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Russia and Europe's Energy Strategy

Reports have recently circulated of an agreement between Russia and the European Union (EU) for long-term energy sales. Europe wants more Russian oil and gas, but this does not mean that it will not continue to seek oil and gas from other Caspian countries. However, for Europe to take more oil and gas from Russia, new pipelines would have to be constructed, and this in turn would require a clear legal framework. The best step Russia can make right now in that direction is to ratify the Energy Charter Treaty (ECT).

Consequently, this article analyzes first what Europe wants from cooperation with Russia and then how Russia can cooperate with Europe for its own benefit. From there it moves on to discuss what have been the obstacles to such cooperation, particularly the obstacles to foreign direct investment in the energy sector. It then emphasizes the need for the rule of law and the implications of this for accounting, banking, and other financial practices. Finally, it emphasizes the need for the Duma to move towards ratification of the ECT, which Russia signed in the mid-1990s.

1. What Europe Wants

The impression that the recent talks between Russia and the EU will have any immediate results should be avoided. According to a report in the Financial Times, discussions between the two sides are focusing on the prospects for a trade of EU technology for Russian oil and gas over a 20-year time frame.

There is great interest in Europe in plans for diversification of the sources of energy supplies, although the EU must give priority to cooperation with oil-producing countries under conditions of the present energy market. But in the longer term, the EU is especially interested in natural gas because this fuel is environmentally preferable to petroleum. At the same time, Russia needs to increase the productivity of its energy sector.

At present, Russia supplies one fifth of the gas consumed in EU countries and one sixth of the oil. However, its export outlets are not large enough to allow for a significant boost in deliveries to Europe. Any supply agreements with Europe would, therefore, necessarily cover new pipeline construction. They would also involve transit across third countries.

Building new pipeline from Russia to Europe would be a long and involved process. Let us recall, for example, that just the negotiations on the conditions for construction of the Baku-Ceyhan main export pipeline (MEP), took five years, while engineering studies will take another year or two and construction is projected to last a minimum of three years. The MEP was the first pipeline in the history of the industry to require multilateral negotiations among producer, consumer and transit countries, together with a multinational consortium of international energy companies. Such a structure would undoubtedly be necessary also for any EU-Russia agreements.

Some steps have already been taken in this direction. For example, the European Commission's President Romano Prodi mentioned the possibility of a "strategic partnership" on energy in a conversation with Russian President Vladimir Putin at the end of September. German Chancellor Gerhard Schroeder also discussed the idea briefly with Putin earlier this month. Important European energy companies such as ENI and Ruhrgas already have long-standing ties with the principal Russian energy trusts, dating well back into the Soviet era.

2. How Russia Can "Win" Europe

If the Russians and the Europeans continue on this course and take the steps needed to set up supply routes as well as arrange for deliveries, Russian producers would be able to boost their European market profiles significantly. But does this mean that Europe will rule out the Caucasus and Central Asia as potential energy sources for the future? Not at all. The EU has continued to state its strong support for the TRACECA and INOGATE projects, which were designed to improve transport and communications links in the Caspian region. The European Union's energy plans still call, for example, for offshore Azerbaijani gas from the Shah-Deniz deposit to be pumped across Turkey into Southern Europe.

The EU has for a long time criticized the U.S. government for supporting the Baku-Ceyhan pipeline project, but its real reason for doing so is that if oil goes to Ceyhan, then it will not end up in Europe. The Ceyhan terminal is built to service ocean-going tankers, and experimental projects have already confirmed that offshore terminals in the Gulf of Mexico have no problems receiving such petroleum.

The EU initiative represents not a rejection of the Caucasus and Central Asia but rather an intention to expand partnership with Russia. The EU's strategy in this respect already comprises a so-called "Northern Dimension", which has seen Russian drawn into positive and practical cooperation efforts around the Baltic and Barents Sea areas. Also, there is strong support in Europe for proposals to work with Russia in the South Caucasus. Among European politicians, such proposals are increasingly being labeled as the "Southern Dimension" of the partnership with Russia.

In this context, the recent tentative contacts between the EU and Russia regarding energy supplies may be thought of as a "Central Dimension." This has become possible now that the EU has decided on the conditions for pursuing negotiations with the Eastern and Central European countries that are seeking to become EU members.

The proposal of the Centre for European Policy Studies, an independent think tank in Brussels, to move towards establish a South Caucasus Community with the blessing of Russia, the United States and the EU, is an example of the attempt to work out a "Southern Dimension" of EU-Russian relations. That ambitious proposal is on temporary hold because the EU does not wish to move forward before Russia and the United States are ready to endorse it. What blocks such movement is the failure to resolve the Karabakh issue.

Russian energy companies have an interest in seeing that the Russian government takes a more definite stance with respect to promoting a political resolution of the Karabakh problem. That is because onshore deposits in Abkhazia and other fields believed to lie offshore in the Black Sea probably harbor significant energy resources. However, Abkhaz separatists and Ossetian autonomists in Georgia are waiting to see the outcome of negotiations on Karabakh because they sense that what is achieved there will establish the maximum limit to which they can aspire.

3. The Most Important Task for Promoting Foreign Investment in Russia

Meanwhile, discussions on EU-Russia energy cooperation continued on the level of "captains of industry" this past weekend, at the Third Roundtable of Russian and European Industrialists, held in Moscow. Further talks will undoubtedly be held in Paris at the end of October, when the EU and Russia hold a formal summit.

All statements made at the roundtable over the weekend emphasized the need for the Russian Duma to ratify the Energy Charter Treaty (ECT). The ECT is designed to promote a secure legal framework, compatible with international norms, in order to encourage Western firms to invest in the post-communist economies.

Russia's Deputy Prime Minister Viktor Khristenko recently visited the ECT Secretariat in Brussels and stated the government's intention of working towards ratification. As the Russian government put it, attention needs to be given to improving the investment climate in Russia and removing obstacles that bar competitive Russian products from European markets.

According to an ECT Secretariat statement, Khristenko said the Russian government would "actively" facilitate the treaty's ratification. Russia signed the ECT soon after it was agreed to in 1994 but never ratified it, because under the Yeltsin-era Duma, the ECT was sent for discussion to the Industry Committee, which was chaired by a member of the Communist Party of the Russian Federation, which in turn wished to avoid the necessary restructuring of the domestic energy industry. President Boris Yeltsin himself tried to circumvent the logjam by proclaiming the provisions of the ECT as domestic law in a presidential decree, but this was not observed in practice.

Some countries can be compelled by circumstances to take decisions in favor of reforms. But Russia is not one of those countries. Conditions are such in the country that an affirmative political decision in favor of such reforms is necessary, if the reforms are to succeed at all. Yet the Russians cannot be forced to take such a decision but must find the political will to do so by themselves.

4. Why Strategic Alliance Require the Rule of Law

Investors have until now been reluctant to risk too much in Russia due to the absence of the rule of law in stock-exchange affairs. So far, they have only sought to establish a presence, but with only a few exceptions (such as the important contribution by Italy's ENI to the Blue Stream project, which will bring Russian gas to Turkey) they still do not count Russian energy in their global plans for strategic development. It is worth noting that the rule of law in stock- exchange affairs also means bringing the norms of accounting and banking practices into correspondence with international standards.

The most effective foreign investment for industrial cooperation in Eurasia nowadays in the energy sector is not in limited-duration partnerships, which tend to be narrowly focused on specific objectives, but in strategic alliances. Successful alliances have clearly defined processes that provide for goals, risks, control, and decision-making to be shared. In an alliance, it is unlikely to find universal solutions to any problems. Rather, it is better to start with step-by-step collections of specific projects that grow naturally into full alliances as the projects develop over time.

In practice, strategies must differ according to whether the energy deposit is large and mature with an existing skill base or immature and partially developed with satellites. In the former case, it is necessary to address fixed costs and to optimize infrastructure. In the latter case, it is necessary to clarify the applicable tax law about joint ventures.

Because development projects today require strategic alliances between energy companies, the rule of law is necessary for contemporary energy development because the progress of such strategic alliances cannot be normatively planned. Such alliances evolve over time, and they are optimal when they develop their own goals on the basis of their own experience.

The state of the legal system in the host country is the most significant issue, and it can either block or open the road to practical cooperation. That is because it is not the first successful agreement, or even the second, that proves convincingly that cooperation is possible. Rather it is the third, fourth and fifth deals that prove this.

It is no accident that companies such as ENI and Ruhrgas, which have a long presence in Russian energy development, are better able to balance strengths and weaknesses with Russian partners and to arrive at objectively agreed project evaluations. Yet for strategic alliances to work, even for companies such as ENI and Gazprom that have the experience of working with the Russians, difficult issues of taxes, corruption, legal structures and transport must be managed. That is because in the absence of the rule of law, it is not clear how an investor even obtains rights to a project or enforces the contract in case of a breach.

5. Conclusion

Russia is too large to be compelled by the international community to undertake the reforms needed to make increased deliveries to Europe possible. A positive decision by the Russians themselves would be required for this. Political will is necessary. If the Duma ratified the ECT, for example, there would be a legal instrument by which Russian authorities could assist in reforming the country's energy sector so that it was able to receive foreign investment in greater quantities than it has until now.

But even ratification of the Energy Charter Treaty (ECT) is not by itself enough. It must also be implemented. If Azerbaijan and Kazakstan have received large amounts of foreign direct investment in the energy sector, this is not so much because of a Western desire to circumvent Russia. Rather, it is because the climate for investment in those countries has been better. That means accounting and banking practices have been suitable, and it means that contracts are enforceable.

Industrial development requires political stability, and the conditions of that stability are usually less important than the stability itself. But industrial development in general, and energy development in particular, requires not just political stability: it requires also secure and dependable transport, as well as an investment-friendly financial and legal climate. When these three conditions come together, the result is called "cooperative energy security."

Copyright © Robert M. Cutler unless otherwise noted.
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URL:  http://www.robertcutler.org/blog/2000/10/russia_and_europes_energy_stra.html
First published in FSU Oil & Gas Monitor, No. 103 (11 October 2000): 4–6.

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