained. It could find that the future is determined by other actors: China, the Central Asian states, Turkey, Iran and, very possibly, an embittered fortress Russia. In the worst but entirely realistic scenario, energy policy will be made for the EU rather than by it.
Realism would suggest four directions of activity. First, and the point should not be confined to the question of energy, the EU should devote more effort to implementing the priorities that unite it than arguing about what divides it. The 2008 EU Energy Security and Solidarity Action Plan wisely replaces language about unbundling with a call to “press for further liberalisation of trade and investment in the energy sector”. It also highlights the EU’s greatest deficiency to date: the failure to improve infrastructure within the Union and, in particular, interconnectors between member states—a point of consensus agreed in 2006. Implementing this priority, more than any other single step, would give substance to the “solidarity” plan’s key priority: “strategies to share and spread risk”.
Second, the EU must become more effective at enforcing its body of regulations and codes of practice within its own space. The pressures on Russia’s energy sector make this more important rather than less, because they are increasing Russia’s reliance on aggressive energy diplomacy, opaque “understandings” with European politicians (inside and outside the EU) and intelligence methods of business. Europe is more familiar with these methods than it was in the past, but it continues to tolerate them more than it needs to or should. If energy security requires Commission directorates and authorities to become more intrusive, then that is what they should be. So should concerned member states.
Third, the EU must relaunch efforts to engage Ukraine once it has a functioning presidency and government. Until then, there is no basis for conditionality or progress. In foreign policy and national security matters, Ukraine will have only one condition to meet: fulfilling its agreements. In March 2009 the EU, World Bank and associated investors committed themselves in principle to providing [euro]2.4 billion towards the modernisation and reform of Ukraine’s grotesquely derelict and opaquely managed gas transit system. That scheme requires a capable Ukrainian partner. Until there is one, it should stay on the shelf.
The fourth dimension is EU-Russia negotiation and discussion. The theme of discussion should be clear: the transformation of today’s malign interdependence into a relationship that brings security and benefit. But this discussion will lead nowhere until the EU puts its own house in order.