The Merits of Dual Pricing of Natural Gas by Russia

1. The Merits of Dual Pricing of Natural Gas by Russia Prepared for the World Bank Institute Course in Moscow, Russia “Trade Policy and WTO Accession for Development in Russia and the CIS”  March 28-April 8, 2005 David Tarr and Peter Thomson

2. 1. WTO Negotiation Context • Demand for unified pricing by the EU of gas and some support by the US. • Why the US—fertilizer producers complained about competition from Russian exporters with lower costs. But US took a back seat to the EU.

3. An effort to obtain cheaper prices for European consumers. The EU indicates that this is part of their strategy for integrated, competitive energy markets in Europe. • Set back discussions-Russians reacted very strongly and very negatively. It would not agree to unified gas pricing in Russia and Europe.

4. The World Bank saw the need for good analysis. The Financial Times and all major Russian newspapers (except Commersant) reported on a draft version of the paper in March 2003. But inaccuracies in the stories.

5. 2. Russians call the demand “WTO-Plus” • A subsidy must be specific to an industry or group of industries. The price of gas is the same to all Russian users, so it is not a subsidy.

6. 3. Optimal Export Price • Russia has market power in European markets. 66% of European imports are from Russia, and Russia supplies Europe with about 27% of all its gas. Cf. OPEC share of world oil markets is 33%. • The Russian and European markets are segmented. Pipelines deliver the gas, so gas sold in Russia cannot be resold in Europe.

7. These two facts together imply that Russia cannot supply significantly more in Europe without lowering the price there. (Gazprom sells three times as much gas in Russia as it does in Europe.) That is, there is no “world price” at which Russia can sell all it wants. Russian sales determine the market price in Europe in an important way. • Then there is an optimal markup over marginal costs for Gazprom on its European sales.

8. where • If gas suppliers play a Cournot game in Europe, the optimum is defined as: market elasticity of demand in Europe and the market share of Gazprom in Europe, and the ratio is the perceived elasticity of demand by Gazprom in Europe.

9. The optimal markup of Gazprom in the Europe market, increases with the market share s and decreases as the absolute value of market elasticity of demand increases. The optimal price also increases as marginal costs c, or transportation costs t increase. • Figure 1 depicts the optimum for Gazprom in Europe on the left hand side.

10. Gazprom earns rents on present sales in Europe equal to the value DD’E’E (P-costs)*Q= about $6 billion per year ($5 billion in 2000, $7.5 billion in 2001). • Triangle of deadweight loss equal to about $2.5 billion per year, if we assume an elasticity of -1.5. (Estimate increases with the elasticity, but it can’t be lower than unity assuming that Gazprom is optimizing.) European consumers would gain more dollars than Gazprom would lose if Gazprom lowered the price to marginal costs. Triangle of deadweight consumption losses.

11. Price = LRMC in Europe would result in the EU gaining $2.5 billion per year more than Gazprom loses. • One question: is there a cooperative solution that allows both Russia and Europe to be better off? There are $2.5 in potential gains. A cooperative solution may appear infeasible (there are over 20 countries involved (Eastern Europe, the Baltics, Turkey in addition to the EU countries). But the question can be posed non-cooperatively—can Gazprom design a price policy that would allow it to capture the additional $2.5 billion from the EU?

12. 4. Optimal Domestic Price • Gazprom is close to a monopoly domestically in Russia. The World Bank supports competition in the Russian gas market. But while Gazprom is a monopoly, the price should be regulated to prevent monopoly restriction of output. There is an offsetting consumer interest on domestic sales from the Russian perspective which is not present on foreign sales.

13. Price equal to the long run marginal costs LRMC (including environmental costs) is the efficient price. • No world market price for gas—if there were, the appropriate price in Russia would be the world price, since that would be the opportunity cost of the gas.

14. We estimate that LRMC is about $40 per TCM in Russia, but current prices are about $20 per TCM. Thus, prices should double in Russia to be efficient. • Price increase are required to maintain production. Output is forecast to fall by 7% per year unless investments increase. Presently, Gazprom invests about $2-3 billion per year, but $8-9 billion per year is required over the next few years in order to maintain production.

15. 5. Comments and Criticisms • The whole point of the note is to clarify the issues for Russia and the WTO members. We explain that the WTO members are not helping Russia by demanding a single price for gas in Russia and Europe. If WTO members wish to continue the demand, that is their choice, but they should be aware of the costs they are imposing.

16. Isn’t the LRMC higher, so the difference in price between the two markets is smaller? Gazprom estimates LRMC at $35. It is in their interest to have a high LRMC for discussions with their regulatory authority, so I would be wary of an estimate very much higher than Gazprom’s own.

17. Hotelling rule from exhaustible resource models would call for a depletion premium to be added to the LRMC—so efficient price is greater than $40 TCM? The depletion premium is inversely related to the size of the reserves. With over 80 years of proven reserves remaining, it would be close to zero.

18. Moreover, these models imply that the value of a unit of remaining resources should increase over time. But in the last 125 years, the real price of exhaustible resources has not increased—contradicting these models. Either additional discoveries or technological advance has mitigated the impact of finite availability on their scarcity value in production and consumption.

19. Environmental costs should increase the efficient price in Russia. We agree, but gas is probably the cleanest of the various energy sources. There are no pollution costs of production of natural gas, only greenhouse gas effects of consumption, as with all fossil fuels. If we are putting pollution taxes on the cost of energy, gas would have a relatively low tax since other energy sources are much less environmentally friendly.

20. Biggest environmental issue is to allow the oil companies access to the pipelines, so they stop flaring associated (by-product) gas. About 20 Billion cubic meters (BCM) out of 580 BCM of production is flared annually in Russia.

21. The markup over marginal costs in Europe should be tempered by consideration of long run competitive pressures. I agree that the price should be based on dynamic considerations—the most appropriate model is the dominant firm with a competitive fringe. The dominant firm will lower the short run markup over marginal costs to deter entry. But it is reasonable to assume that Gazprom maximizes profits and takes this into account.

22. I assume a perceived elasticity of –1.5 in Europe. The markup is a function of the elasticity. Elasticities could be lower, then the estimated losses of profit of Gazprom are overestimated. The loss of profits are simply the rents on current sales; therefore they are independent of the elasiticities.

23. Gazprom will become more profitable—can it be taxed. We estimate that Russia will collect $6 billion in taxes from Gazprom in 2003. (excise tax, wellhead tax, export tax and profits tax). Only $0.3 billion in profits since Gazprom is not very profitable. So it is being taxed. Moreover, it is necessary to increase profits to expand investment.

24. Doubling domestic prices will create hardship. We agree that in a cold climate these are life threatening issues. The Bank is working on a well targeted safety net for poor consumers to prevent severe hardship as energy prices are raised. But cutoff of supply from lack of production will also create hardship.

25. Why does Russia charge lower prices to the CIS than in Europe—trying to be nice politically or economic reality? • Application of the same model (price discrimination in three segmented markets (home, Europe and CIS) would imply a lower price in the CIS than Europe. Prices are breakeven in the CIS, and Gazprom shows it is willing to give this market up.

26. 6. Press reports and recent developments New EU Position • The EU now argues for competition in Russian gas markets and especially non-discriminatory and transparent access to the gas pipelines. This is a long standing position of the World Bank, part of SAL II and SAL III.

27. Competition among Russian companies will drive down the price in Europe to LRMC in Russia. • The Russian government can still extract the monopoly profit by imposition of an export tax, but only an export tax regime (or monopoly exporter) will be able to extract the monopoly profit once there is competition in the Russian gas market.

28. EU-Russia protocol on Russia’s WTO accession of May 2004 reportedly calls for Russia to raise domestic prices to roughly what we believe is LRMC, but does not require.

29. Figure 1: Optimal Pricing of Russian Natural Gas in Europe and in Russia

30. Figure 1, footnote 1: Optimum in Europe Market. We assume Gazprom maximizes profits on the quantity of natural gas sales in Europe. This occurs at point E, where perceived marginal revenue equals marginal production plus transportation costs. At this quantity (126 billion cubic meters), the market clearing price is at point D ($106 per thousand cubic meters). For quantities greater than at point E, marginal revenue is less than marginal production plus transportation costs. Thus, expansion of sales to the point F, where the price ($67) equals marginal production plus transportation costs, will result in losses on Russia’s exports (relative to point D) equal to the value of the shaded triangle (EFG) (which is equal to the rectangle DD'E'E). For quantities greater than point H, additional sales will reduce the revenues received, and additional costs are also incurred.

31. Figure 1, footnote 2: Russia Market Gazprom faces a controlled price at $20 per thousand cubic meters, leading to quantity demanded (and sold) of 375 billion cubic meters of sales in Russia. The social optimum for Russia is at point B where long run marginal cost equals price at $40. An increase in the price in Russia from $20 to $40 results in an increase in welfare in Russia equal to the triangle AA’B.Gazprom would maximize profits where marginal revenue equals marginal costs, leading to point C. Since the value to Russia exceeds the marginal costs of production for quantities less than at Q*, there is a triangle of losses equal to BB’C for an increase in the price resulting in a movement from B to C.