Reader Energy security in International Relations (IR) theories Andrei V. Belyi Higher School of Economics Cathedra on political issues of international energy Structure 1. First approach: Realist approach 1.1. General views on security 1.1.1. General definitions of security (A. Belyi, Copenhagen School) 1.1.2. Subsystems and energy security 1.1.3. What is energy security ? (S. Haighighi) 1.2. Oil geopolitics 1.2.1. History of energy supply disruptions (S. Haighighi) 1.2.2. Actors in oil geopolitics (R. Mabro) 1.3. Trends in oil and gas geopolitics in aftermath of the Irak war (G. Luciani) 2. Second Approach: Institutionalist approach 2.1. Theoretical conception of institutionalism (Steimo) 2.2. Overview of Institutions dealing with energy security 2.2.1. IEA and views of IEA on energy security 2.2.2. International public law (conception of T. Waelde on international arbitration) 2.2.3. International energy law, including the Energy Charter Treaty (Belyi & Klaus view on institutional and realpolitik approach in using the ECT) 2.2.4. European Union (views of the European Commission and of private commercial actors on energy security) 3. Third approach: New economics of energy 3.1. International energy interdependency (Ph. Andrews Speed) 3.2. Gas markets, regulation and security (OIES publications) 4. Fourth approach: critical political economy 4.1. Structuralist analysis of energy security (S. Strange) 4.2. Agency-structure analysis (M.Pistor) 4.3. Producers views on liberalization (Gazprom conception of energy security). Introduction A consensus seems to exist on the issue of energy security achieving a particular importance since the energy shocks of the 1970s, when present asymmetries between the geographical distribution of resources and energy consumers had been consolidated by oil shortages in the petroleum-dependent countries1. Since then, the energy security has been integrated into the debates of the IR theories. An overview of the existing IR theories demonstrates four various approaches. First approach focuses on a rational approach of international political relations, shapes by structural unbalances between energy producing and consuming regions. Oil supply became a subject of vulnerabilities, either perceived or real. Since then, much analysis has been done on the growing rate of energy consumption and on energy import dependency of many industrialized states. A particular emphasis has been attributed to political conflicts in connection to natural resources. Failures of cross-border energy trade cast a sharp light on the efficacy of institutions governing and regulating this trade. Here, the second approach attempts to analyze the efficiency of international economic institutions on enhancing security. Third approach can be defined from a number of recent assessments from the academic and business world of a “new political economy of energy”2 characterized by a growing diversity in energy technology, trends towards a deregulation, foreign investments and interdependency in the sector. The energy becomes a complex system of trade transactions, where the price formation becomes the major source of political vulnerabilities. Fourth approach is basically the international political economy (IPE) critics towards rationalist economic theories. This conception stems basically from the points of view of S. Strange. The interest in taking into consideration the critical IPE consists in an importance accorded to economic values (nationalism, liberalism), which limit the rational approach of the international regimes. In order to analyze those divisions, the reader contains a number of texts, which help to demonstrates different views on energy security. 1. First approach: Realist approach 1 CHOUCRI, N. (1977), International Politics of Energy Interdependence, Lexington Books, pp. 185-186. The term borrowed from the Editors foreword in the special issue of the Journal of International Affairs, Spring 1999, 52, no 2 2 Realist approach includes general definitions of security in international relations, oil geopolitics and definition of the latest trends emerged in aftermath of the Irak war in 2003. 1.1. Conceptualization of security If one wants to define the energy security, he or she should address the question: what does “security” means in general? Is it a response to a concrete threat? Either is a strategy to avoid a potential threat? Or is a motivation justifying a concrete policy objective? 1.1.1. General definitions of international security: from K. Waltz to Copenhagen School Realist approach of IR theories has been traditionally focused on the definition of international security. In light of a Realist conception presented by K. Waltz3, states are acting accordingly to their structural power within international relations. Waltzian system assumes states to struggle for survival within an international system characterized by an absence of any “world-wide” authority. The rise for power features the interstate relations, including those of the access to resources. K. Waltz predicted that the oil shocks, provoked by the Arab export embargo, would not constitute any change of power for the West4. However, security of energy supply became a matter of security motivation for many developed countries in the aftermath of the oil shocks of 1973. K. Waltz argues that there is a continuity of strategies of the major Western states in energy geopolitics. Political actors change, the national strategy remains5 Security can be defined as defensive (in relations to a threat) or offensive (optimizing of profits in relations with other actors6). The Walzian meaning of security is mainly defensive: security stems from the anarchical structure of society. The energy security is offensive: as is the only vulnerable point of the Western states, they prefer to use the offensive strategy. The concept of security redefined by B. Buzan. In 1990s he joins the Copenhagen School of security studies. According to this School of thought, “security” is not considered to be a direct consequence of threat, but is rather defined as the result of the political interpretation of the threat, a process called securisation. The authors of this School point out the need to construct a conceptualisation of security that means something much 3 WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979. WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979, pp. 155-157, 195. 5 WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979, 117. 6 GRAFSTEIN, R., « What Rational Political Actors Can Expect », Journal for Theoretical Politics, Vol. 14, n°. 2, 2002, pp. 139-165. 4 more specific than just any threat or problem7. Therefore, security is defined as a nonlinear reaction to the threat. Having inherited the Realist perspective towards international relations, the Copenhagen School considers anarchy as the main feature of the international structure, which also explains states’ attitudes towards security (security preoccupations). Furthermore, according to this approach, the term security includes five separate sectors: the political sector involving the internal and external stability of states, the military covering their defensive and offensive capabilities, the sector of societal security meaning the stability of cultural (i.e. national or religious) identity, the economic security related to the access to resources and markets, and the environmental security defined as a protection of ecological biosphere8. However, the Copenhagen School does not distinguish energy security from other security sectors although it would appear evident to observe its importance among the above-mentioned sectors. First, political security in international relations involves security relations with other states because of the international anarchic order: states are looking for energy self-sufficiency. Second, energy availability also indirectly contributes to military capabilities. Third, economic security is defined by the difficulty to foresee the behaviour of economic actors in a decentralised capitalist economy9. On that basis, securisation is related to political attitudes towards unpredictability of energy markets. Fourth, environmental security involves the incompatibility between high-speed economic development and natural resources protection. In the 1970s, this issue concerned a preoccupation with the possible expiry of fossil fuels (especially oil) whereas in the 1990s the ecological security issue is translated to the threat of climate change caused by growing energy use. Under this context, political and societal attitudes towards technological development are of strategic importance, i.e. nuclear safety and air pollution. The Copenhagen School focuses mainly on the political structure of international anarchy, while neglecting the impact of other structures (production, finance and technology) on securisation, that constitutes a certain weakness of the theory. The Copenhagen School describes a multi-level approach to international politics, and distinguishes four main levels: international (system), regional (sub-system), national (unit) and internal (sub-unit). The international system is the global level of security preoccupations. The national or state level is a bridge between traditionally separated fields of international and national security, therefore called unit level10. Within this unit level, the internal (sub-state) level involves local policies and logically includes subnational security perceptions. However, the key level for security studies is the subsystem, defined by a group of states who are geographically linked, and whose primary security concerns link together sufficiently closely that their national securities can not 7 BUZAN, B., WAEVER, O., DE WILDE, J. (1998), Security : a new framework for analysis, London, p. 7. 8 BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the post-cold war era, Harvester Wheatsheaf, Second Edition, p. 19. 9 BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the post-cold war era, Harvester Wheatsheaf, Second Edition, p. 235-237. 10 DE WILDE, J. (1995), "Security Levelled Out: the Dominance of the Local and the Regional" in DUNAY, P., KARDOS, G., WILLIAMS, A. (ed. by), New Forms of Security: views from Central, Eastern and Western Europe, Dartmouth, p. 88. realistically be considered apart from one another11. The sub-systems are named the regional security complexes, which have evolved throughout history, while retaining their geopolitical and historical roots: i.e. Middle East, South Asia, Europe, etc. 1.1.2. Security sub-systems and energy security The Energy Security Complex 1 Energy Security and the Regional Security Complex Theory DRAFT, PLEASE DO NOT QUOTE Mikko Palonkorpi Researcher Aleksanteri Institute / University of Helsinki mikko.palonkorpi@helsinki.fi The Regional Security Complex Theory (RSCT) Buzan and Wæver have defined regional security complexes as follows: “The central idea in RSCT is that, since most threats travel more easily over short distances than long ones, security interdependence is normally into regionally based clusters: security complexes. […] Process of securitization and thus the degree of security interdependence are more intense between actors inside such complexes than they are between actors inside the complex and outside of it.” In other words, the regional security complexes can be seen as a group of security dilemmas concentrated into certain geographical area, where essential threat perceptions by states (or other actors) are so interlinked and create such strong Energy security complexes on the other hand could be defined as follows. The regional energy security complexes are formed by energy related interaction between two or more states in a limited geographical area, which includes an energy dependency relationship between the states involved and perception of this dependency as a threat (securitization). The energy interaction includes transactions such as production (export), purchasing (import) and transit of energy. Analogous to RSCT definitions by Buzan & Wæver, also the threats arising from energy dependencies are usually more intense between states (or regions) in close geographical proximity. On the other hand, thousands of kilometres long oil and gas export pipelines can link states, located geographically far apart, into a same chain of energy (inter)dependency. In other instances, this direct geographical link either does not exist and or is less obvious. A good example is the US and Western European energy dependency on Persian Gulf hydrocarbon resources, in particular crude oil, which can be - at least logistically – more easily substituted by energy imports from alternative sources. In energy security complexes regional distribution of energy resources and regional energy dependencies could be regarded as parallel to the distribution of military power in politicalmilitary based security complexes. This highlights an important question: are the regions and actors the same in the energy security complexes and in the more traditional 11 BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the postcold war era, Harvester Wheatsheaf, Second Edition, p. 190. political-military security complexes? In order to outline an energy security complex one needs to evaluate the relative strength of energy dependencies by measuring such factors as energy trade balance, level of (domestic) energy resources and possibilities for energy diversification. In the Eurasian context this idea can be roughly conceptualized by thinking the relative (%) energy dependency of different CIS-states on Russian gas, oil and electricity imports measured against their ability to diversify energy imports from alternative sources or increase their own domestic energy production. However, these percentages or relative dependency figures are aggregate measures of overall energy (supply) dependency from specific exporting country; therefore these shares have to be balanced against energy mix of the individual states. For example, at first sight Finland’s 100% dependency on natural gas imports from Russia would indicate strong dependency pattern resembling circumstances in Georgia and in Armenia. However, the decisive difference is that natural gas constitutes only around 11% of Finland’s primary energy consumption. Therefore, there is room for analytical choice, whether one chooses to construct regional energy security complexes based upon aggregate energy dependencies or whether it makes more sense to construct these along major energy sources (i.e. natural gas, oil, coal, electricity, renewables, hydro power ornuclear power). Analyst has to make the assessment, whether or not this is well-grounded or justified. What speaks heavily against dividing energy security complexes according to the energy sources is the fact that in the policy making process the energy security of any given state is treated as an aggregate whole. However, a powerful counter argument for analyzing the security implications of the different energy sources separately is the difference in their transportation capabilities and the structure of their markets. For example, the crude oil can be easily transported by large tankers from the other side of the world and thereby the oil market is truly global, where as the natural gas trade rests upon far less mobile gas pipelines and that is one of the reasons why there is no such thing as the global gas markets or a global gas price. Although it is technically possible to transport liquefied natural gas (LNG) over long distances by ships, for the most part the gas producers and customers alike are still lacking the expensive LNG-infrastructure to create a truly global market for natural gas. Since the 1960’s and 70’s the dependency and interdependency concepts have been widely used in the Marxist oriented research on global inequality structures, north-south and centre-periphery conflicts. More over, in the mainstream IR theory interdependency has been associated with liberalist emphasis on markets (dependency) versus realist or neo-realist emphasis on political (dependency). According to Sullivan for example, the mainstream liberal arguments have advocated separation between economic and political issues, i.e. that economic activities occur in nonpoliticized space, where as realist regard economics subordinate to politics, because for them nations are the main actors and the power is the main objective. The difference is illuminated by Benjamin Cohen, who by building upon Richard Rosecrance’s distinctions has argued that in the two extremes liberalism sees states mainly as trading states seeking absolute gains and not interested what are the gains of other states, where as realism sees states mainly as territorial states, seeking gains relative to other states, i.e. gaining (better) position among the states. […] Based upon these annual energy dependency fluctuations it could be argued that the structures of the energy security complexes are dynamic, perhaps even more dynamic than the structures of the militarypolitical security complexes. A separate question is how much these energy dependency levels have to change before it affects the threat perceptions of the dependent state? Presented above is only the energy consumer side of the energy security equation that needs to be balanced against securitization of the market dependency levels by the energy producers. Equally important factors that define the energy security complexes are the historical amity and enmity patterns that have an influence on how the energy dependency is perceived. Each energy dependency case can be perceived in varying degree either as a mutually beneficial interdependency (positive dependency) or as an unequal and threatening dependency (negative dependency). In other words, the amity and enmity patterns can be seen as factors that partially explain why certain energy dependencies are politicized and/or securitized when others are not. Based on the different dependency perception alternatives, the nature of the energy dependency can be placed into an economic-political-security continuum.For example state with cordial bilateral relations to another state might not consider 30% energy dependency from neighbouring state as a serious security threat, where as two states with antagonistic relations might perceive even 10% dependency as a serious threat to national security. Although, in reality the economic and political aspects of energy security are often merged together, that doesn’t reduce the impact of analytical separation of these aspects, which forms the foundation for the study of energy security complexes. Without analytical separation of these different aspects, energy security would be interpreted as either completely market driven quest for equilibrium between energy supply and demand or a completely state driven geopolitical competition for energy resources, transit routes and so forth. This distinction is well illustrated in the report “Energised Foreign Policy – Security of Energy Supply as a New Key Objective” by the Clingendael International Energy Programme (CIEP) in which two scenarios are constructed based upon global geopolitical developments that effect energy markets (see figure 1 below). In these scenarios sections D and C would include China, Russia, India and majority of the producing states which have preferred the state centric global energy (trade) system. On the contrary the sections A and B would include the US, Japan and the EU which have opted for global energy market mechanism instead. In the first scenario movement of energy trade towards dominance of states and national oil companies in the global energy sector favors the state centric system and therefore even actors advocating market driven system are forced to adopt more bilateral practices to secure the energy supply. As a result the role of the governments is increased at expense of the (international) energy companies as the main actors in energy policy. In the opposite scenario the global energy sector is dominated by international energy market mechanisms and it favors the (international) energy companies as the key actors. Functioning energy markets ensure the balance between energy demand and supply. Since most of the producer countries and the important future consuming countries (China and India) prefer the state centric system, the future global energy sector is likely to gravitate towards the first scenario. An example of positive energy interdependency the president of the European Commission José Manuel Barroso described in March 2006 the nature of EU’s energy relations with Russia as interdependency. “[…] if we need a flow of energy from Russia, namely gas, I believe that it is also in interests of Russia to have a stable market and a stable relationship with such an important customer as the European Union”. In Georgia the tone has been very different. Unlike Western Europe Georgia has been repeatedly target of natural gas supply cuts or disruptions, which according to President Saakashvili, have been politically motivated. “[…] Manipulation of energy prices and supplies is a critical tool of those in Russia who believe that hydrocarbons are the best means of political influence … [R]ussia’s arbitrary cut-off sent a clear message to the European Union: There can be no energy security when an undependable neighbour is willing and able to use its energy resources as a weapon in political influence”. The Georgia’s 100% dependency on Russian natural gas could be considered as a revealing example of negative energy dependency. However it is important to emphasize that interdependence as such is not inheritably a positive phenomenon. Climate change is an illuminating example since it is mostly caused by consumption in the developed North, but the most serious consequences of the climate change will be felt in the underdeveloped South.23 Similar negative interdependency analogy could be pointed out between the single crop economies or “monoculture” producers (for example bananas) in the developing world and the markets in the developed world. Monoculture comparison is also relevant to many “one commodity” energy producing countries, but unlike devastating effects of ruined crops (and/or sharp global price fluctuation) to the entire economy of single crop producing countries, the energy producing states are better shielded from the annual fluctuation risks, because ever increasing global energy demand has kept at least oil and gas prices relatively high. Moreover, count out the Hurricane Katrine type direct hit, the natural phenomena are usually less of a threat to the energy production. As a conclusion it is argued that energy dependency is politicized or securitized more easily if it is linked to other controversies or conflicts (enmity) between states and these enmity perceptions can be regarded as factors which turn dependency into a negative energy dependency. Therefore, the energy security complexes are likely to follow the already existing lines of security interdependence in the region. On the other hand, positive energy interdependency is likely to develop according to the rules of the energy market where the main threats are secure supply and stable price of energy as quoted above. As Howard Chase has pointed out, in itself lack of self-sufficiency in energy is not a problem, because energy trade is the mechanism that should balance that out. But on the other hand the concentration of the future oil and gas reserves/production in the hands of smaller number of states with uncertain prospects for political stability emphasizes enmity or negative perception aspect.25 By this criteria energy security complex could be defined as a geographical area where negative energy dependencies are concentrated and for positive energy interdependencies a more appropriate term would be an energy security community 1.1.3. What is energy security? The energy security per se stems from a number of complex factors, related to international trade, supply and pricing. The text from S. Haighighi paper “The legal dimension of the EU energy policy”, Florence, 2006, pp.11-13: It is imperative to distinguish between the two sources, oil and gas, since they have different characteristics from the perspective of energy security. Unlike oil, gas is relatively difficult to store and gas transportation infrastructure is rigid in nature (for the time being). This means that a physical link between producer and consumer is required and the number of alternative routes to the consumer is limited. For example, a cargo of oil destined for the UK can easily be switched and sent to another country in another continent: this is actually an everyday occurrence, whereas for gas this flexible switching does not happen. This is because, unlike gas, oil transportation is not costly, and therefore oil that is destined for a specific place can easily be redirected to another destination. Moreover, unlike the global oil market, the gas market is regional. A global oil market implies that a disruption of oil supply in one part of the world may affect the whole world whereas gas disruption does not necessarily have worldwide repercussions. This is again due to the fact that firstly, the costs of gas transportation are higher than oil, and delivery systems are inflexible, and secondly, gas development in one country or region is isolated (due to a lack of easy switching between routes) from the development of other regions, which suggests that disruption in one region does not necessarily influence another. Another difference between oil and gas is that seven cases of oil disruption have been reported since 1950, occurring for purely political rather than physical reasons, whereas no gas disruptions have occurred and if they did, were only minor and short-term. This last difference shows that oil has historically been used as a political weapon while gas does not have such political characteristics. (The most significant example of politically motivated gas disruption was the blockage of gas exports from Russia to Ukraine in early January 2006. This blockage lasted only four days, and the political motives behind it are controversial and are not widely accepted). In addition, gas security is mostly concerned with physical shortage rather than price shocks, the latter being an oil security concern (for example, the energy crisis of 1973 was about the high price of oil and at no time was the physical availability of oil endangered). There are debates over what constitutes energy security and these arguments have been sometimes hindered by a lack of clear understanding concerning the different components of the energy security problem and their policy implications. The multifaceted nature of energy security, which will be elaborated below, makes it very difficult to provide a definition of energy security that is accepted by all. A commonly accepted practical definition of this concept is adequacy of energy supply at a reasonable price. This definition suggests that energy should be physically available and its price should be reasonable. There is also a subtle difference between the definition of oil and gas security. Gas security could be defined as the "guarantee that all the gas volumes demanded by customers will be available at a reasonable price". Oil security means "reliable and adequate supply of energy for a reasonable price". The difference between these two definitions is that gas security necessitates the satisfaction of demand without necessarily emphasizing the adequacy of gas supplies in all sectors. If one particular sector normally uses gas, but gas cannot be obtained, then it can be substituted by other fuels, such as coal or oil. The same does not apply to oil there are sectors in which oil is the dominant source of energy and no other energy can currently substitute it, such as the domain of transport in the European Union. Consequently, if there is no oil reaching that sector, the sector cannot function. In this case, as the oil market is a global market, a major shock anywhere in the world will be felt throughout the world oil market. The global nature of the oil market has prompted some to suggest that even if an energy-producing country could magically and inexpensively raise its domestic output to eliminate total imports, a shock in the world oil market will affect its domestic price and threaten the stability of its economy. Therefore, efforts to combat oil insecurity should also be made at the global level. 1.2. Oil Geopolitics Oil geopolitics is the centerpiece of the global energy security. The overview of oil security history is a complex structure, which includes cultural, political and economic factors. 1.2.1. Events of energy disruption Events occurred in the Middle East between 1956 and 1973 had a global impact on the conceptualization of energy security. Somehow, the “securization” of energy trade started from these events. S. Haighighi, 2006, pp. 37-47: On July 26, 1956, Gamel Abd al-Nasser of Egypt froze the assets of international oil companies, defied the West, and nationalized the Suez Canal. France and the U.K. took retaliatory measures, blocked all Egyptian accounts in their countries, and later declared their intention to seize the Canal. Eventually an Israeli-British-French trio attacked the Canal on October 29, 1956. A ceasefire order by the United Nations was finally accepted by these countries on November 6th. However, in the meantime the Egyptians had blocked the Canal by sinking ships and blowing up installations. This event had grave consequences for Europe’s economy because the Canal was considered vital to the European energy supply, and that year 69 million tons of oil was carried through this canal to enter Europe. However, the temporary interruption of the import of this oil was not in the beginning considered as problematic because of a belief in the abundance of European coal. In 1967, the Suez Canal was again blocked by Egypt during the Arab-Israeli six-day war. Representatives of Abu Dhabi, Algeria, Bahrain, Egypt, Iraq, Kuwait, Libya, Qatar, and Saudi Arabia, together with representatives of Lebanon and Syria decided to halt the export of oil to those countries whose policies were supportive of Israel or hostile to the Arab side in the conflict. After some time the shipments resumed but oil was not sold to embargoed countries, such as the U.S., Britain and West Germany.147 Interestingly enough, the consequences of this embargo were not critical. Some believe that in fact no real crisis materialized due to some factors: 1) the embargo on the U.S. was mostly symbolic because the export constituted less than 5 per cent total US oil consumption; 2) stockpiled supplies existed in Western Europe; 3) swap arrangements undermined the destination embargoes; 4) Iran and Venezuela, the two main non-Arab producing countries carried on their shipments and they further increased them after the embargo; 5) due to the introduction of a new generation of tankers too large to pass through the Suez Canal, the importance of this Canal for shipments from the Gulf to the West had decreased. On October 6 1973, Egypt and Syria declared their aim of recapturing the Arab territories occupied by Israel since 1967. Following this event, the Arab Oil Exporting Countries threatened to cut their production of oil by 5% and to continue to reduce that amount thereafter, until Israel withdrew from the occupied Arab lands. Saudi Arabia pressured the U.S. to change its policy towards Israel and declared that Aramco's exports (a major Saudi Arabian oil company) would be halted if no change in their policy took place. The United States, having the weak repercussions of the 1967 crisis in mind, did not take this threat seriously and thought of the use of the "oil weapon" by Saudi Arabia as having no more effect than in 1967.157 Saudi Arabia, on the other hand, sought to ensure that the non-Arab productive capacity would not undermine the embargo and also supervised the destination embargo more closely to prevent the swap arrangements, which had been used during the 1967 crisis to undermine the boycott. Exporting countries, worried about the negative effects of the embargo on their revenue, increased the tax on oil, which enabled production to be cut without causing the revenue to fall below the revenue of the previous month. In order to minimize the detrimental effects of these gradual cutbacks, a wide variety of measures were introduced, such as conservation of the oil stocks, restrictions on the sale of gasoline and the use of motor vehicles, restrictions on non-essential uses of electricity, and limitations on the heating of buildings.161 There was at no point a shortage of petroleum in European markets, but the price kept increasing. Oil import prices quadrupled. The posted price of Arabian light crude increased from $3 per barrel in early October 1973 to $11.65 per barrel in January 1974. Sudden inflation and economic recession ensued, leading to unemployment, the closing down of schools and offices and cuts in the production of major factories. This fact caused some to believe that "a staggering disequilibrium in the global balance of payment will occur that will place strains on the monetary system far in excess of any that have been experienced since the war".The German Chancellor Helmut Schmidt explained the situation as an extraordinarily instable one, which revealed the fragility of the elaborate system of economic relations among the nations of the world. However, the positive note was that, whereas the oil crisis could have touched off a chain reaction of destructive forces, it might in fact have helped to improve international cooperation The anxiety of an oil shortage led some consumers to approach oil-exporting countries directly in order to satisfy their crude oil needs, trying to buy as much as possible at whatever price (panic buying). Major oil companies also failed to take steps to reduce this consumer anxiety. Unlike some who believe that their failure to act was due to impotence, others believe the reason to be the fact that "they welcomed the higher prices and higher profit margins that this panic-buying induced". 1.2.2. Actors in oil geopolitics R. Mabro, Middle East in World Geopolitics, OIES 1. INTRODUCTION The Middle East holds a very Iarge proportion of the world's proven oil reserves. More importantly, the region has been the major potential source of incremental supplies since the 1940s, and will retain this role in the foreseeable future. Other oil regions that played this roIe in the past, such as the North Sea and Mexico, have not been able to sustain it for very long. Yet, the Middle East is unstabIe politically. Its troubled history has been punctuated with crises since the end of the Second World War; crises that were associated with either a threat to or an actual disruption of oil suppIies. The list of these events is long but familiar: Mosaddeq in 1951, Suez in 1956, Arab-Israeli wars in 1967 and 1973, the Iranian revolution in 1979, the Iraq-Tran war in 1980-88, and now, in 1990, the new Gulf crisis induced by Iraq's invasion of Kuwait. Some of these crises, particularly in 1973 and 1979, involved an interruption of oil suppIies that caused significant price increases. Others affected oil production and trade while failing to cause prices to rise. But even these "miId crises induced important structural changes in the oil industry. The role and behaviour of oil companies changed after Mosaddeq; the pattern of oil transport changed after Suez with the introduction of VLCCs and the diversion of tanker traffic around the Cape; and the Iraq-Iran war, which was not associated with oiI price increases, prepared nevertheless the grounds for the emergence of a very tight oil situation in the 1990s - a development which would have occurred in any case, even if Saddam Hussein had not invaded Kuwait. PoIitical instability in the Middle East has not yet negated the importance of the region for world oil. To be sure, many industrialized and developing countries made strenuous efforts in the 1970s and 1980s to reduce their dependence on oil imports from the Middle East. And for a short period in the 1980s, the view that "the Middle East may not matter after all" emerged and gained some currency. But oil-import dependence is on the rise again despite the initial successes of conservation and fuel-substitution policies. The compIacency which characterized the second half of the 1980s has been devastated soon after by the new Gulf conflict. In fact, the world's response to the long sequence of Middle East crises has not robbed the region of its significance. On the contrary, every new crisis seems to reveal over again the vulnerability of the world oil system to political developments in the region. Every crisis brings out in sharp relief all the features of the world's dependence on Middle Eastern oil. For these reasons, any serious understanding of major petroleum issues - supply security? O.I.E.S. 1 market market performance, prices, industrial structure, investment patterns, the future place of oil in the energy demand-mix etc - involves an assessment of Middle Eastern political problems. OiI, in some fundamental sense, is a commodity subject to the normal economic laws of supply and demand. But oil, aIso in a fundamental sense, is apolitical commodity. Politics influences supply and demand, fiscal regimes, investment decisions, profits and losses. It generates and alters expectations, these powerful determinants of oil price movements in volatile and nervous markets. It determines policies. And more importantly, we can now see once again, as on so many occasions in the past, that oil is a cause and an instrument of war. In the old days the international oil industry took pride in its understanding of the politics of oil. Major oil companies devoted resources to maintain an expertise on the Middle East, following developments and analysing their implications. They were a source of information and knowledge on these issues. In recent years, a new philosophy that emphasizes almost exclusively the economic and commercial aspects of oil has taken over. The old relationship stemmed from the nature of the relationship between companies and governments in the pre-1973 era. Oil companies were concessionaires that owned assets on the ground. In the late 1970s and 1980s the relationship changed, and the companies became mere buyers of oil from OPEC countries, traders engaged in arm’s length, short-term commercial deals. They probably thought that this changed relationship dispensed them from studying the politics of the region. Why should a trader care about his commercial partner’s politics. Now, the perceptions have become totally different. The current Gulf crisis has brought back politics to the forefront. For this reason we decided to incorporate a study of the political dimensions of the Gulf crisis in our new series of papers on oil issues. Our purpose is to identify and analyse the main features and causes of political instability in the Middle East. Although this paper is about politics, and rarely mentions oil explicitly (except in this Introduction), its main aim is to enhance the understanding of oil, the foremost political commodity. O.I.E.S. 2 The causes of poIitica1 instability in the Middle East are many. We do not propose to draw a comprehensive list however, for this would go well beyond the scope of this essay and cause confusion. The approach followed here is highly selective and focuses entirely on the few factors which have played the most important part in destabilizing the region. To begin with we consider three factors which Middle Eastern countries share with the rest of the third world. The first is economic underdevelopment. All countries in North Africa, the Levant, the Arabian Peninsula and the rest of Western Asia are underdeveloped. Oil wealth has not removed this feature. It may have raised standards of living in parts of the region and created a small number of very rich families. But even those Gulf states where per capita incomes are higher than anywhere else in the world are still underdeveloped. Their manpower resources are limited and poorly endowed with technical and professional skilIs. Their institutions are bureaucratic and inefficient. These economies depend entirely on a single commodity, and lack therefore the diversified productive structures capable of sustained economic growth. The poorer Middle Eastern countries, which account for a very large share of the region’s population, suffer from both these and other problems. High rates of population growth have caused, and continue to cause, greater impoverishment and social tensions. Internal migration, the inevitable consequence of a galloping demography in countries where the rural resource base is exceedingly narrow, is a source of social dislocation and economic frustration. In these countries the educational system and the health and social services are alI failing to keep pace with population pressures. And governments are becoming increasingly unable to manage their economy. They are finding themselves squeezed between the problems arising from the servicing requirements of their foreign debt and those posed by their country’s poverty. Continuing underdevelopment is perceived as a failure by populations which harbour expectations of betterment, expectations sown in by education, the lure of the town, the money remitted by migrants working in oil countries, the television image and the allintruding symbols of the consumers’ society. The frustrations born of a sense of economic failure, which in the eyes of the frustrated means political and social failure, are one of the many ingredients of extremism and instability. Underdevelopment is also a fertile ground for the emergence of dictatorships. The second factor of political instability in the MiddIe East, as in Africa and in the Indian subcontinent for example, relates to the drawing of political boundaries by the imperial powers either at the time of colonization or at the time of independence. In the Levant, the British and the French divided parts of the Ottoman Empire into countries - Syria, Lebanon, Iraq, Transjordan, Palestine - in ways which reflected partry local historical realities and partly compromises between the rival ambitions of the European powers. In the Arabian Peninsula the British drew peculiar, and almost everywhere, very imprecise boundaries between the small emirates of the region, and between the emirates and their big neighbours - Iraq and Saudi Arabia. O.I.E.S. 3 Once a new country has been created, be it with artificial or very ill-defined borders, it tends to acquire very quickly all the features and attributes of a nationstate. Lebanon, Syria, Jordan, Iraq, Kuwait, Qatar, all of these countries are nation states. The native populations that live within the borders identify themselves as Lebanese, Syrians etc. even if some ethnic or religious communities have been artificially divided between two countries. Both Iraq and Iran recently learned this truth to their chagrin. Iraq thought that the "Arab" populations of Khuzestan in Iran would rally to them at the beginning of the war. They did not, and fought the Iraqi invaders instead. The Iranians thought that the vast Shia population of Iraq would welcome their Shia brothers from Iran. They did not, and fought the Iranians instead. The people of Khuzestan were Iranian first, the Shia of Iraq were Iraqi first. And when Iraq invaded Kuwait this year, all Kuwaitis whether in opposition to their government, or dienated from their country because of its divisive nationality laws, rallied around the Emir as a symbol of the unity and integrity of Kuwait. It is always important to remember that the Middle East now consists of nation states which provide populations with their first identity. It is not possible to divide these countries up, it is not possible to merge them into larger entities without much bloodshed and destruction. This is now visible to aII with the annexation of Kuwait by Iraq which is in fact a process of wanton devastation. This has been visible for a while to those who want to see, with the Syrian presence in Lebanon, a presence which aims at annexation but which has turned out to be for more than ten years a very degraded form of miIitary occupation. And there is a lesson there reIating to the long-run prospects of Israel's survival in the region. Although a country, once established, quickly sets hard and becomes a nation state, the artificial features of its creation do not usually die away. They constitute, and for a long time, potential sources of both internal unrest and conflict with neighbours. The problem of illdefined borders is dso a dangerous cause of trouble. Border .disputes have plagued relationships between pairs of neighbouring countries in the Middle East, particularly in North Africa and the Gulf, since their emergence as independent states. The problems tend to be more acute when oilfields straddle these imprecise boundaries. RecaIl the longstanding disputes over Buraimi between Saudi Arabia and Abu Dhabi, recent military incidents involving Qatar and Bahrain, to give just two examples out of Iists involving dozens of cases. The Iraq-Kuwait border dispute which played such an important role in the August 1990 events is but one instance of a very widespread problem which is at the root of much regional instability. The third factor of political instability, in this set of causes that is not specific to the Middle East but extends to most of the third world, relates to the role of the superpowers in the post Second World War era. The USA was determined to prevent the spread of communist parties and regimes in the third world, and favoured therefore military dictatorship or right-wing traditional governments. The USSR also supported communist dictatorships as well as noncommunist strongmen who happened to be allies. For almost half a century all the important outside powers (for Britain, France and others have much to answer on this score) have reinforced, if not positively induced, nondemocratic tendencies that arise from social and economic underdevelopment, the domestic conflicts that plague the post-colonial third world state, and a host of other O.I.E.S. 4 internal factors. Democracy does not blossom easily in a third world country. The first step in the very long process that leads to the establishment of democratic institutions is the emergence of a national consensus on important political issues and of rulers or leaders legitimized by public support. It is worth noting that the great powers have always reacted antagonistically, if not violently, to any leader who embraced national causes. Any leader who legitimised his rule with his people by embracing deep national aspirations was confronted at the very time when he was enjoying legitimacy. The honeymoon between an emerging dictator and his own people may be a fleeting moment. It is during this moment that the great powers usually tried to remove or villfy the leader – Mosaddeq in 1951, Nasser in 1956, King Feisal in 1973, Khomeini in 1979. But the dictators who never enjoyed the support of their people were never seriously challenged. They only incurred the powers’ wrath when they embarked on foreign adventures without the support of their people - like Qaddafi after twenty years of unpopular rule when he pushed his luck too far with terrorist attacks, and Saddam Hussein, cajoled so long as he was fighting Iran, when he turned his guns onto Kuwait. Of course, the problem is that the legitimacy of a ruler in a post-colonial state begins with the issues that top the national political agenda. These issues always relate to the colonid heritage: the ownership of assets such as oil (Mosaddeq) or the Suez Canal (Nasser), removal of pro-Western or pro-Soviet regimes (Khomeini, Afghanistan), the conflict with Israel (all Arab states). By definition these issues involve major confrontation with the West, and in some cases with the Soviet Union. Thus the moment of internal legitimacy is inherently and inseparably the moment of confrontation with the outside world. Dictatorships may achieve, at the cost of coercion and at the expense of basic human rights, a period of apparent internal stability. But dictatorships are like lids tightly secured on the top of boiling pans. The pressures are ody contained for a while. When the lid can no longer hold securely, explosions (like the Iranian revolution) with considerable side effects occur. Dictators also cause instability because their power tends in the end to affect their judgement and their wisdom. Power becomes very quickly absolute power; absolute power becomes arbitrary power. The exercise of power shuts the dictator’s ears: he does not listen to advice, and even if he wishes to listen he will rarely find an adviser or a messenger willing to convey bad news or to contradict the master. The exercise of power by unchallenged individuals can lead to adventurism and therefore cause considerable instability. The West and the Soviet Union have encouraged and supported unpopular and illegitimate regimes in the Middle East. They have been paying and will pay in the future a very heavy price for this policy. They did it because of the cold war, and because they have economic and political interests in the region which go against the national aspirations of the countries and their population. The cold war has ended but the interests which induce great powers, continuing interference in Middle Eastern affairs are still there. Their names are Israel, oil and the market for arms. This leads us to the discussion of two major causes of instability which are specific to the Middle East. 0. I. E. S. 5 The existence of Israel is a fundamental cause of instability. Israel is a small foreign body artificially inserted in a large living organism, and kept there with the application of tremendous force. The organism wants to reject it but has consistentIy failed to do so for more than forty years. This failure has traumatized the organism. Hence the deep political frustrations which cause extremism and terrorism on both sides of the conflict, in the Arab world and in Israel. Everybody may unite in condemning terrorism and political extremism and their excesses. Everybody, you and I, could become one day the innocent victims of an incident. But this should not blind us to the real and deep significance of the phenomenon: it is an expression, sick as it may be, of despair. More tragically it is the brutal expression of the fundamental nature of the Arab-Israeli conflict: that the Arab world cannot destroy Israel but can deny it forever true recognition; and that Israel can ensure its immediate security with the force of arms and the exercise of vioIence, but cannot through these means obtain the true and permanent security that derives from mutual recognition. There is no solution to this impossible state of affairs. And in their mad ways the terrorists on both sides are merely telling us that the contradictions inherent to the Arab-Israeli conflict do not appear to have a rational solution. Madness often involves the revelation of some unpalatable truth. The existence of Israel has destabilized the region both through the emergence of extremism and through open wars. It has provided further excuses for the establishment of dictatorships and coercion (the argument being that strong regimes are needed to stand up to the outside enemy). It has frustrated very deepIy every Arab because of the failure of the Arab nation and all its governments to solve the Palestinian problem and because of repeated military defeats in the confrontation with IsraeI. This has resulted in alienation on two important counts. Alienation of the people from their "incompetent" governments, alienation of the self from the self. The former has made most, if not all, governments in the region illegitimate in the eyes of their people; the latter has induced a search for a new basis on which to build self esteem and reconcile through a solid bridge of values the alienated parts of the self. Hence, the deIving in the past in a search for roots and values in religion and the culture. Hence the emergence of fundamentalism which is not the initial cause of instability and frustrations but its consequence. In its extreme forms (see above) fundamentalism at the fringes may also become destabilizing in turn. This is how vicious circles emerge and trap those involved in developments where nobody gains. The factor that deserves a final mention is oil. Oil has been a'source of both wealth and corruption. It has induced, after 1973 and 1979, rising expectations for rapid and significant betterments which the oil economies could not deliver. This phenomenon has played a partial roIe in the events leading to the Iranian revolution. To be sure, oil wealth has benefited more people in the Middle East than generally recognized but it has caused considerable social tensions between those who obtained a little and those who acquired a lot, be it countries or different groups in the same country. Because it is a major source of wealth, oil elicits envy and calls therefore for protection. The arms race in the Middle East, which recycled very wastefully a large part of the oil income, was not entirely due to the Arab-Israeli conflict. Many countries also wanted to protect their oil assets from neighbours. The Iraqi aggression on Kuwait was partly motivated by the oil factor. O.I.E.S. 6 Oil also aggravates the separation between governments and their subjects because it provides governments diredy with all their required revenues. The oil state has no need to tax citizens or residents; the absence of taxation removes a possible instrument of accountability. Much worse, the population becomes dependent on the largesse, direct or indirect, of the state. The citizens become intermediaries, rentiers or courtiers. Deep down they may despise and resent those who govern their destiny and on whom they depend for handouts. In these societies there is dependence but no real allegiance. Oil corrupts, not only because many deals and most contracts and activities arising from the expenditure of oil revenues involve bribes and commissions, but because the basic nexus between work and reward is broken throughout large segments of society in an oil economy. Finally oil brings in foreign intervention. So long as the Middle East remains the major source of incrementd oil supplies it will live under the threat of foreign miIitary incursions. Foreign troops may well be called in by Middle Eastern states themselves. The fact remains that these calls would not be heeded if oil, among other things, were not at stake. Compare, for example, the level and nature of US military intervention in the Lebanon in the early 1980s with the scale of their response to the arrent Gulf crisis. The destabilizing forces which operate in the Middle East originate both from within and from outside. There are important interactions between external and internal factors. There is much that the West can, but most probably will not, do to unlock the vicious circle. The essential items on the agenda are the settlement of the Palestinian question, the encouragement of democracy, a disarmament plan for the whole area, including Israel, and substantial economic aid. This is a tall order indeed. Furthermore, this set of actions constitutes the necessary, but by no means sufficient, conditions of stabilization. Much has to be done at the same time by the Middle Eastern countries themselves. O.I.E.S. 7 3. IRAQ AND KUWAIT The Iraqi invasion of Kuwait cannot be justified. Very few Arabs, if any, really approve of the forceful annexation of an Arab country by another. Where Arabs differ is in their assessment of the greater evil: is it Saddam Hussein’s aggression on Kuwait or the massive return of foreign forces on Arab soil for, as many think, a future aggression on Arab countries? Although it is impossible to justify the rape of Kuwait, one still needs to understand the phenomenon and explain the actions and motivations of all participants. Moral outrage does not dispense us from the duty to analyse. Clues to President Saddam Hussein’s objectives and behaviour may be found in his formative years when he was a young political exile in Cairo in 1959. It is said that he used to avidly read any book in Arabic he could find on Stalin and his regime and that he developed an admiration for Nasser’s pan-Arab aspirations. Readings about Stalin provided many of Saddam’s ideas on how to rule and controI Iraq. And the ambition of becoming the leader of the Arab nation explains much of his foreign policy. In 1979 he led the Arab campaign to ostracize Egypt after Camp David. This was his first bid for the leadership of the Arab nation. But he had little to offer then. The fact that Egypt’s defection created a vacuum was not sufficient to consecrate him as the recognized leader of all Arabs. The Iranian revolution provided him with an important opportunity. He thought that a quick and victorious war against Iran would establish him as the saviour of the Arab Gulf countries threatened, as they saw it, by the hegemonic intentions of the Shia revolution. He was told by exiled Iranian generals, and probably by the Americans, that the Iranian army was in a very poor state and could be destroyed in a few weeks. The war lasted eight years and ended with a very ambiguous Iraqi victory. After the Iraq-Iran war Saddam Hussein, always pursuing the dream of Arab leadership, probably thought that he needed a wider resource base to achieve his ambition. Hence the temptation to attack and annex Kuwait. He may also have been prompted in this direction by a sentiment of defiance towards the West. Saddam Hussein, as indeed many Iraqis and some Arabs, began to believe soon after the end of the Gulf war that the West, having contributed to the defeat of Iran, was going to turn its attention to Iraq and try to weaken it. In 1988 the West suddenly became outraged about the use of gases (nobody had mentioned in the past their earlier use against Iranians and Kurds); in 1989, there was much talk about the dangers of Iraq’s military power; in 1990 much fuss was made about a strange device which may or may not have been a super-gun, an unlucky journalist who may or may not have been a spy, and some little clocks which were supposed to detonate nuclear bombs that Iraq, by all accounts, would not be ready to manufacture for many years. More worrying for Saddam Hussein was the state of Iraq’s economy burdened with a large foreign debt; the stem refusal of bankers, sovereign creditors, foreign investors to heIp; and the continuing weakness of the price of oil caused, as then widely alleged, by overO.T.E.S. 8 production in Kuwait and the UAE. There is no doubt that, rightly or wrongly, Saddam Hussein believed that he was the victim of a plot. It is said that a typical trait of his character is to confront and kick when he feels threatened or insulted. The invasion of Kuwait was therefore a complex act involving a gesture of defiance, an attempt to grab riches for redistribution to other Arabs in a bid for leadership, and a hope that by shattering the status quo in one part of the Middle East forces would be set in motion to shake the stalemate on another front, that of the Arab-Israeli conflict. An analogy may help to understand Kuwait’s situation. Kuwait is a Switzerland without mountains. Like Switzerland, Kuwait is a small country completely surrounded by three regionaI powers (Germany, France and Italy in one instance; Iran, Iraq and Saudi Arabia in the other). Switzerland succeeded in keeping them at bay partly because of a neutrality pact and largely because it was able to defend itself by resisting with guerrilla warfare in the mountains. In the early 1960s Kuwait sought to protect its independence by emphasizing both neutrality and friendship with all Arab countries. The enlightened Kuwaiti government of the 1950s and early 1960s understood that some form of internal democracy and a wide network of good relationships with other Arab countries were their best protection . . . in the absence of mountains. Kuwait’s Arab and foreign policy did not maintain this same direction in the late 1970s and in the 1980s. Those in power grew tired of the claims made by neighbours and many others on their wealth. The dictum that there is no security for Kuwait outside the framework of Arab security, interdependence and alliances ceased to be understood. Kuwait was successful both in its financial and oil policies and grew confident, despite the disaster of the Souq a1 Mannakh. The new generations in power did not have direct experience of the poverty and difficulties of the pre-oil era. Oil wealth shielded them from immediate problems and probably obscured their perceptions about the nature of their situation and its structural weaknesses. It is possible that even the old wisdom would not have protected Kuwait from Saddam’s ruthless ambitions and horn aggression. But now that the tragedy has occurred the question of how best to protect Kuwait’s independence, how to ensure its survival and prosperity in the long run, is posed in very stark terms. Kuwait will always be the object of a neighbour’s envy. Today it just happens to be Iraq, but only recently Iran was perceived as a threat. And on the other side lies quiet and friendly but powerful Saudi Arabia. In this tragic affair both Iraq and Kuwait miscalculated. Saddam thought that he couId get away with a blatant act of aggression. Or perhaps he thought that he was soon going to be attacked by Israel backed by the USA and decided to kick first where it was the easiest. Both cases imply huge miscalculations. Kuwait perhaps believed that it was stronger and better protected than warranted by its situation. Alternatively, it may have known its weaknesses and decided to conceal them and bluff its way through by bargaining very hard. It may have felt that concessions to blackmail would incite further blackmail. The miscalculation lay in discounting the 0.LE.S. 9 possibility of an all-out invasion. The purpose of this analysis is not to apportion blame; there are no blames to be apportioned. Its main aim is to describe the situation in which Iraq and Kwait found themselves, and their respective perceptions of the situation in which they found, or had their respective perceptions of the situation in which they found, or had put, themselves. 1.3. Oil and Gas geopolitical trends in aftermath of the Irak war (2003) New trends in energy geopolitics constitute a major impacting factor for energy security. These trends are following: regionalization of oil trade and globalization of gas trade. Those trends are explained in the background paper of Prof. G. Luciani from European University Institute (2004). G. Luciani, Third Annual Conference on the Geopolitics of Energy, 2004: The fallout of Iraq Speaking at our second Geopolitics of Energy conference one year ago, Claude Mandil commented on “The Geopolitics of Oil after the Iraq War”. At that time, the vision of those that expected the war to mark a turning point in global oil affairs – allowing for the privatisation of Iraqi oil, the return en masse of international Oil Companies (IOCs) to the Iraqi upstream, a quick build up of Iraqi production and exports, a period of low prices and possibly even the marginalisation of Saudi Arabia – had already lost much of their credibility. Mandil sounded a cautious note: “The recovery of Iraqi production remains one of the greatest uncertainties currently affecting the oil market. Iraq’s reserves are the third largest in the world after Saudi Arabia and Russia. Production potential is enormous. Iraq has proven reserves of 78 billion barrels and an estimated 108 billion barrels of probable reserves. Of 73 discovered fields, only 15 have been developed. Despite this vast endowment of resources, Iraq’s performance peaked in 1979 when production reached 3.5 million barrels per day. Production levels fell, affected by the political instability resulting from the Iran-Iraq War and the Gulf War. Lack of investment and poor maintenance in the intervening years further strained the country’s oil infrastructure; bad management and lack of spare parts may have damaged reservoirs. In 2002, output averaged 2.1 million barrels per day under the UN Oil-For-Food program. Iraq’s sustained prewar production capacity was estimated at 2.8 million barrels per day. Yet production was halted during the recent war and is returning slowly. (…) It will take time before Iraq will surpass 2mbd. Although a limited number of wells were set on fire, looting has resulted in damage to surface installations and loss of data; and it continues. The results of poor management and maintenance during the 1990s combined with insufficient security at oil facilities and questions regarding the state oil company’s (SOMO) legal status may prolong the recovery beyond the end of this year.” But notwithstanding this caution, Mandil’s expectation one year ago – in line with that of most other commentators – was still that Iraq would exert downward pressure on prices, to the point that possibly OPEC’s target band would turn out to be indefensible: “In the long term, the world will need Iraqi oil – and Iraq will need oil export revenues to fund its development. (…) As older fields in the North Sea and elsewhere are retired, Iraq’s plentiful, relatively low-cost reserves will become increasingly important. (…) In the shorter term -- barring any unforeseen events -- consumers should be assured that oil supplies are ample, even if Iraqi production recovers more slowly than initially anticipated. Assuming that Russian production will increase over the near term, a resurgence of Iraqi exports will likely pose some challenging decisions for Dr. Silva Calderon and his colleagues at OPEC. Because oil prices have been held at an artificially high price by the OPEC price band, higher cost producers and nonconventional oil have gained a stronger position in the market. The re-entry of Iraqi oil could create downward pressure on prices, forcing OPEC to act in order to maintain their price band – but such action comes at a cost. OPEC will lose additional market share or revenues, or both, or must accept a price below the OPEC band at a level compatible with a stable market.” OPEC’s dilemmas OPEC’s understanding of the market was not altogether different. The fear of excess supplies and soft prices continued for the rest of 2003, although very little softness was in fact apparent in the markets. OPEC reacted to the perceived danger by deciding to cut supplies in September 2003 and then again in February 2004. After the February meeting, Saudi oil minister Ali Naimi, interviewed by Walid Khadduri on MEES, explained: “In September, we decided to reduce the ceiling from 25.4mn b/d to 24.5mn b/d – a 900,000 b/d reduction. The market, though, behaved otherwise which means that the data in front of us was either inaccurate or it did not include all the future events. And so instead of reducing the 900,000 b/d, we actually increased production beyond the 900,000 b/d to keep the market from overheating. This was done in an informal manner, but by agreement of course. We looked at it in December and we thought it’s OK, let’s leave the ceiling and the leakage continued. Now at this meeting, OPEC data says there will be a reduction in demand or surplus of 3mn b/d in 2Q. The IEA data also indicated a 3-4mn b/d reduction in demand or surplus of that amount; so the quandary was: what do you do, do you wait until you have a huge build-up in inventory and have a precipitous price fall or do you take a preemptive, proactive course of action?” The February decision, although in fact never fully implemented (see Table below for MEES’s estimate of OPEC production levels in recent months), sent prices skyrocketing. In June OPEC had to formally reverse its decision of four months earlier, and indeed Saudi Arabia started producing at a level not seen since 1990. These events are indeed extraordinary in many ways and demonstrate how poor is our understanding of global oil demand and supply even in the very short run. Weather forecasts have now become more reliable than oil demand/supply/market predictions. Paul Horsnell, in the paper which he presented to the International Energy Forum ministerial meeting in Amsterdam, has presented two very interesting charts showing how expectations concerning demand and supply for a given period (the fourth quarter of 2003) evolved over time. Demand estimates were progressively increased, from mid 2002 to early 2004, gaining fully 3 million b/d, or about 4 per cent. Non-OPEC supply estimates were progressively reduced, losing about 1 million b/d. The difference, needless to say, is quite substantial and much larger than any swing in OPEC quotas. This points to several important questions. Firstly, should we conclude that we have a systematic tendency to underestimate demand growth and overestimate non-OPEC supply potential? Secondly, is it conceivable that OPEC may ever succeed in defending its stated target band by proactive quota management in the face of such blindness about the even close future? Thirdly, have we entered a new phase in the evolution of the global oil market, characterized by a higher price equilibrium (i.e. the band must be shifted upwards)? The difficulty experienced in anticipating demand growth is very surprising, because demand estimates use econometric parameters established on the basis of a very large number of observations. These parameters have a high degree of statistical reliability, and point to relations that are stable over time. Of course, there is the China factor: the Chinese economy is one that experiences very rapid structural change, and is therefore difficult to capture with econometric techniques. We are constantly surprised by China in many ways, and with respect to Chinese oil import requirements the matter is complicated by the fact that they are incremental, and grow much faster than demand. There is little that can meaningfully be added at this stage, except to note that the impact of Chinese demand on the global oil market over the next five to ten years (not to speak of further into the future) remains very controversial and clouded in uncertainty. Prospects for non-OPEC oil The supply side is more interesting. Here we have two diametrically opposite readings of the situation. One would insist on the random and unsystematic concentration of “bad news” that characterized the last 12 months, and which is unlikely to be extended over time or repeated in the future. The first piece of bad news was of course Iraq: the political unrest, the looting and sabotage, the increasing realization that massive investment will be required to restore or increase Iraqi oil production capacity and political conditions for that will not be realized for another two years at least (i.e. when a new constitution is approved and a democratically elected government with full legitimacy is in place – if we believe the current, and very optimistic, official calendar of things to come). But there have been more bad news, from Venezuela (where the US and others are hoping that Chavez might eventually be democratically unseated) to Nigeria and other smaller producers. These have all one thing in common: they can be categorized as political interference in industry affairs, i.e. manifestations of irrationality that will eventually be put right. In contrast, the second approach points to other, more genuinely oil-related ominous developments. The one development that caught the eye of the majority of non-expert observers is the re-categorization of Shell’s reserves, leading to a 20% downward adjustment. However strictly speaking this shift is not so terribly important, because those reserves are not lost – simply not considered proved any longer; and we all know that the concept of proved reserves is quite subjective to say the least. Yet there was more: reports of declines in mature fields much steeper than expected in numerous areas – ranging from Oman to the North Sea and the US lower 48. In other areas – e.g. the Caspian, delays were announced in the bringing on stream of key new fields – notably Kashagan. In the Barclays Weekly Oil Data Review of 5 May, Paul Horsnell wrote: “We have been using very downbeat forecasts for non-OPEC growth this year, with no net growth forecast outside Russia for the second straight year and for the third year out of the past four. Our belief is that decline rates in mature areas are higher than has been anticipated, and that the drag from the mature areas is negating the net growth elsewhere. However, now that the flow of data for 2004 for mature areas has started, the picture that is emerging is dramatically weaker than even our prior expectations. Over the past week, new oil production data has been released by the UK and US, and both sets were far worse than expected. In February, the combined year-to-year decline in production in the UK and US alone amounted to an extraordinary 757,000 b/d. The UK reported a February output level that was 411,000 b/d lower than a year ago, following a 240,000 b/d year-to-year decline in January. The US numbers show a 236,000 b/d year-to-year decline in March following a 346,000 b/d decline in February.” And on the 9th of June he added: “We expect that the oil market will again move above $40/B. The only question is whether this happens due to some turbulent geopolitics and short-run gasoline market dislocations at a time of painfully limited spare capacity, or whether it happens further down the line due to the grinding of some very ferocious fundamentals. The further down the line you look, the more difficult it is to see how enough production capacity can be brought on in time.” So, there was a revival of talk about Hubbert’s curve and the “peak”. At the November ’03 meeting of the Oxford Energy Policy Club a majority of the opinions expressed seemed to be quite pessimistic about the prospect of continuing growth in non-OPEC supplies. On the opposite side, Daniel Yergin, writing on the New Your Times on April 4, predicted that it would be another 50 years before any problem of oil scarcity arises. And in the paper he presented at the Amsterdam ministerial of the International Energy Forum, Olivier Appert has written: “Among the more pessimistic experts, some believe that world production of conventional oil has already peaked, others that this will happen before 2010. The optimists - especially those basing their forecasts on data from the U.S. Geological Survey – say that production should peak in 2020 or later. These divergent opinions rely on different estimates of the ultimate recoverable reserves of conventional oil. But future oil resources will not be limited to conventional oil. By mobilizing other resources (exploiting nonconventional oil resources, improving the recovery of oil in place to add resources, etc.), the production peak can be postponed.” The debate on Saudi reserves and production prospects It is in this context that the controversy over Saudi oil reserves erupted. For years, the EIA has published estimates of “required” future Saudi production capacity that seemed quite unrealistic: the latest International Energy Outlook projects Saudi capacity at 14 million b/d in 2015, 18 mb/d in 2020, and 22 mb/d in 2025 (reference case). (See also EIA’s Saudi Arabia Country Analysis Brief published in June 2004). And that is in a context in which non-OPEC production capacity is assumed to continue growing until 2025 – no peak in sight. Does Saudi Arabia have the required resources? Do they intend to increase their production to such an extent? The controversy about Saudi oil reserves and prospects of future production increases was sparked by Matthew R. Simmons. At a debate organized by the Center for Strategic and International Studies (CSIS) in Washington on February 24, 2004, he argued that Saudi Arabian oil production might soon be peaking, because of expected growing problems with the country’s key long-producing oilfields. In one of his concluding slides, he argues: The entire world assumes Saudi Arabia can carry everyone’s energy needs on its back cheaply. If this turns out to not work, there is no “Plan B”. Global spare oil capacity is now “all Saudi Arabia”. Representing Saudi Aramco, Mahmoud M. Abdul Baqi and Nansen G. Saleri argued that Saudi production policy has been very conservative, and the Kingdom could increase its production easily. The argument was reiterated on April 27 at the same venue by the Saudi Minister of Petroleum, Ali Naimi, and the CEO of Saudi Aramco, Abdallah S. Jumah. Jumah had the following to say (and I quote from the speaker’s notes published on the CSIS web site, which include some interesting detail which is not in the transcript): “Saudi Aramco’s current production capacity is 10 million barrels per day, including some 2 million barrels of surplus production capability. This capacity has been tested and put into effect as required. Depending on global market demand, we can produce and sustain the 10 million barrels a day level for more than 50 years, by relying primarily on our already proven reserves. Further reserve expansion efforts will certainly push the plateau beyond 50 years. (Ad Lib: Only minimum use of the probable and possible reserves will be required to sustain the 50-year plateau.) [Note: Minimum means only 15% or 15 billion barrels use of probable and possible reserves.] [Note: These figures place the probable and possible reserves at about 103 billion barrels. Considering the 80 billion barrel figure referenced earlier, the 103 billion barrels include additional recoveries from the existing fields, which are not a part of the 80 billion barrels number, enhanced recovery processes and other reserve expansions referenced below]. We have developed a range of long-term crude development scenarios that call for raising production to 12 or 15 million barrels per day, depending on demand growth. We are confident that we can develop and sustain production at these levels for at least the next half century by utilizing a higher proportion of Saudi Aramco’s probable and possible reserves. (Note: For 12 MMBD and 50 year plateau, 34% or 35 billion barrels use of probable and possible reserves is required. For 15 MMBD and 50 year plateau, 68% or 70 billion barrels transfer of probable and possible reserves to proved is required). Potential also exists for extending the 50 year horizon for these higher production levels by further expanding reserves. Such expansion will come from a combination of oilfocused exploration that leverages Saudi Arabia’s rich hydrocarbon potential; the prudent use of technology; well-conceived reservoir management practices; and incremental oil recoveries through the application of enhanced recovery processes.” The point is therefore that sustaining production at 15mb/d over 50 years would require very substantial draw down of reserves. Higher production levels, as hypothesized by the EIA, would not be sustainable for such an extended period of time. But would it be wise and prudent for Saudi Arabia to greatly intensify the rate of exploitation of its reserves, considering that oil remains the most important asset for the long-term future of the Kingdom? Furthermore, the Saudi rebuttal of Simmons’s argument proves that Saudi Arabia can indeed increase production, but does not negate his last point quoted above, i.e. that Saudi Arabia possesses almost all available spare capacity in the world, and any talk of increasing OPEC production means in fact increasing Saudi production. When the decision was made to increase OPEC quotas in June 04, Saudi Arabia was the only country with any effective unused capacity left: everybody else was already producing at capacity. In this context, the centrality of Saudi Arabia, and of US-Saudi relations, can hardly be underestimated. Following September 11, US-Saudi relations have entered an extraordinarily difficult period, which combines a tendency to prejudiced Saudi-bashing to well-intentioned advice and the perception that Saudi stability can only be guaranteed in the long run if taboos are overcome and painful reforms are undertaken. Russian production prospects and political uncertainties Asserting the centrality of Saudi Arabia does not necessarily mean negating the increasingly important role that Russia is playing. Indeed, Russian production has continued to increase steadily, and might have grown even more, had it not been constrained by logistical bottlenecks. But Russia’s increase simply compensates for declines elsewhere (in the UK and USA), meaning that incremental demand still needs to be met by OPEC, i.e. Saudi Arabia. Furthermore, how far can we expect Russian production to grow? Some observers have exceedingly optimistic expectations about Russia. Julian Lee of the CGES, for one, presented the two slides reproduced below at a conference organized by CERI in March 2004. One cannot fail to note that the extrapolation represented by the “second curve” (the red curve) is quite a bold one. Towards regionalisation of international oil trade? These controversies are interesting not just because they indicate that further developing Russian exports may not be a straightforward affair; but also because they might be interpreted as pointing to growing regionalisation of the international oil market. While sufficient arbitrage will always exist to guarantee that petroleum prices are equalized globally, net of transport costs, most of the oil is in fact likely to move on short haul, establishing closer ties of interdependence between pairs of regions. Thus, if we consider the likely evolution of oil exports from North Africa, the Caspian and Russia, we come to the conclusion that Europe’s reliance on oil from the Gulf is bound to decline. The US will become ever more of a dominant factor in the Atlantic basin, while Gulf oil will increasingly be directed to East and South Asia. The exception in the Gulf is likely to be Saudi Arabia, which might continue to ship significant volumes of oil to the United States, more out of political than commercial motivations. As mentioned, Russia would very much like to do the same, but finds the goal considerably more difficult to reach. If we accept the inevitability of the tendency towards regionalisation – which might be strengthened by rising transport costs and the preference recently expressed by the European Union for transporting oil by pipeline rather than ship whenever possible, for environmental reasons – we should conclude that the EU has good reasons for concentrating its attention on developing a cooperative relationship with Russia, the Caspian and North Africa, while devoting much less attention to the GCC. But is this a sensible approach, in the light of the noted centrality of Saudi Arabia to global supplies? In the case of the United States, the tendency to regionalisation is manifested especially in calls to intensify relations with West Africa, primarily in order to reduce dependency on the Gulf. Because this is not enough, proponents of reducing dependency on the Gulf point to the need for having access to Russian and Central Asian oil, notwithstanding the negative logistical implications. So we have the paradox, that while the European Union speaks of possibly eliminating petroleum carrier traffic from the Mediterranean (see “Preliminary Discussion on Options Aiming at Diminishing Risks in the Maritime Transport of Oil and Oil Products”, chapter 5 of Technical Annex 1, “Initiatives on the Development of Infrastructure Projects of Common Interest”, in Annexes to the EuroMediterranean Ministerial Conference of Rome, December 03), the US presses for Russian and Caspian oil to be available at deep water ports, for loading on VLCCs bound for the opposite side of the Atlantic: the potential for conflict there should be underestimated. Finally, regionalisation also means rapidly growing ties within Asia. Especially if Russia deliberately plays down its ties with China, and takes east Siberian oil to the Pacific, the result will be that Gulf producers will focus on exporting to the major Asian markets even more than they already do. In the eyes of Gulf producers, the Asian markets offer the additional advantage that their transformation capacity is much less developed, meaning that there is scope for exporting refined and/or petrochemical products, to satisfy a demand that will systematically outpace domestic supplies. The emergence of an “Asian block”, whose political priorities and values are very much different from those of either Europe or the United States, may significantly alter the interplay of political and economic factors in the international oil industry. Major developments in international gas trading As the oil market is moving towards regionalisation, the opposite is happening in the gas market. Historically, the market for gas has been regional rather than global, with three main trading regions being North America, Europe, and the Far East. There has been little arbitration between regions (indeed, also within regions, except for North America), because of the absence of transportation capacity. This has led to widespread price segmentation and persisting differentials between regions. However this situation is now rapidly changing, due to the emergence, on the one hand, of the United States as a major importing country, “pulling” gas from all directions, not just from within North America; and, on the other hand, of Qatar as the new global source, based on massive investment in new LNG projects aiming at the US and European markets, in addition to Far Eastern ones. Thus, although the ability to redirect gas from one region to another will remain limited some arbitraging will take place through adjustments in the origin of marginal US imports and the direction of marginal Qatari exports. According to BP (a major producer of gas in the US) “US gas production has recently plateaued despite ample, available domestic gas resources, because they are becoming increasingly costly to recover”. The decline in domestic production, coupled with limited import capacity has led to a shift in the average level of prices. Although the spike of 200/1 remained an exception, Henry Hub prices over the last year never fell below $4.50 per MMBTU, a level that makes LNG import projects quite attractive. Consequently, it is now expected that US LNG imports will increase very rapidly (see the table from EIA’s Annual Energy Outlook), leading to concerns about security of supply. Dan Yergin, for example, had this to say (at the same CSIS gathering on April 27 primarily devoted to Saudi Arabia): “U.S. really is on the threshold of a new era in natural gas, and this has major implications. In a sense the U.S. is today in natural gas where it was 30 years ago in oil, about to go from being a minor importer to being a major importer, and a decade from now the United States could literally overtake Japan as the world's number one importer of LNG. That will add to the dimensions of energy security that we talk about, a host of new energy relations, and give a larger dimension to the conversations.” The importance which is attributed to ensuring abundant LNG supplies to meet the growing US requirements was manifested by the December 2003 LNG Ministerial Summit convened by the US DOE. The Summit’s objectives included: “Reveal innovative approaches to meeting the challenges facing the growth of US LNG” Provide “a perspective of expected LNG market growth over the next two decades”; Identify “significant US market and investment opportunities”; Explore “concerns and issues that producing nations need to discuss to ensure a successful and fast-growing US LNG market”. In this same context, we can also point to the Geopolitics of Natural Gas Study, jointly launched by the Program on Energy and Sustainable Development at Stanford University and the James A. Baker III Institute for Public Policy of Rice University. The Study generated a set of papers on several major historical pipeline case studies, plus a paper by Peter Hartley and Kenneth B. Medlock III entitled “A Global Market for Natural Gas? Prospects to 2035”. The latter strongly argues in favour of the globalisation of the natural gas market – dominated by Russia on the supply side and the United States on the demand side: “According to the Rice World Gas Trade Model, in a global natural gas market events in one region of the world will influence all other regions. (…) The model also suggests that Russia will play a pivotal role in price formation in a more flexible and integrated global natural gas market. Eastern Siberian gas begins flowing into Northern China in the middle of next decade. Toward the end of the model time horizon, specifically 2025-2030, Chinese growth pulls gas from both Western Siberia, via pipeline through Eastern Siberia to Northern China, and from Kazakhastan through Western China. Sakhalin production serves LNG markets as well as Japan via pipeline around 2010. Some Sakhalin gas also moves toward South Korea via pipeline through Nakhodka. Throughout the model period, Russia is a very large supplier to Europe via pipeline, exceeding 50% of total European demand post 2020. Strategically positioned to move large amounts of gas both east and west, the presence of low cost Russian pipeline gas in both Asia and Europe will serve to link Asian and European gas prices. The model also suggests that Russia will eventually enter the LNG trade (via Barents Sea), providing an additional link between gas prices in North America, Europe and Asia. Russia benefits not only from its location and size of resources but also because it was one of the first major gas exporters and has access to a sophisticated network of infrastructure already in place. Other resource-rich players like Iran and Saudi Arabia must bear the fixed costs of market entry due to the lack of existing infrastructure. Early entry would drive down prices and lead to inadequate returns on investment. Therefore, entry must be delayed until world demand --in excess of alternative sources of supply-- is large enough to accommodate those incremental supplies. Consequently, Iranian and Saudi Arabian LNG supplies do not enter the world market until after 2020. Another factor limiting exports from both countries is domestic demand growth in part to facilitate oil production. From the point of view of consuming regions, preliminary modelling results suggest that the United States market will be a premium region pulling in gas supplies from around the world.” In the immediate, however, it is Qatar, rather than Russia, which is emerging as the leading global supplier. After a gestation that has lasted some three decades, Qatar’s North Field is poised to finally become a major factor in the international gas industry. The globalisation of international gas trade will therefore be made possible by the expansion of LNG trade. However, we should keep in mind what has been noted by van der Linde & Stern (in the paper they presented at the IEF Amsterdam ministerial meeting), i.e. that in any case LNG growth cannot possibly be sufficient to meet the expected growth in global demand, meaning that pipeline gas will need to continue growing - but little progress has been achieved in establishing new pipelines, as political problems continue to prevent the implementation of various projects. “In the period to 2020, LNG trade is expected to grow manifold, with the most optimistic projections assuming a quadruplicating of LNG trade to around 600 bcm/a. This will fall considerably short of the projected growth in demand of 1700 bcm (IEA). The difference, consequently, will have to be met by cross-border piped gas. Nevertheless, the current development of international gas pipelines yields a less dynamic perspective with regard to the actual commitment to new investments. Many conceptual opportunities are being discussed and explored. And indeed, these will be very much needed to achieve the growth projected. But it takes at least 5 and usually up to 10 years for projects to get off the ground. There are discussions and plans around the development of pipelines from Russia to Europe via the Baltic Sea, from the Caspian region and Iran to Europe, and from Russia to China and beyond. So far, none of these have reached the stage of a commitment to invest. Political issues, regulatory design, as well as the harmonisation of investments and supply risk, prove to be very difficult to align.” The difficulty in establishing new pipeline projects therefore remains central in the debate on security of gas supplies. As I have noted elsewhere (CEPS Policy Brief 51), it is only through the deliberate creation of redundancy in import facilities – pipelines and LNG terminals – that we can achieve at the same time a more competitive and secure European gas market. However, the market is unlikely to bring about redundancy, tending rather to eliminate bottlenecks only once they become critical. Ensuring competitiveness and security of supply through diversification is likely to require continuing public attention, but how this can be done without distorting market conditions is a question that remains open. 2. Second approach: Institutionalist theories Institutionalism is one of the most novatrice conceptions of international political and economic relations. Its core idea consists to demonstrates that institutions (stemming from norms and regular practices) build a basis for stability and security of economic relations. The process of legalization of international relations stems from the juridical ideology: respect of law leads to a better security. A crucial contribution to institutional analysis has been provided by analyst D. North. According to his definition, institutions are “the rules of the game in society or, more formally, are the humanly devised constraints that shape human interaction” (North, 1990: 3). D. North marks how formal and informal constraints have been created by practices, which then lead to the formal development of institutions. (North, 1990:69). D. North’s definition opens the idea of institution to a broader sense of the term, but does not overlap the definition of organization. D. North belongs to the Rational Choice perspective of institutional analysis. Rational Choice is the objective centered view, believing that the institutions are created purely out of the goals they are attempting to reach. 2.1. Theoretical conception of institutionalism S. Steimo, The new institutionalism, Barry Clark and Joe Foweraker, (eds.) The Encyclopedia of Democratic Thought, London: Routlege, (July, 2001). There are two contending research/theoretical approaches within political science which identify themselves as Institutionalists today: Rational Choice Institutionalists and Historical Institutionalists. The role institutions play in these two analytic traditions overlaps in many ways (cf. Hall and Taylor 1996; Rothstein 1996; Thelen 1999). At the same time the theoretical, indeed epistemological, goals of scholars in these two schools separates them in some rather fundamental ways. In both schools, institutions are important for politics because they structure political behavior. Perhaps surprisingly the core difference is NOT over whether people are Arational or not. Historical Institutionalists do not argue with the observation that most people act rationally most of the time. Nor do Rationalists necessarily believe that all action is motivated exclusively by short-term economic self-interest. Historical Institutionalists are primarily interested in understanding and explaining specific real world political outcomes. Building on the earlier work of Peter Katzenstein and his colleagues in Between Power and Plenty, and then Theda Skocpol and her colleagues in Bringing the State Back In, a group of younger scholars embarked upon a variety of studies of specific historical events in widely different places and across large spans of time. They could not explain these variations without specifically examining the way in which the political institutions had shaped or structured the political process and ultimately the political outcomes. In other words, Historical Institutionalists are first interested in explaining an outcome (say, for example, why France and Britain have pursued such different styles of industrial Policy or why some welfare states generate more popular support than others. Because theirs is not a theory in search of evidence, Historical Institutionalists do not argue that institutions are the only important variables for understanding political outcomes. Quite the contrary, these scholars generally see institutions as intervening variables (or structuring variables) through which battles over interest, ideas and power are fought. Institutions are important both because they are the focal points of much political activity and because they provide incentives and constraints for political actors and thus structure that activity. Rather than being neutral boxes in which political fights take place, institutions actually structure the political struggle itself. Institutions can thus also be seen as the points of critical juncture in an historical path analysis (see below) because, political battles are fought inside institutions and over the design of future institutions. In either case, the Historical Institutionalist is interested in developing a deep and contextualized understanding of the politics. The goal Rational Choice Institutionalism is different. For Rationalist scholars, the central goal is to uncover the Laws of political behavior and action. Scholars in this tradition generally believe that once these laws are discovered, models can be constructed that will help us understand and predict political behavior. In their deductive model, Rational choice scholars look to the real world to see if their model is right [test the model] rather than look to the real world and then search for plausible explanations for the phenomenon they observe.1 For these scholars, understanding real outcomes is not the first point – creating, elaborating, refining a theory of politics is (Weingast 1996). The implications of this scientific orientation are substantial. Morris Fiorina, a highly regarded RC scholar at Harvard put the issue in the following way: The most important thing to remember when reading examples of PTI is that, at heart, most PTI scholars are theorists. This means, first Athat most PTI scholars are not as interested in a comprehensive understanding of some real institution or historical phenomenon, so much as in a deeper understanding of some theoretical principle or logic. Second, Athen [Rationalists] do not demand a complete understanding of an historical or institutional phenomenon. 2.2. Overview of Institutions dealing with energy security The density of institutions explains the various angles of energy policy strategies. Indeed, each institution is shaped by particular principles, norms and rules which influence different approaches to resolving problematic resource management. On this basis, five groups of institutions are distinguished: Institutions/Markets International Information-based General rules of International Economic Law Oil & Gas Upstream IEA WTO, Law of the Sea, International Arbitration ECT Sector-specific institutions EU internal market None legislation Private Commercial Multinational Firms Institutions Gas (downstream) & Electricity IEA GHG IPCC Emerging Application of WTO and International Arbitration Non-existent ECT Kyoto Protocol Internal Market Internal Market Emerging Mergers; Industry Associations Emerging Above are institutions which: - promote knowledge and information on energy and energy-related issues such as environment; establish general legal binding institutions, which have emerged through general multilateral conventions and agreements; - constitute issue-specific agreements which directly involve the international energy markets; form practices of regional economic organizations, with a particular focus to the practices existing in the EU internal market; Cross-border institutions set by private commercial actors. 2.2.1. Information-based Institutions The analyzed energy markets of oil, gas & electricity as well as GHG are shaped by information-based institutions. These institutions aim to provide better availability of data, better transparency of policies, and more awareness of ongoing problems in each sector. The International Energy Agency (IEA) is one of these agencies. The IEA was set up for the oil, gas, and electricity sectors in te aftermath of the first energy shock of 1973. Its’ activities also delve into evaluation of investment needs, and best practices in different member states. By providing recommendations and data, it has political impact on national decision-makers. For instance, the IEA’s recommendations have contributed to the establishment of emergency stocks for oil, a higher consideration of energy efficiency policies, and investment risk evaluation. In addition, the IEA provides comprehensive information on energy markets, such as CO2 emissions. The IEA recommendations contribute to the best-practice transfer of market mechanisms attracting investments. Cross-country information provides a clear picture of best-practices in energy policy. However, the IEA does not create any binding regulations. The bestpractice transfer is a purely voluntary procedure which is applied, if not entered into contradiction with the national interests of particular states. It reflects, in cases such as France for instance, where state-owned enterprises are keen to avoid the practice transfer from liberalized energy sectors (such as the UK). International Energy Agency, security of gas supply in open market, 2004 SECURITY OF GAS SUPPLY IN OPEN MARKETS: MAJOR ISSUES In open gas markets, supply and demand can usually be balanced by the market. The challenge of security of supply is to make sure that the market can always clear supply and demand. Open markets allow customer choice. Eligible customers can choose their suppliers and eventually their own level of reliability of supply, but they are responsible for that choice. Open markets will not always result in lower prices for customers, but they will result in an efficient allocation of resources, capacity and investment. Compared to markets for commodities, the design of gas markets requires special consideration as gas delivery is capacity-bound and therefore supply is restricted in the short term, and because part of gas demand is price-inelastic, especially the household sector, which is even temperature-dependent. Therefore prices may be volatile, when capacity limits are close, and there is a risk that supply and demand do not meet for low-probability events, whatever their cause. Governments in open gas markets play a different, but important role to ensure secure and reliable gas deliveries from the production/import point to the final customer. Instead of managing the sector, they have to set clear policy objectives all along the gas chain to manage the geopolitical implications of increasing import dependence and impacts on the environment, and to ensure the working of markets to deliver reliable gas supplies. At the time of stateowned gas companies, or private companies with exclusive concession rights, governments played an important role in the management of the sector but delegated responsibility for security of supply to these entities and made all customers pay for it. These companies were responsible for security of gas supply across the whole gas market. In open markets, governments have to define the right framework for the market players so that markets can deliver reliable gas supplies, and they have to make sure that market players follow the rules. Governments have the responsibility of creating a framework for security and for defining the responsibilities of each player. However, low-probability events (like supply interruptions 19 and extreme temperatures) may not necessarily be valued by the market itself. Governments therefore should set objectives for reliability of gas supply, especially to ensure gas deliveries to household customers at extreme low temperatures. They should also foster demand-side response as one of the important policies to ensure security of supply. The opening of the gas (and electricity) market results in the development of hubs and market centres which prove a useful instrument to optimise the use of the capacity of the gas system, to bring gas to its highest value use and foster market transparency. Governments may be concerned that market outcomes – like volatile prices, or high prices – may lead some industries to relocate to regions with lower gas/electricity prices. Governments may take unsatisfactory market outcomes as an impulse to rethink the framework and implement its modification to mitigate market outcomes in line with their policy. However, dealing with the day-to-day operation of the market is hardly the role of governments. While some of the arguments to ensure security of gas supply are similar to oil, the arguments for establishing stocks and a coordinated stock draw do not apply to gas. Strategic gas storage is much more expensive than oil storage and requires additional substantial investment into a spare transport infrastructure. Other instruments like interruptible contracts or fuel switching may be less expensive than strategic gas storage, if storage is possible at all. As the market is not yet global and disruptions only have local impact, a global response is not possible. It is therefore best to leave the design of the response mechanism to individual countries and their market players, taking into account the effect of the development of larger regional gas markets. The global gas supply and demand balance is at a turning point. From 1971 to 2000 worldwide gas consumption more than doubled from 895 mtoe to 2,085 mtoe. World Energy Outlook 2002 (WEO 2002) projects another doubling to 4,203 mtoe by year 2030. Gas consumption for power generation was about a quarter of total gas consumption, or 207 mtoe, in 1971; a bit more than a third in 2000, 725 mtoe; and is expected to come close to half of total gas consumption, or 2,032 mtoe in 2030, so gas consumption for power generation almost triples every 30 years. 20 For OECD countries the trends in gas consumption look similar: from 1971 to 2000 gas consumption almost doubled from 653 to 1,143 mtoe and is projected to almost double again to 2,012 mtoe by 2030. Gas consumption for power generation was 117 mtoe in 1971, or about onesixth of total gas consumption, increasing to 328 mtoe in 2000, or a bit more than a quarter of total gas consumption, and is projected to reach 958 mtoe in 2030 – almost half of gas consumption in OECD countries. So in OECD countries the trend towards increased use of gas in power generation is even more pronounced, due to increasing saturation in the residential, commercial and industrial sectors. The import dependence of OECD countries is projected to increase from a total of 274 bcm/a or a share of about 20% of total gas consumption in 2000, to a total of 1091 bcm/a, or more than 40% of gas consumption. The major part of increase in gas imports is explained by the projected increase in gas used in power plants. Gas has developed into the fuel of choice for the residential and commercial sectors, but also for process and small applications in the industry sector, wherever gas can be economically supplied. While gas can be replaced for each individual customer mainly by oil products, which define price limits for individual customers, many IEA countries have no large-scale alternative to gas on a country-wide scale. The use of gas is not only linked to a long-lasting investment decision on the customers’ side, but also to large investment in the gas infrastructure, which would become obsolete in case of a substantial shortage of gas. With domestic gas reserves of IEA countries on the decline, imports are going to cover an increasing part of gas demand in most IEA countries. This raises the issue of import levels from different non-OECD countries versus the ability of the market to handle a gas shortfall. It also raises the issue of the implications of uneven reform in countries along the gas chain. The increase in gas use for power (and the dominance of gas as a fuel for new power generation since the beginning of the 1990s in many IEA countries) is driven by the high technical and economic efficiency of new gas turbines and CCGTs, as well as by the environmental advantages of gas compared to other fossil fuels. Projections show that there is likely to 21 be a substantial increase in gas use in power generation in OECD countries, which, on balance, will have to be imported from non-OECD countries. The result will be a strong increase in import dependence in most OECD countries/regions and a strong increase in cross-border trade of gas by pipeline and as LNG. For volume and diversification reasons, gas for export from an increasing number of resource-owning countries will mainly be developed as LNG. The LNG industry has now entered an era of unprecedented growth. New large markets are emerging, cost reductions along the LNG chain allow new projects which were uneconomic 20 years ago, and increased interregional trading adds flexibility and security to the global gas sector. Larger regional markets are emerging with the opening of gas markets (in addition to the already strongly interlinked North American market), e.g., in the EU. With more flexible LNG trade, more trade develops between LNG buying countries, like Japan and Korea, and also in the Atlantic basin between parts of the EU and the US. The creation of larger markets offers more possibilities for underutilised capacity/volumes to find their way to other regions, with higher gas value, thereby creating higher liquid volumes on which to draw in case of shortage or extreme temperatures. Creating a larger (regional) marketplace may require extra investment into interconnection infrastructures, which so far have been built on the basis of national markets. This may require governments to define common standards (e.g., technical norms, gas quality, LNG specification and safety norms for LNG tankers), to foster interoperability, and to arrange for the right framework to remove obstacles to cross-border investment and trade. Increased links between open gas and power markets offer the chance for more efficient use of both systems. However, the reliability of each system must also be ensured in view of the interlinks between them. The increased use of gas in power generation combined with the parallel opening of both sectors creates operational and market links between the sectors. However, it must be observed that while the link is creating greater flexibility for the use of gas and for the production of electricity, both systems are capacity-bound. Experience shows the need to set 22 reliability objectives, which take into account the interdependencies of the systems. The projected high dependence of power generation on imported gas might create a domino effect on the power sector in cases of gas supply shortages, if not anticipated. The willingness of non-IEA gas-rich countries to develop their gas resources for export is key to the further development of gas markets in IEA countries that increasingly depend on such exports. This will require a stable balance of interests between gas importing and gas exporting countries. The import volumes of all OECD regions are increasing substantially and even the UK and US are becoming substantial net importers of gas. About 10% of world proved gas reserves are in OECD countries, whereas non-OECD gas reserves are highly concentrated. More than 50% are in three countries: almost 30% are in Russia, 15% in Iran, 9% in Qatar. While the investment decisions for exploration and production, transportation and other gas infrastructure, as well as on the use of gas, is best left to private investors, the decision on the depletion of natural resources is in most countries vested in the government of the resourceowning country. To optimise the use of their resources, they have to decide on the development path for their reserves, on domestic and export use, as well as on maximising the remuneration for the export of a finite resource. While maximising the rent income for a finite resource is a sensible objective for an exporting country, IEA gas importing countries will try to subject such rent transfers to competitive forces by promoting diversification of supply sources, routes and the use of other fuels. While IEA countries are interested in reliable gas supplies at competitive prices, governments of resource-owning countries will look for secured access for their gas to IEA markets and for a reliable income from selling their resources. Long-term contracts have been a useful instrument to create a stable balance between gas exporters and importers. With more open markets new, additional instruments develop, such as selling into a liquid market, as well as more flexible LNG deals, but long-term contracts will remain an important instrument, although with increasing flexibility as markets mature. While having a bankable gas market or a creditworthy gas buyer is a major precondition for viable investment in gas production and export infrastructure, a clear framework for foreign investors and 23 a neutral conflict resolution mechanism would help to mobilise financing for new export capacity at favourable conditions. A suitable way to address how to create a fair and stable balance between gas producing and consuming countries is to foster more dialogue between them. Governments have to ensure that investment for all parts of the gas chain can be mobilised in a timely way and in competition with other capital use. The increase in gas demand requires the alignment of timely investment in all parts of the gas chain, from exploration and production to transporting the gas to the market, as well as investment into the distribution and gas consuming infrastructure, especially gas-fired power. While governments cannot and should not play a role in managing geological, technical or commercial risks, they should help to reduce sovereign and regulatory risks. This is particularly important in creating clear and stable frameworks for investment, especially in cross-border infrastructure, where there is the risk of abuse of market position. They should also help with the adoption of clear and streamlined siting rules, while minimising regulatory risk by creating a stable and predictable regulatory framework, which would allow investors free commercial disposal of their property and, where regulated, a risk-adjusted rate of return competitive with other investment opportunities. The choice of instruments to hedge long-term risks should be left to market players. Both the industry from all parts of the gas chain and the resource-owning countries have an interest in being able to hedge their decisions dedicating investment or gas resources on a long-term basis. A variety of instruments linked to the development and maturity of reforms in each gas market/region has evolved to hedge the risks stemming from the long-term nature of the gas business: _ Long-term sales contracts associated with long-term transportation contracts; _ Vertical integration along the gas chain; _ Access to liquid markets (by investing into LNG regasification terminals and import pipelines) and to financial instruments derived from liquid gas markets. 24 Governments of IEA countries should leave the choice of instruments to the market players concerned; they should not favour or disfavour any of these instruments, as long as they do not negatively impact competition. In spite of generic and global developments the status of market opening and the challenges of security of gas supply are specific for each IEA region and in some cases even for single countries: North America: open gas markets introduced in the 1980s were able to mobilise private investment in time for expansion of the infrastructure and the development of reserves. These markets led to the development of liquid hubs and gas exchanges and to a more efficient use of the gas infrastructure. So far gas supply and demand have been balanced by markets. Upstream, the role of governments was restricted to rule setting and in the case of Canada, also encompassed rent taking – however, with some restrictions on E&P in US federal/state owned land, offshore and in arctic areas. The decline in production due to the depletion of North American gas reserves combined with the massive increase in gas use in CCGTs with only limited fuel-switching capacity, resulted recently in rising gas prices so that some industrial gas users considered moving to other regions. This situation signalled the need to increase LNG imports substantially to satisfy the projected use of gas in power generation. After the requirements were dropped for third-party access (TPA) in LNG terminals, many new projects emerged. While the chances of obtaining diversified LNG supplies are good, the expected large share of LNG supply may raise the question whether interruptions of LNG supplies can be compensated by the market. Europe: there is a marked difference between the UK gas market and the continental gas market. While the UK was a frontrunner in opening the gas market, the opening in the continental part of the EU happened more recently with the two EU Gas Directives and their implementation in EU member states. The opening of the gas market in the UK resulted in the establishment of the National Balancing Point (NBP), a liquid (notional) market place where gas is traded on a daily basis. It assisted the massive use of gas for power generation in the 1990s and, in parallel, a remarkable increase in gas production from the UK continental shelf (UKCS). However, lacking large new finds in frontier areas and with the UKCS 25 becoming a mature gas province, within a short time span the UK will change from being a net gas exporter to a massive net importer. Long-term contracts are still predominant in the UK, though now they are increasingly linked with the price at the NBP and in some cases also use the NBP as the delivery point. The UK is well underway to attract the additional supplies and the necessary investment to adapt its infrastructure, although with some specific challenges caused by the differing quality of the gas to be imported. Another challenge to be addressed is the link between gas and power, as a large increase in imported gas will go to gas-fired power plants. In continental Europe, the implementation of the two EU Gas Directives is underway with some decisive changes to become binding as of 1 July 2004. Several of the challenges for reliable gas supplies set before the gas sector by the Directives still lie ahead, such as finding the right allocation between the responsibility for reliable gas supplies and the effects of unbundling; finding the right incentives for the enlargement of the transport, import and storage infrastructure by allowing for a rate of return which is competitive in a global context. Creating more regulatory stability by giving the industry the time to adapt to and to fulfil the requirements stemming from the Directives currently in force is now of paramount importance. In view of the increasing import dependence from only a few gas exporting countries, long-term contracts will remain an important instrument to ensure gas supplies. In the continental gas market, some hubs are developing, although they still do not have a deep liquidity. However, beyond the challenge of creating open gas markets in each EU member state, the challenge remains to create a single gas market for the EU, which requires rules, standards and technical regulations as uniform as possible. The infrastructure, which was built on a national basis driven by large import projects, must be adapted to allow for more EU-wide gas trade and liquidity. As in North America, the projected strong increase of gas in power generation, which will, on balance, be based on imported gas, raises challenges of increased gas import shares from non-IEA countries and their impact on the gas and power sector. The pace of supplier and transit gas sector reform has important implications for the quality and reliability of security of gas supply to European end-use customers. 26 27 The EU is to a large extent dependent on Algerian and Russian gas imports, which are projected to increase substantially. Both countries have a long-standing record as reliable suppliers, fulfilling their contractual obligations. However, in 1980, Algeria cut off supplies to its US and European customers to make them accept unilateral changes in contract terms. While the interruption was only temporary for Europe, it led to the collapse of Algerian LNG trade with the US. There is some concern about the long-term future of gas imports from Algeria and Russia: neither of these countries has yet a clear gas upstream nor transport regulation. In addition, gas production and export are managed by companies which, in addition to their commercial role, exercise sovereign rights of the state in the gas sector. Another concern is that the transit of Russian gas to the EU is highly concentrated in Ukraine, a country which is struggling to find an appropriate regulatory framework for its gas sector. Increased diversification of suppliers and supply routes, and provision of market flexibility (back-up supply and/or demand management), will remain crucial issues for the EU. OECD Pacific: the gas industries of the OECD countries in the Pacific region differ very much from each other: Japan and South Korea are almost entirely dependent on LNG supplies, Australia is becoming a large LNG exporter and New Zealand is so far self-sufficient. While Japan and South Korea were the driving force of the growth in the LNG trade, market reforms in both countries has led to more uncertainty about future gas demand growth. This has led the LNG importing companies to seek more volumes and pricing flexibility in their LNG contracts. Increased competition among LNG suppliers, as well as cost reductions in the LNG chain, allow producers to accept more flexible LNG terms. Security of supply in the region has always been ensured through diversification of supplies and infrastructure. The recently increased flexibility of LNG trade allowed importing companies to swap LNG cargoes, e.g., to exchange cargoes to meet peak gas demand. It allowed Japanese and Korean buyers to successfully manage the seven-month shut-down of the Indonesian liquefaction plant at Arun in 2001. Policy-makers now have to define the objectives and the framework for the global role of gas for decades to come. Decisions for major expansions and replacement of gas and electricity infrastructure have to be taken soon. These decisions stem largely from a need to enlarge and replace power generating capacity (built in the aftermath of the 1973/74 and 1979/80 oil price crisis) with a view to minimising environmental effects and GHG emissions. Due to declining domestic gas reserves in IEA countries and the increased use of gas for commercial purposes, but also for GHG mitigation reasons, the overall dependence on imported gas will increase. That raises the question of a stable balance between the interests of gas exporting and importing countries, the issue of diversification of gas supply and the potential of the gas market to cover any interruption of gas supply, or that of the electricity market to mobilise back-up capacity to compensate for any shortfall in gas supplies. 28 2.2.2. Legally Binding Institutions Legally-binding institutional frameworks have been set up in order to create transparent and predictable rules of game within a market economy. Indeed, the need of “legislative” legitimacy is inherent in national economic systems. Likewise, the development of law at international level corresponds to the facilitation of cross-border trade. They institutionalize practices of market economy: non-discriminatory trade, inter-state dispute settlement mechanisms in case of frustration of interests by one of states, cross-border investments with an international protection of investors against discretionary power of host states, standards of contracts, etc. Among the binding agreements, the most comprehensive trade arrangement is the framework created by the World Trade Organization (WTO), which lays down uniform international norms and practices for the promotion of competition. The WTO principles can be summarized as follows: transparency of economic policies, interdiction of quantitative restrictions, and of Most Favored Nation clause which supports nondiscrimination of trade partners. In addition, the WTO norms forbid subsidies that distort trade. The system provides flexibility: it combines a legalist approach to international economic law and the pragmatic power logic (Jackson, 1997: 109-111). The impact on energy trade has not been significant. In fact oil trade has been de facto exempted from the WTO principles since the oil shocks of the 1970s when consumer countries proceeded to the diversification policies that aimed to restrict markets. Moreover, the largest producing countries, such as Saudi Arabia, Iran, and Iraq, have been outside the WTO for a long time. As for gas and electricity, they are considered services rather than commodities. The current wave of liberalization in this sector, consisting of the restructuring of vertically integrated companies, may further increase the importance of the involvement of the WTO institutions in the sectors. Dr S. Haighighi view on energy subsidies §§ 5.4.9. The Agreement on Subsidies and Countervailing Measures 5.4.9.1. Introduction Because of the strategic importance of energy and its related products, they have been specifically provided for in some bilateral as well as multilateral agreements. Some of these special treatments have been acknowledged to carry some trade distorting effects, and one has been considered as a subsidy. Although the WTO law on subsidies is not designed to expressly reflect upon subsidies granted in the energy sector, its general provisions apply to such subsidies. Subsidies are mostly used by governments as instruments of economic, social and political policy and serve a variety of purposes, "including benefiting underdeveloped regions, combating pollution, favouring particular constituents or economic sectors and developing new technologies and products.” Moreover, the main rationale for regulating subsidies is that their elimination will reduce energy consumption, raise economic growth, contribute to the liberalization of energy trade by reducing trade-distorting effects, which will all ultimately contribute to energy security. One of the important features of the energy sector is that it has always been strongly subsidized. Reasons for subsidization include the creation of better energy security through increased energy production, or permitting a given country to diversify its energy sources from, for example, coal to gas, through subsidization of gas production, or to keep up with environmental standards through subsidizing those industries that, for example, use renewable energy to produce electricity, etc. Moreover, the indirect link between an energy subsidy and its effect on another economic sector where energy is strongly used is clear. Subsidies are also strongly linked to the development of the domestic industry of a given country. These are all reasons why the use of subsidies is closely supervised in both the WTO and the ECT. The definition of subsidies is an unsettled issue, and various definitions are provided by different institutions dealing with energy. One definition adopted by the International Energy Agency is that: 'an energy subsidy is any government action that concerns primarily the energy sector and that lowers the cost of energy production, raises the price received by energy producers or lowers the price paid by energy consumers".763 This definition tends to cover a vast array of activities in the energy sector, which can be considered as interfering in the way prices would otherwise have been attributed to a given act, such as consumption or production. Within the WTO, however, a narrow approach to the definition of subsidies is taken.764 As defined by Article 1.1 of the "Agreement on Subsidies and Countervailing Measures", subsidies are 1) financial contributions 2) by a government or any public body within the territory of a Member State, which 3) confer a benefit.765 All three requirements mentioned above should be satisfied for an act to be considered a subsidy. A contribution may be in the form of a direct or potential transfer of funds, forgone or relinquished government revenue, provision of goods or services or the purchase of goods by the government for an entity, and making payments to a funding mechanism. The other negative effect of subsidies is categorized as their trade distorting effects. An energy-exporting country can raise its share in the energy market through subsidizing its energy production where a majority of energy production is dedicated to export. The subsidy that is contingent upon the use of domestic energy rather than imported energy in a specific sector could also indirectly affect energy exports. Moreover, if the importing country takes up production activities, it will be adversely affected through the import of cheaper subsidized energy products from other energy-producing countries that satisfy the remainder of its domestic demand. Energy subsidies could also be dedicated to energy transportation and marketing of energy. They could also indirectly affect other industries where energy is used. Thus, it is clear that energy subsidies occupy a wide variety of activities and touch upon many other economic sectors. Subsidies that boost energy production can be said to be in line with concerns of consuming nations over security of energy supply. This point, however, should be read along with the fact that an increased flow of the volume of crude oil or natural gas does not necessarily guarantee security unless the price of that energy is also reasonable for the consumer. However, assuming that the price is reasonable, the subsidy, although trade distorting, could guarantee security by increasing imports up to the limit of their demand. As one author rightly declares: [i]f a country is a net exporter of a product, the rest of the world as a whole must be a net importer of it. Thus an export promoting subsidy for a product of which a country is a net exporter, must improve the terms of trade of the rest of the world as a whole. Net importers of the product thus benefit from improved terms of trade arising from countries' export subsidies. Based on this example, export subsidies could be considered as benign from the point of view of international trade. However, the energy-producing countries seek to limit their production and adjust their level of production to meet demand. Exporting beyond demand would result in lower prices for energy, which will in turn lower their income from that export. That is why OPEC countries undertake studies to lower or increase production based on a supply-demand analysis. The use of subsidies in energy-related activities has not yet been analyzed within the context of the WTO. However, these types of subsidies were specifically addressed in the context of negotiations on the accession of Saudi Arabia and Russia,. The analysis of the law of subsidies in the WTO, as incorporated into the ECT, is elaborated on below, followed by an analysis of the circumstances in which the activities in some energyexporting countries could be considered as subsidies. 5.4.9.2. A General Overview: The Law on Energy Subsides in the WTO as incorporated intothe ECT i Under the Agreement on Subsidies and Countervailing Measures (hereinafter the SCM Agreement) a subsidy is deemed to exist when a benefit is conferred on an industry as a result of (Article 1.1): - A direct transfer of funds from the government (e.g. grants, loans, and equity infusion), or potential direct transfers of funds or liabilities (e.g. loan guarantees); - Foregone or uncollected government revenues (e.g. fiscal incentives such as tax credits); - Government providing goods or services other than general infrastructure or purchasing goods; - Government making payments to a funding mechanism or to a private body to carry any of the three functions described above; or, - Where there is any form of income or price support in the sense of Article XVI of GATT 1994. WTO Panels and the Appellate Body have extensively elaborated on these forms of subsidies in their rulings. However, the cases are very specific and in order to analyze whether a certain activity is considered as a subsidy or not, the conditions surrounding each case should be similar to those found in other cases already decided by the Panel or the Appellate Body. The reason is that the SCM Agreement tends to adopt a rather ambiguous wording in defining subsidies in order to cover as many subsidies as possible, and the Panels have tended to restrict its scope by limiting their application. These restrictions, as found in the rulings of the WTO, should become an important reference point. The Agreement on Subsidies distinguishes three types of subsidies: 1) prohibited; 2) actionable; and 3) non-actionable. Based on Article 3 of the SCM Agreement, prohibited subsidies are: (a) Subsidies contingent, in law or in fact, whether solely or as one of several other conditions, upon export performance, including those illustrated in Annex I; (b) Subsidies contingent, whether solely or as one of several other conditions, upon the use of domestic over imported goods. Those subsidies that are conditional upon either export performance or the use of domestic over imported goods are prohibited, and Member States should neither grant nor maintain such subsidies. A Member State that believes this type of subsidy is granted or maintained can request consultation, and if no mutually agreed solution is found, the matter will be referred to the Dispute Settlement Body of the WTO (Article 4). Actionable subsidies are those subsidies that 1) injure the domestic industry of another member, or 2) nullify or impair benefits accruing directly or indirectly to another member or 3) inflict serious prejudice upon the interests of another member (Article 5).770 If a subsidy has these effects, the other Contracting Party has the right either to bring its claim in a dispute settlement body, or to impose countervailing measures on imports of subsidized products to an amount not in excess of the subsidy (Article 10-23 of the SCM Agreement). By doing this, the price of imported energy increases and the injury is alleviated.771 The Dispute Settlement System will decide on the effect of a subsidy and if a violation is established, the violating Contracting Party can either withdraw or rectify its adverse trade effects. Non-actionable subsidies are ‘tolerable subsidies’ and are defined as those activities that provide certain assistance for research activities for disadvantaged regions, or are those in line with promoting the adaptation of existing facilities to new environmental requirements (Article 8 of the SCM Agreement). Only specific subsidies are subject to the rules on prohibited and actionable subsidies as laid down in Parts II, III and V of the SCM Agreement respectively (Article 1.2). The argument for this distinction is that "multilateral rules are needed only to regulate subsidies that distort the allocation of resources within an economy" and not any type of subsidy.773 A specific subsidy exists "when the granting authority explicitly limits access to a subsidy to certain enterprises" (Article 2(1)(a)) or when the granting authority establishes objective criteria or conditions governing the eligibility for, and the amount of, a subsidy. In order to better clarify the rules on subsidies and its link to energy, one example will be provided below, which has been a topic of controversy, especially during the WTO accession negotiations of Saudi Arabia and Russia. This issue is the pricing of energy in these countries and its link to the law on subsidies. 5.4.9.3. A Specific Analysis: Dual Pricing and the Question of Subsidies 5.4.9.3.1. A Brief Remark One activity directly linked to our energy discussion is 'dual pricing', which is argued to be a 'hidden subsidy'. Dual pricing is practiced in various economic sectors including energy. This practice is usually aimed at providing lower prices for products for export and higher prices if they are for domestic consumption or vice versa, and the rationale is to boost either exports or domestic production and consumption. This activity has been subject to scrutiny in the WTO negotiations of Saudi Arabia and Russia, two major energy-producing countries. The analysis of dual pricing is important for few reasons: one is directly linked to the study of the various provisions of the WTO as incorporated into the ECT, and dual pricing is one good example of the inter-relation between these two frameworks. Secondly, the dual pricing practice of some important energy-producing countries has raised some interesting issues in negotiations on the accession of these countries to the WTO, that not only question the adequacy of the WTO rules to deal with the energy sector (and the ECT for that matter) but also shows where the interests of consuming and energy-producing countries really lie. It can be argued that this analysis provides a good occasion for analyzing the missed opportunity that the Energy Charter Secretariat had in emerging as an institution, distinct from the WTO, where consuming and producing countries alike can bring their claims and highlight their interests. These points will be elaborated on further below. 5.4.9.3.2. Dual Pricing in the Energy Sector of the Energy-Producing Countries: The Case of Saudi Arabia and Russia Dual pricing, as practiced in Saudi Arabia, favours natural gas liquids (NGLs) (hereinafter feedstock) for use in domestic production over those for export. For example, the NGLs (ethane, propane, butane) are sold more cheaply if used in the petrochemical industry of that country, and higher, if exported. One example provided by UNCTAD could clarify this issue. The United States imports Methyl Tertiary-Butyl Ether (MTBE), a petrochemical product made from methanol, from Saudi Arabia. Saudi Arabia provides cheaper feedstock to those producers (either domestic or foreign) that use them in Saudi Arabia’s petrochemical industry and export the final product abroad. The feedstock is sold higher to those entities that want to export it abroad without producing the product in Saudi Arabia. American producers of ethanol (i.e. a product that competes with MTBE), claim that the 'dual pricing' system, which exists in Saudi Arabia, subsidizes the MTBE through low-cost provision of the raw material (i.e. natural gas and methanol) to refiners in Saudi Arabia and therefore, the U.S. ethanol industry suffers as the import of the competing product from Saudi Arabia increases.776 This means that, through this practice, the final goods exported from Saudi Arabia will increase and compete with like products in importing countries. On the other hand, Saudi Arabia argues that, by providing cheaper feedstock to domestic producers, more investors are attracted to invest in its petrochemical industry and, therefore, this country can reap the benefits of the foreign investment that will then ensue. They believe that this investment cannot be otherwise encouraged. The European Union has also raised concerns that this practice is indirectly affecting the European petrochemical industry. The Association of Petrochemical Producers in Europe (CEFIC) has been demanding an end to such a practice through lobbying, as they found themselves at a comparative disadvantage with respect to the cheap import of petrochemical products from Saudi Arabia. The executive director of this association has raised his concern by stating that "the dual pricing is an obvious distortion of competition and free trade. Once it is abandoned we will have more of a level playing field in the world petrochemicals market".777 For this reason, dual pricing is addressed in the EUSaudi Arabia bilateral market access negotiations for the accession of Saudi Arabia to the WTO. There have been promises on the part of Saudi Arabia to abolish "a number of obstacles to international trade, such as dual pricing of gas products".778 The negotiations, however, failed in August 2005, the EU surprisingly abandoned its efforts, and Saudi Arabia’s accession agreement was signed. Before examining the compatibility of this practice with the WTO, a brief reference to the subject of dual pricing in Russia is also useful for the sake of comparing the issues at stake in the two countries. Russia's dual pricing is concerned with natural gas itself. Dual pricing takes place because Russia charges lower prices for natural gas destined for domestic consumption than for export. As one writer analyzes, differentiated wholesale prices are set by the Russian Federal Agency Commission, and this differentiation is controlled on the basis of numerous legislative and administrative acts.779 There is also a special export tax on gas exports. Moreover, the market of the Common Wealth of Independent States is charged less than other markets, such as Europe. Russia was not willing to fully abandon this practice, as a result of which their accession negotiations in the WTO had faced obstacles. They have raised many arguments to suggest that dual pricing does not fall within any category of subsidy as defined in the WTO Agreements. Moreover, a World Bank study enumerated the merits of dual pricing of Russian natural gas by explaining that if Russia eliminates this practice and unifies the price of natural gas - thereby charging the same price for exports of its natural gas as it charges in its home market- it would lose between 5 to 7 billion dollars per year, an amount that cannot be overlooked in any given economy. Russia believes that domestic prices of natural gas should be raised, but find no rationale for unified pricing between gas that is sold domestically and exported gas.781 Interestingly, the European Union intervened in this debate through the framework of the EU-Russia bilateral trade talks, and reached an agreement with Russia. Europe previously argued, similar to what was mentioned above, that domestic energy prices in Russia are much lower than the world prices, which led to unfair competition. It therefore proposed their elimination during the WTO accession agreement. The reason was said to be that as the Russian government has a monopoly over the energy industries, it imposes very high export taxes to support a domestic price of gas at a level below the market price, which was found to be inconsistent with WTO principles. On the other hand, Russia argued that firstly, this practice is not undertaken to support domestic markets and secondly, it is impossible for Russia to move to world energy prices in a single day. Finally, Europe managed to convince Russia to increase the price of natural gas for industrial users from the current 27-28$ to 37-42$ by 2006 and 49-57$ by 2010.782 While this increase was previously established in Russia’s energy strategy and domestic plan, Europe sought to expedite the process.783 The rationale behind this increase is not readily available, or can only be explained through complex economic terms, but this achievement was claimed to bring Russia ‘a step closer to the WTO membership’. It was also claimed that the other advantage of this outcome is that the increase in domestic energy prices encourages a It is argued that dual pricing has some effects similar to a subsidy. The price of feedstock is determined by the government at a level that could not be maintained if it was otherwise exposed to market forces. Through this activity, the feedstock will be used for domestic production, because it is cheaper than the feedstock destined for export.786 Granting the status of a subsidy to dual pricing as practiced in Saudi Arabia is complicated, and the indirect complaints by the WTO or the EU are not forthright. There is no express provision in the WTO that prohibits this activity. Although dual pricing is referred to in the Agreement on Subsidies, it is defined differently from what occurs in the pricing of feedstock in Saudi Arabia. As mentioned above, a subsidy that is prohibited is either conditional upon export performance or the use of domestic over imported goods. Moreover, Annex I of the SCM Agreement provides a list of prohibited subsidies. As the provision of cheaper feedstock is not conditional upon the two issues mentioned, we should look at Annex I to determine its compatibility with its rules. Paragraph (d) of this Annex elaborates on one type of prohibited subsidy as: The provision by governments or their agencies either directly or indirectly through government-mandated schemes, of imported or domestic products or services for use in the production of exported goods, on terms or conditions more favourable than for provision of like or directly competitive products or services for use in the production of goods for domestic consumption, if (in the case of products) such terms or conditions are more favourable than those commercially available787 on world markets to their exporters. This provision can be named as one example of dual pricing. As mentioned in this Article, in order for this activity to constitute a prohibited subsidy, several conditions should be met. In simple terms these conditions are: 1) the government or its agencies address domestic or imported products for use in the production of exported goods in more favourable terms; 2) preference is given to these types of products only, and not to those like products or directly competitive ones that are used for domestic consumption; 3) in order to determine whether this discrimination exists, the terms and conditions based on which preference is given to goods for export should be more favourable than those 'commercially available' on world markets to their exporters. The last condition means that there should be unrestricted access to both domestic and imported products, and the only way to prefer one product over another is based on commercial consideration. One commercial consideration can be named as the price of the product.788 For example, an exporter is attracted to export domestic products to a given country because that product is cheaper compared to similar products on world markets due to a preference given to that product. Here, the cheap price of the product makes it commercially available to the exporter. Hence, dual pricing has taken place because the government treats products for export more favourably than those destined for domestic consumption through cheaper prices. It should be highlighted here that this provision expressly deals with the favourable treatment of products that are destined for export and not those that are destined for domestic consumption. The Saudi activity, for example, could fall within the ambit of this provision (Annex I(d)) if the feedstock that is used in the production of petrochemicals for export is cheaper than the feedstock that is used for the production of petrochemicals for domestic consumption. As explained earlier, in the sale of feedstock in Saudi Arabia there is a difference in price between the feedstock itself, which is higher, and the feedstock that is domestically used in the Saudi petrochemical industry, which is lower. Surely, only a very broad interpretation of this article could encompass the Saudi practice. It is curious to see the extent to which the existing provisions of the SCM Agreement could be interpreted to prove these activities as against the basic provisions of the WTO. If this violation is found to exist, it should still be determined what exemptions are available to these countries to maintain this activity as an incentive to attract foreign investment. The latter issue is discussed later in this section. On the other hand, for the activity to fall within the ambit of this Annex, the condition of ‘specificity’ should be satisfied, which necessitates the grant of a subsidy to certain enterprises only. In relation to the sale of NGLs (feedstock) in Saudi Arabia, specificity would exist if feedstock is only sold more cheaply to particular enterprises. Therefore, some kind of discrimination should exist between various enterprises in receiving this benefit. This discrimination does not exist in the method of dual pricing in Saudi Arabia. The raw material is available at a cheaper price for any enterprise established in Saudi Arabia no matter if they are linked to the petrochemical industry or fertilizer industry or any other industry that uses the feedstock. The second condition established by Article 2(b) is also not satisfied. Article 2(b) provides that when a granting authority establishes objective criteria or conditions governing eligibility for a subsidy, 'specificity' does not exist if eligibility is automatic. Automatic eligibility means that the criteria and conditions governing eligibility are neutral and do not favour certain enterprises over others (e.g. based on nationality or when locating a new petrochemical plant close to available sources of feedstock of a given country is restricted to some enterprises). This discrimination does not exist in Saudi Arabia.789 Cheaper feedstock is available to both domestic and foreign producers on equal terms. The third condition is more challenging. Article 2(c) provides that there are cases where, although an activity may not fall within the first two parts of Article 2 on specificity, there are reasons to believe that the subsidy is in fact specific. The factors to determine specificity are: 1. Use of a subsidy programme by a limited number of certain enterprises, 2. Predominant use by certain enterprises, 3. The granting of disproportionately large amounts of subsidy to certain enterprises, 4. The manner in which discretion has been exercised by the granting authority in the decision to grant a subsidy. In applying this subparagraph, account shall be taken of the extent of diversification of economic activities within the jurisdiction of the granting authority, as well as of the length of time during which the subsidy programme has been in operation. The first paragraph is ambiguous. It is not clear what exactly amounts to 'certain enterprise'.790 Whatever the interpretation, it should be different from Article 2(1)(a) where specificity exists where there is an 'express limitation' on the use of subsidy for some enterprises. Therefore, it can be submitted that there should be an indirect limitation on certain enterprises and an indirect specificity should thus exist. In this respect, the only possibility that comes to mind is that the subsidy could only be used by some enterprises due to the ‘nature’ of that enterprise. For example, the subsidy can only be provided for those enterprises that use feedstock due to the nature of those enterprises, as opposed to other enterprises engaged in activities for which no feedstock is needed. However, one should also link this result to the second sub-paragraph of Article 2(c), which talks of the "predominant use by certain enterprises". This could mean that since a subsidy can only be used by some enterprises, an indirect specificity is established. Through this last interpretation, however, as many subsidies as possible could be included since the probability of any activity falling under this category is relatively high. Although it may have been the will of negotiators to include a priori as many subsidies as possible under the term 'specific',791 it seems dubious that the WTO Panel accepts such a broad interpretation. This is more so the case when we look at the last sentence of this paragraph, where 'the extent of diversification of economic activities of the jurisdiction of the granting authority' should be taken into account in addressing the 'specificity' issue. The Agreement suggests that, in calling a subsidy specific, some factors should be taken into account, as mentioned above, and in applying them, the extent of economic diversification should be taken into consideration. This sentence would mean that the more the economy is diversified, the more enterprises exist in that economy, and, therefore, it is easier to verify those enterprises that take advantage as opposed to others. On the other hand, if the economic activities of a given country are not diversified, it would be impossible to favour one enterprise over another, since there will be only one or two major sectors in the country on which the economy is dependent. This consideration could be directly linked to the situation of energy-producing countries, where their efforts to diversify their economies from energy is common knowledge. Those countries, where dependence on energy profits is high, have great difficulties in departing from the old patterns of their economy and have little possibilities to promote new ones. Therefore, it is doubtful that the subsidy is called specific in that situation. If one accepts the arguments above, none of the conditions in the definition of a subsidy applies to the practice of dual pricing of this country, and therefore, the practice can be maintained. As mentioned above, on the other hand, the rules on actionable subsidies (i.e. only when the requirements of specificity are satisfied) should also be analyzed to verify their applicability to the practice of dual pricing. However, even if an activity falls under the provisions of the WTO on actionable subsidies, the so-called ‘injured member state’ can counter that practice through the adoption of countervailing measures, which are also subject to various conditions as prescribed in the WTO. For example, the European Union and the WTO argue that the pricing system of feedstock in Saudi Arabia creates a preferential treatment for those that buy the cheaper feedstock, which indirectly damages the petrochemical industry of other countries that do not have access to such cheap feedstock. However, this ‘preferential treatment’ should be evaluated in detail, and a totality of factors is necessary to establish the existence of such a benefit provided for the recipients of cheap feedstock in Saudi Arabia to allow other members to impose countervailing measures. One issue that could be looked at is the difference between the prices of feedstock, because the main argument with respect to dual pricing is the question of Saudi Arabia’s differential pricing system.792 For example, imports should be looked at to verify whether they are entered at ‘prices’ that will have a significant depressing or suppressing effect on domestic prices and would be likely to increase demand for these cheaper products. These issues could then be analyzed to determine whether, for instance, the European petrochemical industry is seriously injured as a result of this practice. Therefore, one issue to be analyzed here is whether the price charged to the feedstock sold to producers, which was less than the one sold for export, really enjoys a preferential rate. The SCM Agreement does not provide adequate information on how and against what benchmark the difference in prices should be compared. One could argue that the mere fact that the government, or the state-trading enterprise, is selling feedstock at a lower price to selected companies is adequate to determine preferential treatment. However, for an actionable subsidy to be established, an ‘injury’ should exist. Therefore, charging less should amount to ‘charging less than adequate’, which in turn results in an injury. In the past, the Saudi Arabian government issued a decree that dedicated a 30% discount (based on the lowest export price) to the feedstock used for domestic production. Later, in 2003, they abandoned this practice and substituted it with a mechanism which ties the prices of products, such as LPG and other natural gas liquids, to the price in the Far Eastern LPG markets. How would this pricing mechanism be analyzed for the purposes of our study on subsidies? One could argue that an international price could be used, in order to have a yardstick against which the prices of feedstock can be compared. However, this is particularly problematic because there is no international price of LPG, and prices still vary depending on their location and trading conditions. There is, therefore, a high price volatility, which has made the price of butane (one type of LPG), for example, to be 185$/t in the Gulf in 2002 compared to 175$/t in North West Europe.793 This example shows that a ‘generalized’ approach to the issue of dual pricing is not valid. Imposing lower prices on feedstock for domestic production rather than for export in Saudi Arabia does not necessarily mean that prices in Europe are higher. Hence, in order to determine the discrimination, they should be compared either with each other or with other competitive feedstock such as ethane, naphtha and gasoline and at a given point in time. In this case, if the price of the Saudi LPG is based on a link to naphtha prices in Japan, the possibility remains that this price is higher than the price of LPG in North West Europe. Therefore, the dual pricing practice does not necessarily create a competitive disadvantage for Europe’s petrochemical industry because they have access to cheaper feedstock compared to that sold in Saudi Arabia. The complexities of the issue of dual pricing in Saudi Arabia demonstrates that this practice can neither be considered as a prohibited subsidy nor necessarily as creating an injury to the European or the American petrochemical industries. The issue has to be decided on a case-by -case basis. An outright ban of this practice is therefore not justified and it is surprising that this issue has come up as a ‘legal issue’ in the negotiations on Saudi Arabia’s accession to the WTO. The issue can be considered as a rather political issue within the context of a political bargain between various members of the WTO and Saudi Arabia. Two other issues related to dual pricing should be highlighted. One is a reminder of the fact that the WTO and the ECT only regulate the activities of states and not private bodies. In addition, the practice of the international arbitration (both inter-state and state- investor) forms a complex chain stemming from different Conventions including: GATT 1947 (further integrated within the WTO system), the New York Convention of 1958, and the Stockholm Chamber of Commerce with the arbitration tribunal of 1965. International arbitration is a necessary tool for the private commercial companies in order to secure their relations with host countries during investment projects. International arbitration procedures contribute to the centralization of practices by promoting investorstate dispute settlement procedures, which have strongly increased in numbers during the last decade (Allen & Overy, 2004). International arbitration procedures are mostly used by private commercial companies, which have the necessary resources to defend their own rights against a particular state, which is very costly. Another international legally binding institution is the Law of the Sea. Adopted within the framework of the United Nations, the Law of the Sea is a set of norms which involves the delimitation of the Territorial Waters of the Continental Shelf and of Exclusive Economic Zones. The freedom of transit in water areas has facilitated energy trade, allowing the free construction of pipelines under the sea, whereas onshore cross-border pipelines are subject to various national licensing procedures. In this regard, the Law of the Sea represents one of the most consensual international practices among legally-based mechanisms. The Law of the Sea contributes to the facilitation of maritime energy trade. Therefore, the transport by offshore pipeline as well as by tanker represents a lower transaction cost as they do not require any licensing procedures. 2.2.3. Issue-Specific Regimes More particular agreements, which directly involve the sector of energy trade is the Energy Charter Treaty (ECT). The ECT is the first institution of energy trade. It was signed in 1994 by 52 countries representing major energy producers on the Eurasian continent (Azerbaijan, Kazakhstan, Norway and Russia), as well as EU member states, Japan, and Australia. The Treaty covers all cross-border energy markets though it’s main focus is to cover the oil, gas, and electricity sectors. For its trade provisions, the ECT integrates the values established within the WTO framework. The ECT presents an additional set of practices for international arbitration. It favors conciliation between states and provides clear conciliation procedures. In the field of energy investments, investors prefer to use the Energy Charter Treaty framework when claiming their rights from the host states. The ECT contains a particular focus, it attempts to constitute a legal framework for the freedom of the transit of energy. The Treaty outlines two major aspects of the freedom of transit, stipulated in article 7: 1) Non-discrimination in access to the transit onshore pipeline network 2) Non-discrimination when according rights to construct new onshore transit capacities The institutional framework presented by the Energy Charter Treaty is an evolving set of initiatives related to the facilitation of energy trade. In addition to the text of the Treaty itself, contracting parties are in the process of negotiating a transit protocol. The protocol aims to reinforce and clarify aspects related to the allocation of available capacity in networks, and non-discrimination in tariffs. The Transit Protocol has provoked a number of controversial reactions. For instance, Russia’s major gas producer Gazprom is unwilling to give up its trade practices with transit states in favor of non-discrimination. Gazprom considers the Transit Protocol contrary to their commercial interests and reserves the right to the totality of it’s transport capacity through it’s bilateral agreements. However, the ECT’s Freedom of Transit still ensures Gazprom’s free transit to the European markets. Though perhaps not evident by Gazprom’s actions, the feedback concerning the Transit Protocol is very clear: states and private commercial actors are willing to establish a clear framework of practices. Already the Transit Protocol is mentioned in the hostgovernment agreement for the one of the longest cross-border pipelines (Baku-TbilissiCeyhan) from private consortium oil companies and transit states Azerbaijan, Georgia, and Turkey. The reference to the ECT norms and arbitration practices enhances the viability of the host-government agreements. Energy Charter Treaty: short overview The Energy Charter is an international organisation established by the Energy Charter Treaty (ECT). The Treaty has 52 signatories30. It contains legally binding obligations to be upheld by its contracting parties regarding protection of foreign direct investment in the energy chain, international trade in energy, international trade in equipment related to the production of energy, transit of energy, and intergovernmental cooperation in the field of energy efficiency. Political concern about the security of European natural gas supply was an explicit and major driver for the agreement on the European Energy Charter of 1991, a political declaration which started the Energy Charter process. The ECT itself has no explicit references to security of supply, but its rules and the Energy Charter process are directed at maintaining and improving energy security. The Treaty and its Protocols combine rules for securing investment, transit, trade, and energy efficiency enhancing supply security in general, and the security of natural gas supply in particular, by promoting favourable business conditions in the various elements in the natural gas chain, natural gas production, transmission, transit, distribution and supply. Rules for the protection of foreign direct investment reduce investors’ risks in ECT member states in general and in economies in transition in particular. ECT’s transit rules protect natural gas in transit, whereas the trade rules secure non-discrimination and respect of the World Trade Organisation (WTO) rules also in ECT countries not yet members of the WTO. ECT countries are committed to promote energy efficiency, which not only contributes to an improvement in energy security by reducing the energy use, but also reduces the environmental impacts of the energy cycle. In addition, the policy dialogue and international cooperative efforts in the Energy Charter process are focussed on improving the functioning of the energy markets by removing distortions and barriers to competition (the latter is considered as a major instrument of improving efficiency in the energy 30 Albania, Armenia, Australia, Austria, Azerbaijan, Belgium, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, the European Communities, Finland, France, Georgia, Germany, the Hellenic Republic, Hungary, Iceland, Ireland, Italy, Japan, Kazakhstan, Kyrgyzstan, Latvia, Liechtenstein, Lithuania, Luxembourg, the Former Yugoslav Republic of Macedonia, Malta, Moldova, Mongolia, the Netherlands, Norway, Poland, Portugal, Romania, the Russian Federation, the Slovak Republic, the Republic of Slovenia, Spain, Sweden, Switzerland, Tajikistan, Turkey, Turkmenistan, Ukraine, the United Kingdom of Great Britain and Northern Ireland, and Uzbekistan. 226 supply chain, adding to multiplicity of supplies as a way to adequately respond to the growing energy demand), and by promoting market reforms and restructuring of the energy sector. The Charter process is an important part of the international efforts directed at creating an open and competitive Eurasian natural gas market as stipulated in Article 3 of the ECT. The key dimensions of the ECT activities related to the security of natural gas supply are outlined below in more detail. Foreign direct investment The expected increase in demand for natural gas on the Eurasian continent of more than 40% over the next twenty years, as well as the need to replace production from existing fields in decline on the continent, will require significantly increased investments in natural gas production, transportation and distribution across the Eurasian continent. The fundamental objective of the ECT is to ensure the creation of a “level playing field” for such energy investments throughout the Charter’s constituency. The ECT ensures protection of energy investments based on the principle of non-discrimination. By accepting the Treaty, a state takes on the obligation to extend national treatment, or most favoured nation treatment – whatever is the most favourable – to nationals and companies of other member states who have invested in the energy sector. This protection is applicable for existing investments. As a complement to the legal obligations and rights there is in the Energy Charter process a constant focus on general investment climate issues by providing regular assessment, through survey activities and peer reviews, of investment practices in the participating states. The aim is to improve the general investment climate in the energy sectors of the member states. Transit rules Transit of gas is of increasing importance for the supply to the Eurasian market and improving the access to transit will result in an improved security of supply. The ECT’s transit rules oblige the participating states to facilitate the transit of energy, and therefore also of gas, on a non-discriminatory basis consistent with the principle of freedom of transit. These rules are currently being enhanced through the elaboration of a legally binding Transit Protocol, which will develop a regime of commonly accepted principles and “minimum standards” for transit flows. The aim of the Protocol is to establish, inter alia, negotiated access to available capacity and it sets the principles for transit tariffs. 227 227 31 They are Azerbaijan, Belarus, Bosnia & Herzegovina, Kazakhstan, Russian Federation, Tajikistan, Turkmenistan, Ukraine and Uzbekistan (situation as of November 2003). Trade rules The ECT’s trade regime applies by reference WTO rules and practices, which are founded on the fundamental principles of non-discrimination, transparency and commitment to the progressive liberalisation of international trade. The Treaty’s trade regime represents an important stepping-stone for the nine member states that have not yet acceded to the WTO31. The commitment to non-discrimination and trade liberalisation is also an important element in securing gas supplies by creating a stable international framework for gas trade from multiple supply sources. Dispute settlement The ECT’s provisions for dispute settlement are crucial elements in securing the application and respect of the Treaty’s fundamental rules. In the area of investment, the ECT establishes dispute settlement procedures concerning the application or interpretation of the ECT. There are rules for dispute settlement between a private investor and member state of the ECT and there are also rules for settling state-to-state investment disputes. In addition, there are specific mechanisms under the Treaty for trade-related disputes between member states of the ECT. Policy dialogue Policy dialogue supported by analysis of key energy market and policy issues is increasingly becoming an integral part of the Energy Charter process. At present, a major part of the Energy Charter activities is focussed on issues related to the Eurasian gas and electricity markets and has directly or indirectly a bearing on policies related to the security of natural gas supply. Some examples of the ongoing work in gas-related areas are: Gas pricing: a structural issue affecting the competitiveness and the security of supply of the Eurasian natural gas market is the lack of cost-reflective natural gas prices in about 50% of the Eurasian market, predominately in Central and Eastern Europe and in the CIS countries. In order to support the policy dialogue on this important issue, the Energy Charter Secretariat has undertaken in-depth analysis of the economic and gas market effects 228 of the needed gas price reforms, taking into particular consideration possible social effects of price increases to cost-reflective levels; Alternative sources of gas – liquefied natural gas (LNG): LNG has the potential to both reduce short-term security of supply uncertainties as well as long-term security of supply issues related to over-dependence on one source of supply of natural gas in Eurasia. Lower costs and the emergence of a more competitive global LNG market could increase this role. Article Belyi & Klaus, “Transit Dispute Resolution Mechanisms in the ECT and Russia Missed opportunities for Gazprom or false hopes in Europe?”, Journal for Energy and Natural resource Law, August 2007 1. Role of Dispute Settlement Mechanisms in the Political Approaches: Realpolitik vs Institutionalism In modern International Relation theory, much of analysis is attributed to the use of institutions by states for their foreign policy purposes. Addressing the issue of state influence at the level of international institutions, various models are proposed. In this context, D. Dessler (1987) suggests taking into account two ontologically different models of states’ “action” and “interaction”. First, Dessler distinguishes a positional model containing three phases: (1) unit action => (2) interaction => (3) its result (i.e. arrangement between units). Second, he conceptualizes a transformational model, which involves (1) existing set of rules => (2) action using the rules => (3) transformation of the structures of rules. The first model largely corresponds to the bilateral interstate relations. The second rather reflects the international norms as an impacting factor on the international system. Both models are interdependent: an arrangement resulting in the positional model can involve a creation of international norms; a transformation of norms of the transformative model does not exclude inter-state power relations. The two models reflect the way a state can use its power within in relation with other states and the way to take into account a normative interdependency. The present article schematizes the two models in the following way: on one hand, the positional model reflects the Realpolitik approach, where states resolve disputes by direct arrangement with another state involved in the conflict; on the other hand, transformative model outlines an institutionalist approach, where an international actor prefers to use norms of the international arbitration to resolve a dispute. The agency-structure perspective of the two approaches suggests that international actors have a power to decide whether to use one or another approach. Realpolitik approach The Realpolitik approach is generally defined by states pursuing their national interests within international structures. In light of a realist conception presented by K. Waltz (1979), states are acting accordingly to their structural power within international relations. Waltzian system assumes states to struggle for survival within an international system characterized by an absence of any “world-wide” authority. States define their national interests in relation to their security within this structure. This security approach is not proportional to the power of the state within international structures. Therefore, Realist approach does not define security to be a direct consequence of threat, but is, rather, defined as the result of the political interpretation of that threat, a process called “securization”. Hence, a definition of national security, according to the more modern approaches of Realpolitik, means “something much more specific than just any threat or problem.” (Buzan, 1996) This approach considers the international law as a state-handled devise in order to defend their interests. In turn, the international law is neglected when a state does not find it appropriate for its security reasons. The security factor remains the most important and the international law is serving to defend national security. Institutionalist approach The institutionalist approach stems from the current development of international norms and regimes. A crucial contribution to institutional analysis has been provided by analyst D. North. According to his definition, institutions are “the rules of the game in society or, more formally, are the humanly devised constraints that shape human interaction” (North, 1990: 3). D. North marks how formal and informal constraints have been created by practices, which then lead to the formal development of institutions. (North, 1990: 69). D. North’s definition opens the idea of institution to a broader sense of the term, but does not overlap the definition of organization. D. North conception of institution is based on is the objective centered view, believing that the institutions are created purely out of the goals they are attempting to reach. The constraints on international economic interactions, or international practices, demonstrate the growing number of knowledgebased, legal and contractual institutions. In international relations theory the influence of an institution on international structures is defined by international regimes: implicit or explicit principles, norms, rules and decision making procedures around which actors’ expectations converge (Krasner, 1982). Institutionalist theories often use the term “legalization”, which is defined as a need for states to find a legal legitimacy for political actions. The rule of law becomes a necessary part in improving investment climate. Here, this approach contrasts with Realpolitik: national security is not the priority of the international relations, instead, the priority is the economic development with the cross-border trade (Gilpin, 2001). Political approaches and DSM In this context, the dispute settlement mechanism (DSM) is reviewed within the two proposed models. Within the realist perspective, states are the only legal personalities in the international relations structures. They create international norms and can choose not to be bound by them. Herein, states are the only official 'subjects' or 'persons' of international law because they have the capacity to enter into legal relations and to have legal rights and duties. According to realists, the DSM stems from the legal positivism, which views an instrumental dimension of the law in resolving disputes. From this perspective, the DSM is rather related to the pressure that one state can exert on the other via the use of international law. From the institutionalist perspective, the international law is related to the consideration, which identify the principles and rules as necessary to live in a predictable international society. In particular, the institutionalist approach points out the importance of the transparent and non-discriminative legal regime for the investors: Likewise to the institutional economics, it helps “to explain the function of the rule of law with respect to both objectives of international investment treaties, the promotion of foreign investment and economic growth and development” (p. 32). Hence, none of the models opposes the DSM per se, but the international arbitration norms find a positive context for their development within institutionalist approach. The present article outlines a possibility for international actors to choose between the two approaches in their international strategy. The choice of the approach also influences the value of the DSM in interstate relation. The article roughly relates the Realpolitik approach to the preference of the state to use directly the bilateral interstate arrangements. In turn, the instituionalist approach involves more the use of the international norms (including DSM) in defending international actor’s interests. 2. Political Approaches Towards Eurasian Gas Markets The present article attempts to schematize both approachs, Realpolitik and institutionalist, in the Eurasian gas trade. The schematization aims to define the strategy of the main political actors towards the dispute prevention. In accordance with the afore-mentioned theoretical scheme, four different approachs can be defined: institutionalist approach of the EU, moderate institionalist approach of its Member States, moderate Realpolitik approach of Ukraine and the Realpolitik approach of Russia. Institutionalist approach of the EU and its Member States The most institutionalist actor is the European Union (EU). The EU is a combination between an international organization and an international actor. The external energy security as well as the energy market regulation remains dominated by intergovernmental logic of an international organization, whereas the discourse of the EU officials attempt to represent the economic union as a very coherent entity. The EU legal system is based on the jurisprudence, where the European Court of Justice served a role of promoting transparency and non-discrimination. The EU system has a legal institutionalist approach, therefore the EU accords an important place to the legal dimension of its external relations. Therefore, the EU considers relevant to establish clear and predictable institutional relation with energy producing countries, such the Energy Charter. On these grounds, the EU strongly supports Russian ratification of the ECT, which is mainly blocked by Gazprom’s lobbying at Russian Parliament. The EU external energy policy is also characterized by an exporting the EU model of the internal market. In particular, this policy is translated into the Energy Community Treaty with South East Europe and requires the adoption of the acquis communautaires of the energy regulation (such as the third party access, unbundling and coordination between regulatory authorities) to the Contracting Parties. Although the Treaty is supposed to further enlarge to Ukraine, Kiev remains outside the application of the acquis communautaires. As far as Moscow is concerned, it remains reluctant to any EU-driven law making inside Russia. The political approach of the EU Member States is not especially same as of the Union, although the countries are on the source of the European integration. Mainly, the institutionalist approach of the EU is moderated by the security concerns regarding the energy security. The best example has emerged in the UK, while British authorities blocked the penetration of Gazprom into Centrica. Basically, the security argument is reinforced by the events of January 2006: if Gazprom does not prove to be a reliable supplier, the image which has been partly damaged during the crisis, it should be prevented from the distribution networks and retail markets in the EU Member States. Realpolitik approach of Russia and Ukraine By contrast, countries emerged from the former Soviet Union (FSU) are less experienced in the international arbitration and in the application of the international norms. The gas trade between Russia and Ukraine is governed by bilateral agreements: Russia-Ukraine agreement on supply of Russian gas to Ukraine and on transit systems of gas through the territory of Ukraine (18.02.1994) ; Russia-Ukraine Agreement on Mutual Assistance in Trunk Pipeline Exploitation (26.07.1995); Agreement between Russian Government and Ukrainian Council of Ministers (01.10.2001), complemented by a Protocol (02.07.2004); Agreement between Russian Government and Ukrainian Council of Ministers on strategic cooperation in gas sector (7.10.2002) complemented by agreement between Russian Government and Ukrainian Council of Ministers on the implementing the on strategic cooperation in gas sector (18.08.2004) The agreement of the 2001, in its Article 9, provides only a narrow definition of the DSM: of “disagreements to be settled amicably between the parties to the dispute”. The political agreements are implemented by specific private commercial arrangements between the respective monopolies Naftogas and Gazprom. Gazprom has the right to take part in capacity expansion in Ukraine, of which the new capacity then becomes « common property ». Gazprom is able to reserve the right to use of the entire transit capacity of Ukrainian networks. In 2001, the agreement between the Russian Government and the Ukrainian Council of Ministers established rules for supply and transit. Gazprom may pay a pre-established transit fee in natural gas in exchange for transit services. During the crisis of January 2006, Ukraine demonstrated a willingness to use the DSM. The Ukraine’s willingness to use the idea of international arbitration was motivated by its political pro-western orientation, which is reflected in the diplomatic semantics of Ukrainian officials since the “Orange revolution”. Nevertheless, the parties continue to prefer conflict resolutions by bilateral political agreements. This situation underlines that using arbitration is more complex in practice than in discourse. Reasons for Ukrainian gas monopoly Naftogas to avoid the ECT dispute settlement mainly consists in the nontransparency about the gas underground storages and about the available capacity in the networks. In particular, the ECT article 7 provisions could be used against Ukraine for violating transit obligations, but Ukraine can hardly use the ECT against Russia for reducing supplies. Moreover, the bilateral agreement of 2001 states that in the case of a violation of the established transit agreement, Russia may reduce either payment for transit or volumes for Ukrainian domestic supplies. Instead, Ukraine can use its transit position as a factor of pressure on Gazprom in its bilateral relations with Russia. As far as Russia is concerned, its state owned monopoly clearly rejected any idea of an international arbitration during the crisis of January 2006. Russia preferred to exert pressure on Ukraine in order to achieve better economic (tariffs increase) and political (political regime change) in Ukraine. As far as the attitude towards the ECT is concerned, Gazprom opposes the ECT for the three following reasons, which are continuously put forth by Gazprom officials and experts12: First, the ECT in its provisions is facilitating energy transit, allows for private pipelines and pushes for a non-discriminatory approach therein. Moreover, Gazprom officials are convinced that the freedom of transit also involves third party access for Central Asian producers to Ukraine and Western Europe. The latter argument has been proved to be the effect of a misunderstanding, as the transit provisions do not involve the third party access. Nevertheless, Gazprom fears that the ECT framework can be used against its domination within the FSU area. In particular, Gazprom opposes any possibility of granting licenses for non-state own pipelines. Second, the ECT does not integrate pre-investment phase in its investment provisions. For that reason, the United States did not sign the ECT because it does not include the necessary clauses for a pre-investment climate and treats purely post-investment situations. For Gazprom, a non-discrimination clause for a pre-investment situation is necessary for its strategy to get distribution markets in the EU. Third, Gazprom considers that the dispute settlement mechanism foreseen by the article 7(7) for transit issues is imperfect. It attributes too much power and responsibility to the conciliator, who can decide on tariffs and supplies for a period up to 12 months. These arguments demonstrate that Gazprom prefers to deal with conflicts on bilateral basis and to avoid a multilateral involvement. The general opposition of Gazprom to the ECT is based on the general perception of it as a consumer-based mechanism. Instead of the traditional formula of “investment vs. supply”, Gazprom prefers “supply vs. market”, where it can keep a dominant position. It goes in line with the newly established strategy of Gazprom, which intends to become an “energy superpower.” An analysis of the international actors’ attitudes towards the two approachs of the international behavior demonstrates contradiction between the EU institutionalist approach and Gazprom views on Eurasian gas markets. It involves a clear misperception of Gazprom’s interests: according to the European approach, the use of the DSM would provide a better set of opportunities than the existing Realpolitik approach. The EU is O.Butchnev, M. Nedzveckyi, “Vlianie Processov glovalizacii na rossijskuu gazovuu promyshlennost”, Gazovyj Biznes, May-June 2006, pp. 40-42. 12 expecting Gazprom to move towards a new logic, regardless political practices within the FSU. On these grounds, it is necessary to understand (1) if and in how far the ECT institutional framework could be used by Gazprom in its strategy. 3. Gazprom and the institution “ECT” The current position of Gazprom concerning Russia’s ratification of the ECT is clearly negative and an intense lobbying of its position in the Russian Duma, which has stated in 2001 the conclusion of the Transit Protocol as a condition for the ECT ratification. At the same time, three concerns within the Transit Protocol remain the major obstacle for the ECT ratification: the calculation of transit tariffs, the Regional Economic Integration Organization Clause and the so called “Right of First Refusal”13. a. Gazprom and the fallout of the Realpolitik-approach in January 2006 But despite all these arguments against ratification, the Russian-Ukrainian Gas crisis in 2006 created a momentum in which some of the possible benefits of the ECT for Russia and Gazprom became visible. Next to the benefits propagated widely, like the attraction of investments, energy security etc., Russia could have used the transit provisions of the ECT to improve its legal and political stance in this conflict. The gas crisis displayed the classical conflict between a supplier and a transit country aimed at in Art. 7 ECT. Looking back in recent history, one may discover that this conflict actually is a constant pattern between Russia and the Ukraine which has developed out of a mixture of Soviet heritage and a lack of will and abilities on both sides to integrate a market approach in the energy trade. From time to time this conflict erupts, but never got as much attention as in January 2006.14 As already mentioned before, bilateral relations were usually favored the Russian side being much more power- and resourceful than the energy dependent (and energy inefficient) Ukraine. The bargaining power of the Ukrainian side in these negotiations generally spoken is reduced to the transit tariff hikes or interruption of flows. Under the Realpolitik-approach, Russia and Gazprom by far had a better bargaining position than the Ukrainian side. Furthermore, by raising the gas prices, Gazprom had economic arguments on its side, too, in trying to obtain higher, market-orientated prices for its gas. And finally, despite all the interdependencies and bonds knitted in Soviet times, there exists no obligation from the Russian side to subsidize the energy inefficient economy of the Ukraine. Political pressure in order to influence the new western-orientated Ukrainian government and the voters are sure to have played a role in the time-setting, rhetoric and staging of the dispute. The culmination, shutting of the pipeline valves on new year’s day 2006 13 14 Shtilkind, Energy Charter Treaty – A critical Russian perspective, TDM, Vol. 2, Issue 3 June 2005. Liesen, Transit under the 1994 Energy Charter Treaty, JERL Vol. 17, No. 1 1999, p. 58. broadcasted live on television, showed that far more than purely economic needs and dissensions were at work here. While the economic questions under discussion have brought the conflict as such on the agenda, political motives have definitely influenced the setting of the crisis on the Russian side. The spill-over of political Realpolitik-pressure beyond the economically justified claims has in the end backfired on Russia. Timing and psychology must not be underestimated in the political fall-out that followed. The staging of the crisis was clearly aimed at the Ukrainian (and Russian) audience, whereas the possible reactions in the West were completely ignored. Moreover, we have observed a willingness to make this crisis public and mass-media oriented. Somehow, Gazprom attempted to make a demonstrative action against Ukraine. In order to estimate the fall-out of Russia’s Realpolitik-actions, one must sketch a short slightly exaggerated personality program of the western audience. Europeans felt that Gazprom could use this power against them as well. In this psychological environment the (overreacting) outcry from western society, press and politicians struck Russia unprepared and the echo could be heard all through 2006. Of course Russian policy strategies first and foremost have to serve Russian interests and to please the Western audience as such is not on Russia’s agenda. But taking a second look choosing power politics over institutional behavior may have harmed Russian interests more than it seemed. In a political sense, Russia gets away with ignoring Western energy sensibilities as long as there is enough undiversified European demand for Russian gas and no Russian companies want to get involved substantially in the European downstream consumer market. But exactly these conditions are bound to change. While European supply diversification seems to be a rather slow process, it is clearly a part of Gazprom’s strategy to expand into the European consumer markets. Economically it is very interesting for Gazprom to control the whole gas chain from the extraction to the end consumer’s markets. But even if the Realpolitik-approach towards the Ukraine may have been a rational choice to gain maximum political and economic profit in the bilateral relations, it significantly harmed Gazprom’s chances with regards to other vital interests of Gazprom and Russia, namely to enter the European consumer’s markets. Liberalization in the European gas markets while having difficulties is advancing and poses a unique chance for Gazprom to diversify its own demand structure by taking over the supply of end consumers directly. But apart from the fact that foreign investment in infrastructural industries, especially in the energy sector, is always looked at skeptically, the Russian Realpolitik-approach in the mid-term perspective did harm Gazprom strategy in getting distribution markets. Although, western European energy markets are relatively open to third country investors the overall mood concerning especially investments from state-backed Russian gas monopolist Gazprom could change substantially. Next to the already installed common safeguards to ensure economic competition, national and European competition law, Gazprom could face much more resistance when political actors in Europe as well as their public opinion call for a limitation of foreign investment in certain strategic industries. Therefore, the Realpolitik-approach of Russia towards the Ukraine indirectly limits its abilities to engage with further players in the EU area, which basically cling to the international institutions to sort out their conflicts. b. Crisis solution under Art. 7 ECT The question is, if a more moderate and institutionalist approach during the gas disputes with the Ukraine could have brought Russia and Gazprom an overall gain. The first question of course is, if Russia actually could have used the instruments transit dispute settlement mechanisms implemented in Art. 7 (7) ECT during its dispute with the Ukraine. According to Art. 45 ECT Russia applies the ECT provisionally. The treaty applies as long as national Russian laws and regulations do not prohibit a provisional application of the treaty or certain clauses. As far as one can say so far provisional application of Art 7 (7) ECT seems possible under Russian law. The DSM of Art. 7 (7) apply and may be invoked by one of the Contracting Parties if “in the event of a dispute over any matter arising from that Transit” (Art. 7 (7) and (6) ECT) occurs with regard to another Contracting Party. The conflict, as mentioned above, arose around a mixture of disputed problems comprising questions of transit and supply tariffs and conditions which were inevitably interconnected due to the barter nature of the gas agreement between Russian and the Ukraine15. Art. 7(6) and (7) ECT do only apply to conflicts arising over transit not conflicts over supply. There is also no other provision in the ECT that applies to the fact, the conditions or the tariff of energy supply. The ECT signatories wanted to leave this directly to the players involved. As a result to this limitation to transit a possible dispute resolution according to Art. 7 ECT would have included only the transit tariff dispute between Russia and the Ukraine. The price hike for gas supplies to the Ukraine would not have been object to the dispute settlement process. Even if transit and supply maybe economically and politically interdependent, the DSM under Art. 7 ECT does only extend to the transit. This 15 Stern, The Russian-Ukrainian gas crisis of January 2006, p. 1. restriction is underlined by the fact, that according to Art. 7 (7) c ECT the conciliator can only decide on the “interim tariffs and other terms and conditions to be observed for Transit from a date which he shall specify until the dispute is resolved.” For the Russian-Ukrainian dispute this restriction to transit would have meant that after the “exhaustion of all relevant contractual or other dispute resolution remedies previously agreed between the Contracting Parties” (Art. 7 (7) ECT) either of the parties could have started DSM procedures under Art. 7 ECT. According to Art. 7 (6) ECT the Ukraine in this case would have been prohibited to interrupt or reduce the gas flow to Europe prior to the conclusion of the dispute resolution procedures. This situation would have put Russia in a rather comfortable situation. While the Ukrainian bargaining power with regards to transit reductions and interruptions would have been bound by an international treaty, the own obligation to supply the Ukraine with gas would legally and economically only have been relevant within the bilateral relations. Using the ECT as an international institution in this specific situation Russia could have gained more, than it gained using power politics. The Ukraine would have been partly neutralized by the DSM proceedings concerning transit. During the conciliation period of 90 days (Art. 7 (7) c ECT) Russia could have started a communicative offensive in order to explain its economically driven price hikes to a western audience, which in a cool atmosphere could hardly have rejected the argumentation with market prices. By using the dispute settlement procedures of the ECT Russia could have shown that it is willing to use international institutions. This would certainly have raised the image of Russia in Europe and diminished any tendencies towards sealing Europe off from Russian investments in the European energy sector. On the other hand any disruptions in the transit of gas to Europe during the formalized conciliation and with regards to the provisions in the ECT could have more easily been blamed on the Ukraine. This would have forced Europe to take a more critical stance towards the Ukraine that it happened during and after the heated crisis in January. Russia could have used one of the very advantages of international institutions, which is, to create a cooled down playing field and equilibrium. Russia has already realized that it has to distinguish its approach towards the FSU countries (more of a Realpolitik-approach) and Europe (more of an institutionalized approach). But so far and especially in the January gas crisis Russia has failed to realize that a too harsh or an ill communicated power politics approach towards its FSU neighbors may also threaten its stance in Europe. Nevertheless, a weak point of the article 7 of the ECT is the opposition of Russia towards the DSM itself. The Western countries seem inflexible to modify any norms related to the art. 7 (7). In turn, this inflexibility complicates the willingness of Gazprom to allocate a right to a third party to decide on tariffs during the mediation within the framework of the Energy Charter. Likewise, the Energy Charter DSM is hardly applicable in the context, where Russian political mood is skeptical towards norms agreed during the period of 1990s, when Russia negotiated them in the position of weakness. Now, Russian political class sees an opportunity to avoid those practices and to avoid the international DSM to achieve best political results. Moreover, the acceptance of the ECT norms could have brought a prejudice in the Russian position towards Yukos affair and the subsequent Kremlin’s sobjective to gain back the control on the oil and gas sectors. 4. Conclusion Contrasting realist and institutionalist perspectives allow us to understand differences in the political attitude of various countries towards the DSM itself. A co-existence of the strong security dimension of inter-state relations with market-oriented institutional norms limits the use of international DSM, which is however reinforced within the institutionalist perspective. The use of the DSM does not mean that a state loses its sovereignty. Instead, a state can use it for its own advantage. In this context, Gazprom had an opportunity of the “best move” advantage using the ECT against Ukraine in January 2007. However, a “loss aversion” seems to prevail the company’s strategy: Gazprom is unwilling to lose its control inside FSU and Russia, which remains the priority strategy to the distribution markets in Europe. A conclusion which can be drawn is: although such a submission under the rule of an independent court or conciliator may be highly unpopular in the current Russian mood of new political strength and economic power, a strategy based on a more institutionalized approach could bring benefits for Russia. A substantial economic expansion will not be gained through money and power politics alone. What it also needs is image and psychology. And a player submitting to rules will always be more trustworthy than a pure power politics player. In turn, in order to support a political attitude move from Russia, Europe should recognize a positive legacy of Russia gaining back the control over natural resources. It would certainly diminish the wrong political perception of the ECT being only a proconsumer legal mechanism. 2.2.4. EU Regime The EU constitutes an important cross-border set of practices, which has an impact on worldwide development of trade practices. By being the most integrated economic bloc, the EU integration is influencing other regional economic agreements. The EU is characterized by principles of the freedom of movement of capital, commodities, and people. Likewise, the EU practice, reflected at its supranational institutions, integrates the principles of transparency and allocates an important place to the prevention of uneven competition. The EU legislation has not established any specific regime for the oil sector. The internal market directives cover gas and electricity. The EU role emerged in mid-1990s, with the Licensing Directive (94/22/EC) of 1994, which regulates the licensing procedures for exploration, taking into account safety and environmental issues. Among the largest oil producers, the UK adopted the Petroleum Act of 1998 in order to implement the aforementioned directive. Since that time, the UK government has preferred to attract small private investors for exploration activities, which demonstrates their decentralized way of governance of resource allocation. Oil transport in Western Europe has never been subjected to vertically integrated companies. Oil transportation has been diversified between tankers and pipelines. Sufficient market fragmentation avoided the dominance of one or a group of companies in oil transport. Oil companies have been able to develop transportation networks consisting of oil terminals in Western Europe, where the oil can be imported by tankers. The maritime transport has not been a subject of the EU regime since is covered by the Law of the Sea. Onshore pipelines have been built and owned by refinery companies in order to supply their own petroleum products. Consequently, the oil markets evolved independently from the EU trade regime and prior to its development. By contrast, the EU has stimulated the gas and electricity in their internal market. Gas and electricity have longtime been exempt from competition rules as well as from the allocation of policy at European level. These sectors were initially subject to vertically integrated monopolies. However, since the mid-1980s, the process of liberalization of electricity markets emerged with the successful liberalization of the UK wholesale and retail markets. The UK experience opened a debate over electricity liberalization and over the extent to which the gas and power markets should be opened to competition (D. Bohi, K. Palmer, 1996: 12). Furthermore, Scandinavian countries have established a common electricity market, called Nord Pool. Nord Pool consists of institutions allowing coordination between regulatory authorities as well as common standards of market, i.e. contracts which can be transferable from one country to another of the pool. Nord Pool became the first cross-border electricity regime. In 1996, after seven years of intergovernmental negotiation, the EU established the 96/92/CE Directive on electricity sector liberalization. Two years later, the similar 98/30/CE Gas Directive was adopted. Both Directives introduced a competitive retail model within their respective sectors. The model requires the unbundling of transmission and distribution channels which remain exempt from the competitive model, and from generation and distribution, which are subject to competition. The unbundling is coupled with the rules of non-discriminatory and transparent access to shippers which are not the pipeline holders, called third party access. In 2003, two renewed Directives (2003/54/CE for electricity and 2003/55/CE for gas) were adopted with a more precise time schedule for the opening of these markets. EU targets reflect the state-of-the-situation within the liberalization process already existing among its member states. Indeed, energy industries proceeded to unbundling and third party access rules, independent of the European normative targets. The internal energy market establishes its own regime for cross-border trade within the EU. Directive of the European Parliament and Council on the security of gas supply concerning measures to safeguard security of natural gas supply (Text with EEA relevance) THE COUNCIL OF THE EUROPEAN UNION, Having regard to the Treaty establishing the European Community, and in particular Article 100 thereof, Having regard to the proposal from the Commission (1), Having regard to the opinion of the European Economic and Social Committee (2), After consulting the Committee of the Regions, Having regard to the opinion of the European Parliament (3), Whereas: (1) Natural gas (gas) is becoming an increasingly important component in Community energy supply, and, as indicated in the Green Paper ‘Towards a European strategy for the security of energy supply’, the European Union is expected in the longer term to become increasingly dependent on gas imported from non-EU sources of supply. (2) Following Directive 98/30/EC of the European Parliament and of the Council of 22 June 1998 concerning common rules for the internal market in natural gas (4) and Directive 2003/55/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in natural gas and repealing Directive 98/30/EC (5), the Community gas market is being liberalised. Consequently, regarding security of supply, any difficulty having the effect of reducing gas supply could cause serious disturbances in the economic activity of the Community; for this reason, there is a growing need to ensure security of gas supply. (3) The completion of the internal gas market necessitates a minimum common approach to security of supply, in particular through transparent and non-discriminatory security of supply policies compatible with the requirements of such a market, in order to avoid market distortions. Definition of clear roles and responsibilities of all market players is therefore crucial in safeguarding security of gas supply and the well-functioning of the internal market. (4) Security of supply obligations imposed on companies should not impede the well functioning of the internal market and should not impose unreasonable and disproportionate burden on gas market players, including new market entrants and small market players. (5) In view of the growing gas market in the Community, it is important that the security of gas supply is maintained, in particular as regards household customers. (6) A large choice of instruments are available for the industry and, if appropriate, for Member States, to comply with the security of supply obligations. Bilateral agreements between Member States could be one of the means to contribute to the achievement of the minimum security of supply standards, having due regard to the Treaty and secondary legislation, in particular Article 3(2) of Directive 2003/55/EC. (7) Indicative minimum targets for gas storage could be set either at national level or by the industry. It is understood that this should not create any additional investment obligations. (8) Considering the importance of securing gas supply, i.e. on the basis of long-term contracts, the Commission should monitor the developments on the gas market on the basis of reports from Member States. (9) In order to meet growing demand for gas and diversify gas supplies as a condition for a competitive internal gas market, the Community will need to mobilise significant additional volumes of gas over the coming decades much of which will have to come from distant sources and transported over long distances. (10) The Community has a strong common interest with gas supplying and transit countries in ensuring continued investments in gas supply infrastructure. (11) Long-term contracts have played a very important role in securing gas supplies for Europe and will continue to do so. The current level of long term contracts is adequate on the Community level, and it is believed that such contracts will continue to make a significant contribution to overall gas supplies as companies continue to include such contracts in their overall supply portfolio. L 127/92 EN Official Journal of the European Union 29.4.2004 (1) OJ C 331 E, 31.12.2002, p. 262. (2) OJ C 133, 6.6.2003, p. 16. (3) Opinion not yet published in the Official Journal. (4) OJ L 204, 21.7.1998, p. 1. (5) OJ L 176, 15.7.2003, p. 57. (12) Considerable progress has been made in developing liquid trading platforms and through gas release programmes at national level. This trend is expected to continue. (13) The establishment of genuine solidarity between Member States in major emergency supply situations is essential, even more so as Member States become increasingly interdependent regarding security of supply. (14) The sovereign rights of Member States over their own natural resources are not affected by this Directive. (15) A Gas Coordination Group should be established, which should facilitate coordination of security of supply measures at Community level in the event of a major supply disruption, and may also assist member States in coordinating measures taken at a national level. In addition, it should exchange information on security of gas supply on a regular basis, and should consider aspects relevant in the context of a major supply disruption. (16) Member States should adopt and publish national emergency provisions. (17) This Directive should provide rules applicable in the event of a major supply disruption; the foreseeable length of such a supply disruption should cover a significant period of time of at least eight weeks. (18) Regarding the handling of a major supply disruption, this Directive should provide for a mechanism based on a three step approach. The first step would involve the reactions of the industry to the supply disruption; if this were not sufficient, Member States should take measures to solve the supply disruption. Only if the measures taken at stage one and two have failed should appropriate measures be taken at Community level. (19) Since the objective of this Directive, namely ensuring an adequate level for the security of gas supply, in particular in the event of a major supply disruption, whilst contributing to the proper functioning of the internal gas market, cannot, in all circumstances, be sufficiently achieved by the Member States, particularly in light of the increasing interdependency of the Member States regarding security of gas supply, and can therefore, by reason of the scale and effects of the action, be better achieved at Community level, the Community may adopt measures, in accordance with the principle of subsidiarity as set out in Article 5 of the Treaty. In accordance with the principle of proportionality, as set out in that Article, this Directive does not go beyond what is necessary in order to achieve that objective, HAS ADOPTED THIS DIRECTIVE: Article 1 Objective This Directive establishes measures to safeguard an adequate level for the security of gas supply. These measures also contribute to the proper functioning of the internal gas market. It establishes a common framework within which Member States shall define general, transparent and non-discriminatory security of supply policies compatible with the requirements of a competitive internal gas market; clarify the general roles and responsibilities of the different market players and implement specific non-discriminatory procedures to safeguard security of gas supply. Article 2 Definitions For the purpose of this Directive: 1. ‘long-term gas supply contract’ means a gas supply contract with a duration of more than 10 years; 2. ‘major supply disruption’ shall mean a situation where the Community would risk to lose more than 20 % of its gas supply from third countries and the situation at Community level is not likely to be adequately managed with national measures. Article 3 Policies for securing gas supply 1. In establishing their general policies with respect to ensuring adequate levels of security of gas supply, Member States shall define the roles and responsibilities of the different gas market players in achieving these policies, and specify adequate minimum security of supply standards that must be complied with by the players on the gas market of the Member State in question. The standards shall be implemented in a nondiscriminatory and transparent way and shall be published. 2. Member States shall take the appropriate steps to ensure that the measures referred to in this Directive do not place an unreasonable and disproportionate burden on gas market players and are compatible with the requirements of a competitive internal gas market. 3. A non-exhaustive list of instruments for the security of gas supply is given in the Annex. 29.4.2004 EN Official Journal of the European Union L 127/93 Article 4 Security of supply for specific customers 1. Member States shall ensure that supplies for household customers inside their territory are protected to an appropriate extent at least in the event of: (a) a partial disruption of national gas supplies during a period to be determined by Member States taking into account national circumstances; (b) extremely cold temperatures during a nationally determined peak period; (c) periods of exceptionally high gas demand during the coldest weather periods statistically occurring every 20 years, These criteria are referred to in this Directive as ‘security of supply standards’. 2. Member States may extend the scope of paragraph 1 in particular to small and medium-sized enterprises and other customers that cannot switch their gas consumption to other energy sources, including measures for the security of their national electricity system if it depends on gas supplies. 3. A non-exhaustive list in the Annex sets out examples of instruments which may be used in order to achieve the security of supply standards. 4. Member States, having due regard to the geological conditions of their territory and the economic and technical feasibility, may also take the necessary measures to ensure that gas storage facilities located within their territory contribute to an appropriate degree to achieving the security of supply standards. 5. If an adequate level of interconnection is available, Member States may take the appropriate measures in cooperation with another Member State, including bilateral agreements, to achieve the security of supply standards using gas storage facilities located within that other Member State. These measures, in particular bilateral agreements, shall not impede the proper functioning of the internal gas market. 6. Member States may set or require the industry to set indicative minimum targets for a possible future contribution of storage, either located within or outside the Member State, to security of supply. These targets shall be published. Article 5 Reporting 1. In the report published by Member States pursuant to Article 5 of Directive 2003/55/EC, Member States shall also cover the following: (a) the competitive impact of the measures taken pursuant to Articles 3 and 4 on all gas market players; (b) the levels of storage capacity; (c) the extent of long-term gas supply contracts concluded by companies established and registered on their territory, and in particular their remaining duration, based on information provided by the companies concerned, but excluding commercially sensitive information, and the degree of liquidity of the gas market; (d) the regulatory frameworks to provide adequate incentives for new investment in exploration and production, storage, LNG and transport of gas, taking into account Article 22 of Directive 2003/55/EC as far as implemented by the Member State. 2. This information shall be considered by the Commission in the reports that it issues pursuant to Article 31 of Directive 2003/55/EC in the light of the consequences of that Directive for the Community as a whole and the overall efficient and secure operation of the internal gas market. Article 6 Monitoring 1. The Commission shall monitor, on the basis of the reports referred to in Article 5(1): (a) the degree of new long-term gas supply import contracts from third countries; (b) the existence of adequate liquidity of gas supplies; (c) the level of working gas and of the withdrawal capacity of gas storage; (d) the level of interconnection of the national gas systems of Member States; (e) the foreseeable gas supply situation in function of demand, supply autonomy and available supply sources at Community level concerning specific geographic areas in the Community. 2. Where the Commission concludes that gas supplies in the Community will be insufficient to meet foreseeable gas demand in the long term, it may submit proposals in accordance with the Treaty. 3. By 19 May 2008 the Commission shall submit a review report to the European Parliament and the Council on the experience gained from the application of this Article. L 127/94 EN Official Journal of the European Union 29.4.2004 Article 7 Gas Coordination Group 1. A Gas Coordination Group is hereby established in order to facilitate the coordination of security of supply measure (the Group). 2. The Group shall be composed of the representatives of Member States and representative bodies of the industry concerned and of relevant consumers, under the chairmanship of the Commission. 3. The Group shall adopt its Rules of Procedure. Article 8 National emergency measures 1. Member States shall prepare in advance and, if appropriate, update national emergency measures and shall communicate these to the Commission. Member States shall publish their national emergency measures. 2. Member States' emergency measures shall ensure, where appropriate, that market players are given sufficient opportunity to provide an initial response to the emergency situation. 3. Subject to Article 4(1), Member States may indicate to the Chair of the Group events which they consider, because of their magnitude and exceptional character, cannot be adequately managed with national measures. Article 9 Community mechanism 1. If an event occurs that is likely to develop into a major supply disruption for a significant period of time, or in the case of an event indicated by a Member State according to Article 8(3), the Commission shall convene the Group as soon as possible, at the request of a Member State or on its own initiative. 2. The Group shall examine, and, where appropriate, assist the Member States in coordinating the measures taken at national level to deal with the major supply disruption. 3. In carrying out its work, the Group shall take full account of: (a) the measures taken by the gas industry as a first response to the major supply disruption; (b) the measures taken by Member States, such as those taken pursuant to Article 4, including relevant bilateral agreements. 4. Where the measures taken at national level referred to in paragraph 3 are inadequate to deal with the effects of an event referred to in paragraph 1, the Commission may, in consultation with the Group, provide guidance to Member States regarding further measures to assist those Member States particularly affected by the major supply disruption. 5. Where the measures taken at national level pursuant to paragraph 4 are inadequate to deal with the effects of an event referred to in paragraph 1, the Commission may submit a proposal to the Council regarding further necessary measures. 6. Any measures at Community level referred to in this Article shall contain provisions aimed at ensuring fair and equitable compensation of the undertakings concerned by the measures to be taken. Article 10 Monitoring of implementation 1. By 19 May 2008, the Commission shall, in the light of the manner in which Member States have implemented this Directive, report on the effectiveness of the instruments used with regard to Article 3 and 4 and their effect on the internal gas market and on the evolution of competition on the internal gas market. 2. In the light of the results of this monitoring, where appropriate, the Commission may issue recommendations or present proposals regarding further measures to enhance security of supply. Article 11 Transposition Member States shall bring into force the laws, regulations and administrative provisions necessary to comply with this Directive by 19 May 2006. They shall forthwith communicate to the Commission the text of those provisions and a correlation table between those provisions and this Directive. When Member States adopt these measures, they shall contain a reference to this Directive or be accompanied by such a reference on the occasion of their official publication. The methods of making such reference shall be laid down by Member States. Article 12 Entry into force This Directive shall enter into force on the 20th day following that of its publication in the Official Journal of the European Union. Article 13 This Directive is addressed to the Member States. Done at Luxembourg, 26 April 2004. For the Council The President J. WALSH 29.4.2004 EN Official Journal of the European Union L 127/95 ANNEX Non-exhaustive list of instruments to enhance the security of gas supply referred to in Article 3(3) and Article 4(3) — working gas in storage capacity, — withdrawal capacity in gas storage, — provision of pipeline capacity enabling diversion of gas supplies to affected areas, — liquid tradable gas markets, — system flexibility, — development of interruptible demand, — use of alternative back-up fuels in industrial and power generation plants, — cross-border capacities, — cooperation between transmission system operators of neighbouring Member States for coordinated dispatching, — coordinated dispatching activities between distribution and transmission system operators, — domestic production of gas, — production flexibility, — import flexibility, — diversification of sources of gas supply, — long term contracts, — investments in infrastructure for gas import via regasification terminals and pipelines. L 127/96 EN Official Journal of the European Union 29.4.2004 The European Union of Gas Supply Industry (Eurogas) views on the Directive 2004/67/EC Eurogas has considered the proposed Directive on security of gas supply. Eurogas agrees that security of gas supply, so vital for Europe’s economic interests and the welfare of its citizens, needs to be discussed with a view to its most efficient delivery, and any necessary enhancement in the expanding market. Eurogas, however, does not accept the premise that, because of structural changes, additional internal market legislation is necessary on top of the revision of Directive 98/30/EC now before the European Parliament for a second reading and to be implemented by 1 July 2004. The Commission’s analysis underestimates the dynamics of the market and the positive effects on security of supply. Implementation of the Directive’s proposals could weaken the ability of the market participants to meet security of supply objectives. Introduction Eurogas agrees on the importance of examining the implications of these changes in the gas market for security of gas supply, and is considering how resulting challenges are to be met18. Eurogas identifies a number of points, which should underpin the dynamics of gas security. Security of supply is best delivered through properly functioning energy markets, sending clear price signals to all market participants. Security of supply has to be a shared responsibility, taking into account that there are several actors in the market, with different objectives. Gas production, supply, and transport companies will continue to play the main role in delivering security of supply because they have a fundamental economic interest in competing successfully with other energy sources, and developing the gas business. The commitment of these companies will ensure the challenge of meeting security of supply requirements is shared along the gas chain. It should primarily be the supplier’s decision how to do business in a competitive market, where to seek consumer market expansion, and when to deliver gas in competition with other fuel and other gas supplies. 18 In June 2002, Eurogas issued a Position Paper Security of Gas Supplies Markets, Principles, and Actors. This paper acknowledged that because of structural changes in the market the approach to security of supply issues would also evolve, and explored how market participants should respond to new challenges in line with commercial and entrepreneurial objectives. Spot markets and the introduction of more flexible contract formulas will enhance choice improving the liquidity of the market, alongside long-term contracts, which will play a very important role. This combination will ensure that suppliers can offer security of supply as a competitive element. Levels of risk and commercial uncertainties, however, may be higher. As far as possible, market participants should be confident that their investments can yield long-term returns in a stable market, with a rate of return commensurate with the risk. A distinction, however, is necessary in the supply security approach to domestic/smaller customers and large customers. Large customers should be free to choose their own level of supply security based on their knowledge of the commercial and technical options available to them. Households and smaller customers may need some protection beyond what is normally provided for consumer protection. In a regulated system, the regime must provide adequate returns to permit transmission system operators (TSO) and distribution systen operators (DSO) to maintain an efficient and safe infrastructure in a competitive market. The regime should also clarify the role, which regulated networks have in contributing towards security of supply. In any system, security of supply must be based on entrepreneurial responsibility. Reliable long-term supply and demand forecasts for the EU will become even more crucial in supporting management decisions on investment. Setting the legislative framework for security of supply remains a matter of national policy. Member states’ Governments should take adequate measures to assure that their energy policy is carried out in the general interest. Eurogas accepts that the EU should have a non-regulatory monitoring role in security of supply issues, and should ensure that different approaches to security of supply do not introduce market distortions. The EU can facilitate market development by fostering stable political relations with gas-producing regions outside the Community, and promoting a sound investment climate. Eurogas’s global views on the proposed Directive In the light of these key principles, Eurogas has concerns about the approach of the proposed Directive. The issues raised in the proposal have to be analysed in greater depth in dialogue with the stakeholders. Furthermore, although the 134 proposal says it aims to ensure continuing security of supply alongside the development of the internal market, the regulatory approach outlined could be counter-productive to market solutions. Eurogas also refers to the reported debate on the legal basis for this Directive. Eurogas has major doubts about the choice of Article 95 of the Treaty as a legal basis for the Directive and the establishment of the Commission’s competence on security of supply matters. Eurogas affirms that: _ Reserves that could supply the market are robust. There is no fundamental problem connected with increased dependence on natural gas. Gas importation is not a difficulty in principle and should not be viewed as a strategic danger. Therefore the reasoning in this respect and the consequent provisions are open to criticism; _ Open markets, effective liberalisation, in which the responsibilities of the different market participants are clear, and a sound infrastructure will deliver greater security and efficiency of gas supplies. The market framework should incentivise investment, encouraging new production and infrastructure development. The proposal does not contribute to these objectives. On the contrary, the Commission’s proposed new competence allowing it to intervene in the market is likely to distort incentives for market participants and would therefore diminish the effectiveness of the market in providing security of supply; _ All security of supply measures will have costs attached. The proposed Directive does not provide for this aspect. Comments on the different elements of the proposal Measures and security of supply standards (Arts. 3 & 4) Eurogas can agree that member states should be encouraged to develop, in consultation with gas companies, output-related objectives on security of supply. The requirements, however, mentioned in Article 4(1-3) are impractical and inappropriate for several member states. Also, the proposal specifies that they are to be set with reference to the whole customer base except those with fuel switching capabilities. In a competitive market, any special protection should only cover small customers, since the position of large users is quite different. Large users will be assumed to have more knowledge on security of supply aspects, including the commercial and 135 technical options the market offers. They should not require the same level of protection as small consumers. Furthermore, the wording of Article 3.4 referring to “supply standards for gas supplies for power generation” is unclear. While member states should monitor the security of power supplies, it would be inappropriate for the EU to encourage interference with the commercial decisions of power plant operations to build dual-firing plant or to negotiate interruptible contracts. These decisions must be left to market participants, otherwise there will be uncertainty and market distortions. Any general guidance at EU level should be in accordance with the principle of subsidiarity. An attempt to harmonise or standardise requirements, as well as instruments, could lead to non-optimal solutions. Exemptions for small companies and new entrants (Arts. 2.3 & 4, 3.6, 6.2) Security of supply policies must be compatible with the internal market and not constitute barriers to market entry. Policies and measures have to be nondiscriminatory. The proposed exemptions for new entrants and small companies would lead to discrimination between incumbents and newcomers, as well as between differently sized companies. Reporting and monitoring procedures (Arts. 4.5, 5) Monitoring and transparent reporting are important, but these should be focussed on the achievement of agreed goals and any difficulties in meeting these. They should not undermine or negate the responsibilities appropriate to member states, nor impact the management of companies. The framework for the reporting procedure has already been established in the Directive amending the current gas and electricity Directives. Long-term contracts (Art. 6) Eurogas welcomes that the proposal recognises the importance of long-term contracts in Europe’s energy supply, but: _ Setting the definition of “more than one year” will not meet the objective, since that would not be “long-term”. It should be left to the market to decide on the duration of contracts. Long-term contracts in practice are usually from ten to twenty years. The definition should reflect this; 136 _ The approach appears to overlook the equal importance of long-term transport contracts and long-term transport provision. Also, the thinking behind Article 6.1 needs to be explored. Promotion and monitoring of market liquidity is important, but the possible supposition that there could be an insufficient degree of long-term contracts (especially if longterm is more than a year) is not well understood. Contracting future supplies is a decision of market participants. Non-discriminatory authorisation procedures (Art. 7) Eurogas agrees that facilitating authorisation procedures to build new storage or LNG facilities would benefit security of supply objectives. The same would be true regarding new pipelines, especially interconnectors and new supply lines. Action in case of an “extraordinary gas supply situation” (Art. 8) It should be clarified what is envisaged by an “extraordinary gas supply situation” (Art. 8.1). Eurogas is concerned that the Commission could apparently act on its own initiative, without member states’ agreement (Art. 8.3), and considers that the measures planned to respond to extreme and unlikely situations would turn out to be legally, technically, and commercially unworkable. Envisaged redistribution of gas throughout the EU, in the event of an “extraordinary gas supply situation”, presupposes that gas (releases from storage) and capacity (provision of pipeline capacity) are available. If so, markets following price mechanisms and international companies can respond more quickly and efficiently than any public authority. Intervention by the Commission would discourage investors. A better approach to the issue would be to ensure that companies that already deliver a very high level of supply security and member states have agreed on the procedures with each other in the event of a crisis. Cooperation at this level would obviate the need for the Committee provided for in Article 9. Proposed european observation system (Art. 10) Apart from the emergency procedures in Art. 10.3c, other points in Article 10 are covered by the other monitoring and reporting procedures. In addition, the Commission already has a role in monitoring implementation of the internal market (Art. 10.1), and there is the Madrid Forum and the Energy Transport Forum. Eurogas is not convinced of the need for this new body. 137 138 Monitoring of access to storage and possible further proposals (Art. 11) This issue is covered by the Amendments to the Gas Directive 98/30. Conclusion Security of supply is best provided through efficient and properly functioning energy markets sending clear signals to consumers, investors, and national authorities. The proposal underestimates the dynamic potential and driving forces in the market, and some elements in the proposal could have the effect of unnecessarily distorting the competitive market, EU policy states it is putting in place. More information on Eurogas can be found on the following website: www.eurogas.org. Centre for European Policy Studies views Box 1. Definitions of security of supply European Commission: “Energy supply security must be geared to ensuring…the proper functioning of the economy, the uninterrupted physical availability…at a price which is affordable…while respecting environmental concerns…Security of supply does not seek to maximise energy self-sufficiency or to minimize dependence, but aims to reduce the risks linked to such dependence” (European Commission, 2000, p. 2). International Energy Agency: “Technological developments will affect the choice and cost of future energy systems but the pace and direction of change is highly uncertain. Governments will…have an important role to play in reducing the risk of supply disruptions. Regulatory and market reforms…will also affect supply. Increased competition between different fuels and between different suppliers of the same fuel will tend to narrow the gap between production cost and market prices, reducing monopoly rents, encouraging greater efficiency and lowering the cost of supply” (International Energy Agency, 2001). European Parliament: “Being dependent on imports is neither necessarily a bad thing nor economically inefficient provided the sources are diverse, no one supplier is dominant and we can produce sufficient goods and services to pay for them…We cannot alter the fact of where the oil comes from, but we can do a number of things on the demand side, in particular in the transport sector” (European Parliament, 2001). CEPS, in the context of a task force has used the following definition: Security of supply consists of a variety of approaches aimed at insuring against supply risks. Security of supply becomes a cost- effective risk-management strategy of governments, firms and consumers (Egenhofer & Legge, 2001). Source: CEPS, based on Egenhofer & Legge (2001; revised). Eight steps towards the discovery and estimation of risks and costs Step 1: Identification of risks (‘what is the risk?’) A first phase identifies the concrete risks (i.e. definition). This necessitates that generic risks such as ‘import dependence’ or ‘dependence on unstable countries’ are broken down into subtopics, which are associated with risk. Generic categories of such risks are too broad to identify a targeted response. For example, in the case of natural gas, the risks stemming from import dependence can be associated with source dependence, transit dependence or facility dependence. In all three cases the response is different. This issue is dealt with in all INDES Policy Briefs. A detailed application is provided by Luciani in Policy Brief No.51. Step 2: Insurability (‘can risks be insured?’) Insurance only makes sense if there are tools (with reasonable effort) to hedge risk. Note that some risks could deliberately go uninsured because they are ‘uninsurable’ at least in the short term (e.g. terrorist attacks; failure of all major gas suppliers to deliver). Step 3: Assessment of risk (‘how likely is the risk?’) The next step concerns the likelihood. Some risks may be extremely unlikely (e.g. a meteorite falling on a major installation). The conclusion on the likelihood needs to be closely related to potential consequences. This will guide policymakers to decide whether the risk is big enough to consider insurance against. It may be rational and reasonable not to ensure against a highly unlikely limited risk. This is where the issue of cost assessment comes into play for the first time. Step 4: Market functioning/failure (‘can the market ensure the risk?’) Companies, or more generally, the market may be prepared to accommodate risk if the market allows for price differentiation to make it commercially attractive. Examples include the price differential between long-term supply contracts and spot markets both in oil and power. Another example is ‘interruptible contracts’. The fundamental question is how to optimize pricing tools and market instruments (term markets, short-term markets, hedging tools, long-term contracts, involvement of the financial sector, etc.) to achieve a maximum degree of security. Step 5: If the market fails, identification of the affected groups (‘who should be insured?’) A particular risk may not have the same consequences for all members of the society. While a major gas supply interruption for a company with dual fuel capacity may not constitute a fundamental problem, it may be very serious for a domestic customer during winter in Finland. Therefore, there is a need for a clear distinction on how different sectors are affected. Luciani develops this analysis in Policy Brief No. 51, by distinguishing between different customers groups, notably priority and interruptible customers. Step 6: Identification of an appropriate insurance tool (in conjunction with step 2) Mitigating policies can have a long-term ‘strategic’ character (e.g. investing in technological innovation and alternative fuels, democratisation and political stability of fuel-exporting states) and a short-term component (e.g. holding of emergency stockpiles for oil, and perhaps natural gas, use of fuel taxation to reduce private car utilisation, while providing incentives for public transport usage). The two approaches are mutually reinforcing. It is thus necessary to decide according to the issue at stake what tool should be given preference, but only in combination with step 7. Step 7: Cost assessment of the measures (‘how much will the measure cost?’) If policymakers and regulators have identified a risk that needs to be insured against and also a target group, there is a need to assess the cost of the measure. Estimation of costs pervades the entirety of the project, with the focus mainly on the methodology of cost assessment. Step 8: Allocation of costs (‘who should pay the costs?’) Once the measure is implemented, there is still the question of who pays. This does not always need to be the customers. For example, it is low income groups that often are most affected by supply disruptions. At the same time, these groups may not be able to pay for expensive measures. Certain costs may as well be allocated at the member state level (and thus burden citizens within one country only), or concern the entirety of the EU (through taxation). They can also be shared among all customers in the Union through the imposition of a levy, or by other means. Answers to questions in Steps 1–8 will differ in relation to the different sectors (i.e. oil, gas, coal, power) as well as to different countries, reflecting for example differences in fuel mixes or vulnerabilities. Nevertheless, there appear to be a number of sensible EU responses while respecting the principle of subsidiarity. The policy synthesis in the framework of INDES does not make the case for a ‘one fits all’ security of supply policy. Rather it provides policymakers and regulators with a framework to shape decisions on what risks to be insured. 3. Third Approach: new energy economy approach 3.1. International energy interdependency The analysis of the international structures explains indeed patterns of capability among different states. In this respect, a British author, P. Andrew-Speed, proposes a schematisation of international oil interdependency16: 16 ANDREW-SPEED, P., "The Energy Charter Treaty and International Petroleum Politics", CEPMLP, University of DUNDEE, http://www.dundee.ac.uk/cepmlp/journal/html/article3-6.htm. 1. Countries exporting finance and technology, but importing energy, such as the USA, Japan and the majority of the EU countries (Germany, France, Italy, Belgium, Spain) ; 2. Countries exporting oil and gas, but also finance and technology, among which are the UK, Norway, Denmark, and the Netherlands ; 3. Oil & gas exporting countries which import technology and finance, such the majority of the hydrocarbons producers; including the OPEC countries, Russia and the Caspian region (Kazakhstan, Azerbaijan, Turkmenistan and Uzbekistan) ; 4. Countries importing both technology , finance, and energy products: the majority of the EU applicant states as well as developing countries of South-East and East Asia. Structural differences lead to a variety of trends in energy security. 3.2. Investment risks The economic sector of security in general is defined by the vulnerabilities within a market economy. Energy is the key input for an economic system and is widely used in industry, residential and transport sectors. Therefore, low energy prices are the basic condition for the overall competitiveness of an economic system. Trends in the security of gas markets are rather related to the ongoing liberalization process, which is ongoing in many consuming states. J. Stern & C. Van der Linde, The Future of Gas: Will reality meet expectations? 9th International Energy Forum 2004 22-24 May, Amsterdam Executive Summary and Questions Natural gas is the most dynamically growing fossil fuel in the international energy market. The reasons for this growth are obvious: it has been competitively priced and is highly convenient in both industrial and domestic use, as well as in power generation. Furthermore, it is the most environmental friendly fossil fuel. Given the premise of ongoing competitiveness of gas prices, it is not surprising that most energy forecasts, among them the IEA World Energy Outlook 2002, suggest a continuing, substantial growth in demand for gas. New supplies, that are needed to meet growing demand, will have to come from sources much more remote from today’s markets by means of expensive, long distance transport through pipelines or in the form of Liquefied Natural Gas (LNG). For the next 25 years the International Energy Agency expects a 300 % increase in international trade between the major supply and demand areas around the world. Indeed, the notion of a global market for LNG is gaining ground. However, the growth in LNG trade will fall considerably short of the projected growth in demand of 1700 bcm (IEA). The difference, consequently, will have to be met by cross-border piped gas. Many conceptual opportunities for new pipeline projects are looked at but few have reached the actual investment stage. The IEA demand-side growth projections, however, will only be realised when the IEA demand-side growth projections, however, will only be realised when the required additional volumes of gas will be made available in a timely and coordinated way. This cannot be taken for granted. The development of new natural gas supplies faces a variety of obstacles. Even when successful, it takes on average 5-10 years to put a pipeline project in place because political issues, regulatory design, as well as the harmonisation of investments and supply risk, prove to be very difficult to align. Natural gas projects will only materialise if the risks inherent to investment in these projects can be properly mitigated. Characteristic is the great magnitude of risk involved, stemming from the combination of very high investment costs and the lack of flexibility in the supply chain, and the long horizon over which these risks have to be managed. Huge, specific investments have to be made into facilities that produce and transport gas from a specific gas province, or field, to a specific area of consumption over a longer period of time. Long term contracts with competitive pricing clauses have formed an important basis to ameliorate and manage the risks. Security of supply to consumers is as important as security of demand is to producers and transporters of gas. The development of gas demand, in part, depends on government policies, such as security of supply and environmental policies, restricting the use of fossil fuels. Security of supply policies can either be aimed at a reduction of the dependence on imported fuels or at an increased diversification of suppliers. Yet, other aspects may also be determined by government policy. Transparency, consistency and predictability of government policies form the backbone of successful gas development. But in addition, positive action and supportive participation in the orchestration of a new gas supply chain is essential. In some gas markets, notably the United States and EU, the governments have embarked on a process of liberalization. Experience learned that economies need an adequate institutional framework to reduce uncertainties among market participants, to correct un-avoidable failures in the operation of the market, or the sheer lack of a market, for certain categories of goods and services and to safeguard public interests. Deregulation became re-regulation, and privatization was to be undertaken as a strategic process. Moreover, it was accepted that structural change should pay due attention to public interest issues and to the objectives of competition policy. Unlike the traditional perspective that denied the feasibility of competition in the whole of the gas industry, the proponents of structural change start from the hypothesis that the introduction of competition is possible in particular segments, and that this would improve the performance of the whole of the value chain. Furthermore, regulatory experience in gas markets has shown that competition in the gas market can be achieved in several ways, each requiring a specific regulatory approach, depending on the stage of development of these markets and the geopolitical and economic characteristics of supply and demand patterns. The size and the complexity of gas projects require a high degree of confidence and assurance. Generally, the economic risk, particularly for large scale international supply systems, is mediated by sellers and buyers, through appropriate arrangements embedded in long term contracts and only to a lesser extent through spotmarkets and hedging facilities. Nevertheless, the need to co-ordinate investments in projects throughout the supply chain and the objective to minimise the lead times will require full cooperation between all stakeholders. Agreements between these parties, as a precondition for investments in large-scale gas projects are complex and may require government support. This important role for government applies both to the active involvement prior to the investments, facilitating the process of putting the necessary conditions in place, as well as to provide the comfort for a prolonged business climate, positive to these large investments. With regard to the long term period of repayment of investments in gas supply chains, sellers and buyers, together with equity investors and financial institutions, also consider risks which are fully in the domain of governments, like: - The political stability of producing countries and the risk that gas supply, or transit, will be refused for political or economic purposes. - The political and regulatory stability of consuming countries and the risk that market circumstances may change unexpectedly for reasons of economic, environmental or other policies. Thus, despite the ability of the private sector to manage many of the risks involved in complex gas projects, the government plays a crucial role in creating such a climate that these risks remain manageable over time. International gas markets as well as public interests are not static but dynamic. The task of the government is to facilitate an investment climate that evolves in line with the various stages of market. Assuming that producing and consuming governments wish to realise the full economic benefits of the projected future production and demand for gas in global energy balances, this will require a more proactive role of governments than would be the case for other fossil fuels. The enabling factors that they should consider include the following: _ Developing clear energy and regulatory policies which facilitate both the production and use of gas and the development of infrastructure; _ Developing policies on environment and emissions where the priority for gas production and gas use - in comparison to other fossil fuels and renewable/nuclear energy sources - is clearly stated, especially in terms of taxation; _ Developing clear policies on security of supply and demand in terms of dependence on: _ imports of gas from a single source of supply or company _ exports of gas to a single market or group of markets _ a specific supply route for gas _ Ensuring that plans for future liberalisation and the development of competition in all phases of the gas chain are articulated well in advance, and that such plans: _ do not compromise existing long term contractual arrangements; _ take account of the requirements to ensure long term security of supply _ recognise the need for long term contractual arrangements (and possibly aggregation thereof) to secure new supplies for most markets _ recognise the need for capacity contracts, back-to-back to the conditions of new supply contracts _ are discussed between producing and consuming governments either bilaterally or in multi-lateral governmental fora; _ Providing active assistance in stitching together international gas chains in terms of treaties, and international/multi-lateral relations between states; _ Providing a policy framework for the power generation industry allowing for timely decisions to commit to investments in new gas-fired generation capacity, recognising the anchor role of power generation for attracting new gas supplies _ Providing financial guarantees (via government credit agencies) and limited financial support, particularly for very large multi-billion dollar gas investments; _ Ensuring that taxes and other fiscal measures upstream and downstream do not discourage market players from moving ahead with gas projects in a timely fashion. The International Energy Forum could play a significant role in developing and achieving these enabling factors for producer and consumer governments. Question to Ministers of Consuming Countries: How do the ministers think they can best organise the balance between liberalization of the gas market and security of supply? Question to Ministers of Producing Countries: How do the Ministers think to they can best organise a balance between risk and rent that facilitates a sustainable exploitation of their gas resources in the future? Question to all Ministers: How do the ministers think they can solve the information gap, that follows from market liberalisation, in order to continue to achieve a timely match between future demand and supply? Risk, investment climate and the role of the government Natural gas projects will only materialise if the risks inherent to investment in these projects can be properly mitigated. Security of supply to consumers is as important as security of demand is to producers and transporters of gas. As is shown above, investments in gas supply chains involve a considered view that an adequate level of sales over a long period can be achieved at market reflective prices. The development of gas demand, in part, depends on government policies, such as security of supply and environmental policies, restricting the use of fossil fuels. Security of supply policies can either be aimed at a reduction of the dependence on imported fuels or at an increased diversification of suppliers. Yet, other aspects may also be determined by government policy. Transparency, consistency and predictability of government policies form the backbone of successful gas development. But in addition, positive action and supportive participation in the orchestration of a new gas supply chain is essential. Market Structure The gas markets around the world differ substantially in their stage of development. Some markets have already matured, such as the United States, Japan and South Korea, while other markets are still in a first expansionary phase (such as India and China). Europe covers the full spectrum from emerging to mature markets. But even mature markets will require considerable new investments in infrastructure to meet projected growth. The United States is in a process of changing from a predominantly domestic gas resource base to a mixed resource base with increasing LNG imports entering an already liquid market. In Europe there are mature markets, mostly based on domestic supplies and/or long term supply contracts from external resources; and new markets (mostly around the periphery) based entirely on imports from outside the region. Based on its conomic competitiveness, it is predicted that gas will contribute substantially to the fuel in the power sector. The Asian market remains a mosaic of national gas markets which largely depend on LNG imports and which have different regulatory structures. There are very few mature markets and a relatively high proportion of countries where gas is either a new fuel, or accounts for a relatively small proportion of energy demand. In an expansionary power market, gas will predominantly be used to fuel new power capacity, while in a more mature market additional gas demand must also come from the replacement of other fuels in the power sector. The size of both new and replacement gas demand will depend on the economics of gas in the power sector and the portfolio management of large power suppliers. In many markets, both developing and mature, the power industry has an “anchor” role in developing new gas supply lines as a consequence of its capacity to absorb significant additional volumes of natural gas. However, if newly planned power stations at the end of the supply line are not built in line with the development of the rest of the infrastructure, less gas will flow and financial risks are incurred of an unacceptable scale. The firmness of contractual obligations and the assurance that contracts can be efficiently enforced is crucial in this respect. Yet, given the key role of the power sector, regulatory certainty in this sector is a precondition for a smooth development of the gas sector. In liberalised electricity markets, the commitments for gas purchases have to be made by the power industry proper. In countries where the power sector is a public utility market, the authorities will have to commit. In either case, keeping options open is not going to bring new gas to the market. It will be hard enough to reconcile the volumes and flexibility that the prospective power generator is looking for with the “security of demand” needed to line up the supply chain. Uncertainty about government policies and regulation in a liberalising business environment will not help in making these commitments. Pricing The immense investments require a certain level of prices for natural gas. Tensions may arise with regard to the understandable objective of consuming governments to keep prices low, especially for small consumers. Regulated low prices, however, discourage natural gas developments in many markets with growth potential, which in turn could frustrate the growth of the national economy. In other markets governments have been promoting the introduction of competition and consequently introduced market prices into natural gas markets. Changing markets bring changes in prices and pricing principles. Increasingly, even long term contracts develop different indexations. In the future short term price volatility, like in other fossil fuel markets, will be a fact of life. However, the greater risk, affecting gas prices over the longer term could well be the lack of timely investments in new supplies: shortages of gas supplies drive up gas prices in the markets, leading to economic pain for consumers and in the second instance to a loss of confidence in the competitiveness of gas among the investors in the power sector. It is argued that the governments have the responsibility to foster investments climate conducive to these timely investments and thus prevent unnecessary and prolonged price fluctuations. Transportation Shipping oil is much cheaper than transporting pipeline gas. LNG can only compete with pipeline gas beyond a few thousand kilometres from the market. Especially for pipelines, inadequate or non-existing legal and regulatory regimes add extra hurdles to bringing the needed regular supplies to the market at viable economic costs. For transit pipeline projects – that is projects which cross third countries between exporter and importerunstable bilateral political, economical and regulatory conditions can prevent gas from reaching the markets. The gas chain is as strong as its weakest link. 4. Regulation of gas markets Where the new rules for a liberalised market environment are still in the process of evolution, natural gas projects, given their long repayment periods, are suffering from a lack of certainty about the future regulatory framework. Liberalisation may, in addition, lead to fragmentation of markets and create noise in the information flow, which in turn could delay the signals that invoke new investments. In response to the characteristics of the gas industry discussed above, a variety of hierarchical relationships have been established over time amongst gas producers, transporters and consumers. In case of contracts, the volume and the price risk were reduced, by agreeing to price structures and by establishing specific terms of trade for a longer time period, so that the producers’ as well as the consumers’ investments would not be jeopardized. Often this involved a role for public bodies, taking ownership and management over (parts of) these systems. As a consequence, gas markets have developed on a regional scale, each with its own market structure, its characteristic institutional framework and specific roles for governments and local authorities and, eventually, its particular outcome, in terms of the economics of supply and demand. Towards the end of the last century a new perspective on regulation developed, driven by, on the one hand, international economic integration of national markets for goods, labour, capital and services, and on the other, by the general aim to reduce the role of the state in the coordination and ownership of economic activities, in favour of the market and private initiatives. This new approach was slowly accepted in the latter part of the last century. Initially, a simple withdrawal of the state from the economy was advocated, through the privatisation of state owned enterprises and the deregulation of public utilities, which would be sufficient to bring about the advantages of unconstrained markets and the associated gains in welfare and economic growth. Over time, however, empirical evidence has shown that economies need an adequate institutional framework to reduce uncertainties among market participants, to correct unavoidable failures in the operation of the market, or the sheer lack of a market, for certain categories of goods and services and to safeguard public interests. This new vision demanded a much more subtle approach. As part of the process, the specific form of economic restructuring in the distinctive industries and sectors and the accompanying sets of rules and regulations appeared on the agendas of policy makers, industry associations and researchers. Deregulation became re-regulation, and privatization was to be undertaken more as a strategic process. Moreover, it was accepted that structural change should pay due attention to public interest issues and to the objectives of competition policy. Of course, this refinement of the recipe for restructuring induced an expansion of the regulatory framework and the toolbox of regulatory instruments and, associated therewith, the responsibilities of the regulatory agencies. The latter, initially, were meant to operate as lean and mean executive organizations, but being forced to develop and apply new insights in regulatory practice, they rapidly grew in scale and scope. A number of general issues of importance can be derived from recent experiences in the economic regulation of sectors, although there is a large difference in the regulation aimed at the identification and correcting of abuse of dominant positions and the structuring of the industry and its processes so as to maximise the objective of creating a competitive environment: The latter, in the absence of adequate experience, contains experimental aspects with their inherent risk of failure and uncertainties about future change. To operate effectively regulators should have a clear, politically determined, legislative mandate, establishing in unambiguous terms, their objectives, their tasks and the degree of freedom in developing guidelines and rules. To operate independently on behalf of their general public responsibilities, regulatory systems and regulators should seek to secure and carefully balance the interests of both the several segments of the gas industry and the (large and small) consumers. To achieve an appropriate level of legitimization, regulators should be held accountable both in respect of the reasons they give for their decisions and by making the regulatory process fair, open and accessible to the firms and stakeholders alike. To gain trust in the industry and among consumers, regulators should have a more than adequate level of expertise, which is as independent as possible from industrial, consumer, or political interests. Finally, a regulatory system should be efficient, in the sense that the benefits of its involvement to society should outweigh the direct and indirect costs of its interventions. Approaches to gas market regulation In this section we discuss policy options in the regulation of the gas sector. Perhaps more so than in other fields of regulation, it is clear that the policy towards the functioning of markets and the safeguarding of public interest is an extremely urgent concern. In complex, specific, networks, such as the electricity, the natural gas, the telecom and the water systems and in transport infrastructures, essential facilities are involved, through which the controlling party is able to obstruct any serious competition by other (potential) suppliers, while exploiting its monopolistic position vis-à-vis the consumers. This effectively ruled out an integral liberalization of these systems and required the establishment of adequate regulatory regimes. To be sure this debate is ongoing. For example, recent experiences, such as the blackouts in Europe and California, railway accidents and the emerging problems with the supply of natural gas, provide confirming evidence of the need to create fine textured regulatory approaches. Unfortunately, there is a serious question whether there is a uniformly applicable approach for all stages of development of the gas market. Quite apart from the fact that a regulatory structure is very much a system and context dependent phenomenon, we are doubtful that such a approach would provide an optimal route as the advocates suppose. We argue that four main facets stand out in respect of the regulation of these systems. The manner in which the value chain of the industry is re-structured ex-ante is related to the question as to what vertical segments of the supply system should be characterized as an essential facility, requiring regulation, and which segments could be potentially competition driven, if an adequate horizontal structure could be arrived at. The determination of the ownership of the essential facilities in the value chain is a strategic issue, involving aspects like the attractiveness to private investors, the degree to which their information can and should be checked by regulators, the possibility to create mutual commitment by establishing public private partnerships, etc. The marching orders of the regulatory agency on how to structure the industry and its processes so as to maximise the objective of creating a competitive environment, vis-à-vis the government, the industry and other agencies involved, like competition authorities and other countries’ regulatory approaches. Unlike the traditional perspective that denied the feasibility of competition in the whole of the gas industry, the proponents of structural change start from the hypothesis that the introduction of competition is possible in particular segments, and that this would improve the performance of the whole of the value chain. Typically gas supply systems involve four segments. The exploration and production segment includes a variety of firms involved in exploration, drilling, production, and the collection of gas from the fields’ wellheads, to move it to the transmission pipelines. Gas production is a potentially competitive segment of the industry. Producers sell natural gas to a gas utility, or to traders, which sell it to the end users. Main elements of the regulation involve a depletion and taxation regime, plus (ex- post) competition policy, to restrict the market power of the gas producers, relative to each other, to the utilities and to large consumers. Gas transmission involves the long distance, high-pressure pipeline transport of gas from the producers to the consumer markets, or LNG systems including, gasification, ocean-going tanker transport and re-gasification terminals. Natural gas distribution consists of the local operations necessary to deliver natural gas to the end users, including low-pressure pipeline transportation, metering, and supply activities vis-à-vis the several types of customers. The distribution segment of the industry is seen as a natural monopoly, because of the economies of scale and scope, the fixed costs of pipeline construction and the relatively low variable costs of their operation, plus their essential facility character. Depending on the maturity of local systems, their specific lay-out and the particular function of these connections, this segment should be more or less actively regulated, with a focus on access conditions, the fees charged, the cost recovery of the systems and their timely expansion. What is crucial here is the balance between the longer-term interest of the investor and owner of the system and the short-term users’ interest of low cost, flexible transport contracts. As gas supply is becoming increasingly dependent on long-distance cross border pipelines, international treaties safeguarding transit will be required. The WTO agreements may not be sufficient to minimize the risk of international transport. Multilateral treaties like the Energy Charter and its Transit Protocol have been established to fill this void. The Energy Charter, as an example, may be an important support to investments in production and transit capacity. So far, 46 countries and the European Communities signed and ratified the Charter, but some important states have not yet ratified. In other situations, specific bilateral transit treaties may be more appropriate. A discussion exists in respect of the regulation of storage, blending and other facilities, to secure open access and avoid an abuse of a dominant market position in the provision of these services. If, because of the scarcity of such facilities, competition policy fails to provide the required openness, other forms of access regulation – similar to that for pipelines - should be taken into consideration. Trading refers to the resale of natural gas in the wholesale market and retail market. Unbundling of the vertical column of the gas industry creates a large number of supply companies, which aggregate demand and supply for a number of smaller market participants by purchasing natural gas and transportation services on their behalf. New flexible shortterm trading and contractual arrangements will be provided to balance supply and demand and give market participants the flexibility they need. Yet, end-users may have to be protected from the market power of gas traders, while ex- ante merger control or expost competition policy may be necessary to reduce anticompetitive behavior in this segment. A general view on the way in which economic restructuring in these different segments of the value chain may take place should recognize that liberalization, regulation and unbundling, and merger control , are means to achieve an end. The aim is to establish efficient and effective systems that supply energy, including natural gas, to end consumers in a manner that is commercially sound and that supports the overall welfare, from an economic, a social and an environmental perspective. This implies that, given these objectives, a deliberate choice will have to be made with respect to the precise means to achieve these goals. Arguably, it is in the combination of context, objectives and instruments that the appropriate outcome emerges in different countries and regions. Fourth approach: critical (non-liberal) approach towards the energy security As has been pointed out by a political economist S. Strange, this economic sector can not be analysed in purely quantitative terms. The oil shocks were partially provoked by Israeli-Arab conflict of 1973, which can not be incorporated into economic modelling17. On these grounds, she stigmatises the existing theoretical barriers existing between three major social sciences, i.e. economics, political science and international relations and stresses the need to analyse energy security from both economic and political angles. Her conception represents a particular view of a structural approach to the international political economy: the structures which shape global political and economic behaviour for states, firms, and other social and economic actors18. She argues that four primary structures, namely security, finance, production and knowledge, constitute a source for structural power of international actors19. Energy, in turn, plays a vital role for production (especially industry, residential and transport sectors), finance (in terms of benefits provided especially by oil trade), knowledge (related to technological development, including energy and environental sectors), as well as security (setting up international institutions dealing with energy supply or direct intervention in oil-producing regions)20. Electricity and gas liberalisation constitutes a basis for new energy security scares. Firstly, opponents of the electricity liberalisation refer to the Californian crisis of 2001, caused by the inability or unwillingness of the private sector of this American state to provide long-term power supplies for its electricity generation (“Californian syndrome”). Secondly, as far as gas security is concerned, full liberalisation might lead companies to refuse to establish legally required gas storage because of tougher competition with other gas distributing companies21. In this respect, liberalisation gives new grounds for political debate over the role of the private sector in ensuring energy security. Gazprom considerations of security of supply in the liberalizing markets 17 STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 191. STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 25. 19 STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 27-29. 20 STRANGE, S. (1980), States and Markets, Pinter Publishers, London, pp 186-206. 21 BUCHAN, D. (2002), “The Threat Within: Deregulation and Energy Security” in Survival, vol. 44, no 3, Autumn 2002, p. 109. 18 OAO GAZPROM (RUSSIAN FEDERATION) General framework Open Joint Stock Company (OAO) Gazprom is responsible for gas production in Russia. The state, represented by the Russian Government, holds 38% of the company’s shares. Gazprom is responsible for gas supply security as well as for the development of the United Gas Supply System (UGSS) of Russia. Gazprom owns and operates a gas pipeline network, which is an integral part of the UGSS. Besides, Gazprom bears sole responsibility for gas export outside the former USSR territory through Gazexport, Ltd., fully owned by Gazprom. Gazprom is also involved in financing, engineering, construction and ownership of gas transmission facilities in a number of European countries. Oil companies and other gas operators also produce natural gas; they each produce about 6% of the total Russian gas production. Gazprom holds interests in the share capital of the majority of the said gas producing companies, while fully independent companies produce somewhat over 1% of the total gas production in Russia. Independent gas producers sell their gas mainly in the Russian internal gas market; nevertheless, in 2001 they provided a quarter of the total Russian gas deliveries to the Commonwealth of Independent States (CIS) and Baltic states. Gas production of other companies and their share in the total Russian gas production is expected to significantly grow in the future – up to 20%. The projects for the extension of the gas infrastructure are financed in Russia by attracting private capital (corporate financing) through bank (non-Governmental) credit facilities. Definition/concept of security of gas supply While security of natural gas supply is supposed to be a multifaceted concept and not easy to define, there are three dimensions of particular relevance: Resource and infrastructure availability (physical existence of sufficient resource, existence of adequate infrastructure to bring the resource to market); Economic availability (affordability of supplies, contractual arrangements in place (including transit); 158 Supply continuity (accidental short-term disruption (natural/technical causes), deliberate supply disruptions). The physical existence of gas resources will be no limiting factor in the further development of the gas market. To mobilise these resources for Europe, the required field developments and infrastructure construction have to take place in a timely fashion. The import dependence is not seen as a problem, given that political and economic stability exist to allow for a long-term supply planning and fostering the required infrastructure investment. The costs of gas production (including gas transmission/transportation) are very likely to increase because of the following: remote production areas; difficult climate conditions and physical circumstances; and stricter environmental constraints. Changes in the European gas market, mainly triggered by the liberalisation process, will lead to new structures and redistribution of responsibilities. As transmission and distribution activities have to be legally separated from other activities in the gas chain, responsibility for security of supply will be a shared responsibility of all market players. One of the gas industry key policy elements for the security of natural gas supply is diversification (new pipelines from new and “traditional” suppliers, new LNG projects either from existing or new players, etc.). At the same time, it is necessary to pay due attention to the reliability of the new gas suppliers. All relevant market players should be involved in deciding the required levels of security of supply and how those levels should be implemented. The end-consumers have their demand and pay for it. The gas industry is responsible for supplying what is contracted. It will be a challenge for the total gas industry to maintain the efficiency and reliability, which the end-consumers are used to. The company’s instruments used to secure supplies All forecasts predict significant growth in gas demand in the EU countries, on the one side, and reduction of indigenous gas resources in the EU, on the other side. The world’s biggest Russian gas reserves are one of the main sources that can be used to meet increasingly growing gas demand. Gazprom, with its undisputed reputation as the world’s biggest and highly reliable gas exporter, has accumulated vast experience (over 30 years) in the gas business and managed to build a long-term portfolio (up to 25 years) of gas export contracts, which 159 enables it to meet a major part of expected gas demand growth. Under the framework of the liberalised gas market in Europe, this objective cannot be reached without signing long-term take-or-pay agreements. In the company’s view, these contracts should lay the basis for further development of the gas market and they should embrace no less than 75-80% of gas market volume. Growth in gas exploration, production and transmission costs in Russia due to natural depletion of major gas producing fields in the northern Russia (beyond the Urals ridge), commercialisation of the far north fields and development of deep-seated gas-bearing structures actually increase gas costs. To implement large projects related to the field development and gas transmission infrastructure construction, tens of millions of dollars are required in investments. It is only long-term contracts that assure the payback of investments incurred – a vital condition for project financing. Since the late 1960s, Gazprom has heavily invested in developing the UGSS, which today plays a key role in securing Russian gas deliveries to Europe. Under present conditions, when huge investments are required to maintain and develop the UGSS in order to build up gas export, Russia cannot successfully implement capital-intensive projects without access to western capital. Financing of capital-intensive gas projects is a key factor which will shape future natural gas deliveries to Europe. Although huge investments are required, the following key issues have to be resolved: Equal rights for Russian companies in getting access to the European capital market (for the time being, loans offered to Gazprom are 2-3 times as expensive as those offered to big western corporations); Financial participation of European consumers in the development of Russia’s export-oriented mineral base and respective gas transmission infrastructure; Investment risk sharing among producers, gas transmission companies and gas consumers, which can be realised through the conclusion of long-term take-or-pay agreements on gas supply, transmission and transit. If a full-scale legal unbundling is to take place in the EU countries, it may cause serious problems and also additional administrative and technical expenses in case of overregulation. This may have a negative impact on the efficiency of the whole gas industry and consequently lead to unnecessary increase in tariffs and end-consumer gas prices. The main problem would be the obvious discrepancy between decision making regarding the infrastructure and decision 160 making regarding market development/supply. Lower investments in the infrastructure and discrepancies between transportation/service contracts and supply/trade contracts could seriously affect the security of supply. In order to maintain the current level of security of natural gas supply, it is important to avoid unnecessary costs or taxes on natural gas. At the moment, there is no significant threat that the gas industries might not be able to maintain their extremely high level of security of supply as has been displayed by them so far. Unfortunately, some new regulations could threaten this favourable future, even in the short run. A clear example is the impossibility in some countries to match long-term supply contracts with long-term transit/transportation contracts. Such anomalies should be removed as soon as possible. They cause unnecessary additional costs and supply risks in the market. The EU policy pertaining to Russian gas purchase is dual. On the one hand, the EU Gas Directive notably worsens Russian gas sales conditions in the EU gas market. On the other hand, the EU leaders expressed their intention to double gas import from Russia. The EU Gas Directive primarily protects the consumer interests, ignoring the needs and interests of producers. At the same time, short-term and spot market deals are considered as an alternative to long-term contracts. In our opinion, the significance of the former is obviously overestimated. A growing number of short-term and spot market deals naturally disturbs gas trade effected under long-term contracts and, in fact, undermines Europe’s gas supply security. At present, the EU Commission is investigating long-term agreements on Russian natural gas purchase in order to find out whether certain articles of these agreements, banning the re-export of Russian gas delivered (the so-called territorial restriction clauses), comply with the EU legislation. The ban was introduced into agreements from the very beginning in order to prevent unfair competition in the gas market due to natural gas price differences caused by different terms and conditions proposed to various buyers in various European countries. Therefore, some western companies could actually obtain unfair profit through Russian gas re-export. For the time being, Gazprom is in negotiations with the EU Commission on this matter. During these negotiations, the EU Commission representatives had to recognise that the issue of “destination clause” was extremely important for Gazprom, and it is necessary to find an alternative economic approach to resolving the re-export issue. Yet, the problem still needs some time to be solved. 161 162 Since major gas resources are located far away from Europe’s main gas-consuming regions and natural gas has to be transported through many countries to reach end-users, it is obvious that the issue of unrestricted natural gas transit through all the EU countries, whose borders divide gas producers and gas consumers, plays a key role in securing gas deliveries to Europe. In this respect, the following issues should be focussed upon and solutions found: Fair, non-discriminatory gas transit tariffs in all countries involved, based on investments and operating costs and a reasonable rate of return, which, therefore, should reflect the interests of gas suppliers and owners of gas transit facilities; Right of first refusal (priority right in getting access to gas transit pipelines) when producer/trading companies have to fulfil long-term obligations and their transit contract is expiring. The intention of the EU Commission to consider gas transit within the EU as an internal gas transportation activity, carried out under the EU regulation, seems to be unacceptable for Russia. This stance appears to be a refusal to respect gas transit obligations taken when signing gas purchase contracts with Russia, and the aspiration to obtain exclusive jurisdiction in respect of gas transit issues within the EU. Belyi & Kuzemko, Conflicting values in gas markets: a view on the UK-Russia relations, 2007 (forthcoming) Introduction The beginning of the twenty-first century has been characterized by the increased role of Russia in energy supplies to North West Europe. Since 2001, Russian gas has been traded in the UK and in 2005 Gazprom engaged in a gigantesque project when it started construction of an underwater pipeline, the Nord Stream, from Russia to the UK through the Baltic Sea and Germany. In turn, the UK is entering a transition period from its recent status of oil and gas exporter to one of import dependency in both products. Hence, the UK and Russia have entered into a position of interdependent interests in the gas trade. Notwithstanding this objective interest between the two States, their relations have, in the past few years, become quite difficult in political terms. Such difficulties are caused by their opposing political approaches, particularly in the case of energy. As any economic policy is based on the preference of certain values over others (S. Strange, 1998), energy relations are based on the political values of both countries. Indeed, their respective recent historical backgrounds demonstrate rather opposite political trends: on the one hand, the UK has since the mid 1980’s been at the forefront of gas market liberalization; and on the other hand, Russia is attempting to reinforce national control over energy flows, including gas. This has led to a number of concrete political issues, namely: - The waiver of Gazprom’s participation in the UK distribution market due to the lack of reciprocity regarding market liberalization in Russia; The insecurity of long term investments in the Nord Stream pipeline undertaken by Russia. In addition, the UK-Russia gas trade relations cannot be separated from the general European context, marked by ever-increasing cross border trading. The UK has been a frontrunner in the liberalization process in Europe, however, it remains unclear what the future prospects of this process are both in the UK and the continental Europe. Considering this context of the gas markets, the analysis of UK-Russia energy relations consists in demonstrating the historical background of these two political approaches particularly in the gas sector, which, in turn, are having an impact on current energy relations between London and Moscow. For instance, Russian re-nationalization of Gazprom and re-negotiation of existing contracts with Shell and BP have provoked a reluctant, sometimes even virulent, response in London. In turn, capacity auctions and spot markets in the UK are feared as a factor of long term gas market demand instability in Moscow. The purpose of this chapter is to demonstrate those misunderstandings between Russia and the UK which stem from the historical development of the differing political approaches in the gas sector. In order to proceed with this study, the present article suggests the following structure: first, we outline the historical development of gas market liberalization in the UK and consequences for current policy; second, we point out the logic of the current trend in Russian gas export policy which is quite opposite to the UK liberalization trend; third, we analyze the resultant influences on UK-Russian relations in gas sector. 1. UK Historical background: gas market liberalization and multilateralism The period of Labour government immediately after the Second World War saw a prolonged attempt by the British government to bring energy supplies under the control of government, not entirely unlike what is happening in Russia today. The 1948 Gas Act allowed for the nationalization of the system which proved a radical departure from the previous system which had consisted of over 1,000 separate municipally and privately owned gas companies. The process of nationalization caused these companies to be consolidated into the 12 gas boards each of which had a good degree of independence with their own executive boards and chairmen. The Gas Act of 1972 further centralized control of the industry with the creation of the British Gas Corporation, the relatively autonomous gas boards became regions of geographic control under British Gas central administration. However, during the 1970’s, there were two major changes in the UK which radically effected gas policy thereafter. The first was the discovery of gas by British Petroleum (BP) in the West Sole field off the coast of East Anglia in 1965. This find, despite early set-backs, encouraged further investment in exploration. The harsh economic conditions of the 1970’s, combined with the first ‘oil crisis’ kept the emphasis on further exploration and development in the UK North Sea with the goal of becoming self-sufficient in oil and gas. This was ultimately achieved in both commodities when the UK became a net exporter of oil in the early 1980’s and of gas in 1997. This self-sufficiency provided the economic and geopolitical backdrop to the next round of reform of the gas sector, but this time in reversal to what had gone before. The second major change was the ascendancy of the Conservative Party which provided a deeply ideological context to future reform. The ultimate liberalization of the UK gas market which took place between 1992 and 1998 found its roots in the 1982 Oil and Gas Enterprise Act under the Conservative government of Margaret Thatcher. This Act not only opened up UK pipelines to third party competition but also gave the government the power to sell off British Gas assets and was part of a general programme of liberalization and privatization across Great Britain. The opening up of UK pipelines is held as being responsible for the ensuing ‘boom’ in the UK oil and gas industry and associated oil self-sufficiency22. By the mid 1980’s there were over 100 oil and gas installations in production in the North Sea. Further ramifications of the domination of neoliberal ideology over UK domestic policy was the freeing up of trading commissions in the financial centre of London, the ‘city’. The ‘Big Bang’ had led to a proliferation of financial organizations and a boom in trading exchanges, including oil and gas. Today London is the global centre for oil and gas trading through the International Petroleum Exchange (re-named the Intercontinental Exchange in 2005) and since 1995 there has been a UK Gas Forwards Market in operation. During the 1980’s the Thatcher government ‘downgraded’ the Department of Energy to an adjunct of the Department of Trade and Industry (DTI) on the premise that ‘the title smacked of economic planning … whereas our (UK) energy needs should be supplied by the market’23. This was the start of the overt depolitisization of UK energy. In 1986 the British Gas Corporation was privatized and the regulator ‘Ofgas’ was created. Liberalization was complete by 1998. In 1992 competition was opened up in the commercial gas market and alternative suppliers to British Gas started to enter the market. This was followed in 1996 by partial, and then in1998, full lifting of restrictions on competition in the retail market. These quite substantial reversals away from state control resulted in a system which was consciously designed so that there would be little or no government involvement in the provision of energy in the UK. This put the UK at the forefront of gas market liberalization. Despite a great deal of European Union discourse about gas market liberalization in most of Europe, including Germany, France and Italy, the encumbant gas company still controls over 80% of the market. In the UK British Gas controls only 25%. 22 23 Hanson, North Sea Oil and Gas website Bob Blackhurst 2004, Foreign Policy Centre: http://fpc.org.uk/articles/264 The context behind current energy policy is very different although the tendency for government to remain apart from involvement in energy supplies is largely the same 24. With the peak and decline of North Sea oil and gas reserves the UK became a net importer of gas in 2004, ahead of expectations, and of oil in 200625. In addition to the UK’s resultant dependence on imports, particularly of gas26, to fuel their economy the demand for gas is increasing across Europe and globally. Coupled with these demand concerns are those over the threat to energy supply from terrorism and from producer countries which are seen, in the UK, as being unreliable. This combination is seen as constituting a threat to energy security which, in turn, ‘has resulted in a threat to market oriented tendency(ies)’27. The argument is that those who seek national energy security are more often than not states but, conversely, ‘liberalized energy markets circumscribe the potential for government intervention’.28 There are a number of further effects of liberalization on the UK gas sector, and on the ability of the UK government to provide ‘energy security’. The legacy left behind of the depolitization of energy supply has implications for the current need to secure stable supplies of gas at affordable prices in the future29. Since privatization the gas sector has been run by the private sector and its rationale of profit maximization means that the spare capacity in gas storage that had been built up by previous generations has now gone30 This means that the UK needs to invest heavily, and swiftly, in adding storage capacity in order to be physically able to import gas in the quantities required to supply future needs without heavily impacting prices31. The issuance of a ‘Gas Balancing Alert’ in the winter of 2005 served as a warning to government and private industry participants that a lack of ‘joined up’ action with regard to future energy needs is at odds with the aims of provision of energy security. Excess storage of gas is recommended by the International Energy Association (IEA) in their guidelines on methods of providing stability of energy supplies in times of oil and gas ‘crisis’. Liberalization has also 24 Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), University of Dundee (2006) Security of International Oil and Gas: Challenges and Research Priorities: A Project for the Economic and Social Research Council: http://www.dundee.ac.uk/cepmlp/Research/ESRC%20CEPMLP%20FinalReport.pdf 25 Lee, Julian (2007) ‘The UK-Russia Energy Relationship’ in Monaghan, Andrew ed. The UK and Russia: A Troubled Relationship Part 1. Conflict Studies Research Centre: http://www.defac.ac.uk/colleges/csrc 26 Alistair Darling, the UK Minister for Trade and Industry, expects that the UK will have to import between 80% and 90% of its gas needs by 2020. Gas is expected to supply up to 80% of our electricity needs. 27 Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), University of Dundee (2006) Security of International Oil and Gas: Challenges and Research Priorities: A Project for the Economic and Social Research Council: http://www.dundee.ac.uk/cepmlp/Research/ESRC%20CEPMLP%20FinalReport.pdf 28 Ibid 29 Energy White Paper (2007) at the Government News Network website: http://www.gnn.gov.uk/environment/fullDetail.asp?ReleaseID=245255&NewsAreaID=2&NavigatedFrom Department=False 30 31 Ibid Alistair Darling, ‘Statement of Need’: http://www.dti.gov.uk/files/file28952.pdf provided for a ‘greater role of the financial markets in the oil and gas business’ 32. Gas is traded in short-term contacts and over-the-counter. The ‘city’-based financial companies and exchanges which are involved have a vested interest in keeping gas trading volumes high, thus keeping volumes of commissions high. All of this is in stark contrast, as already mentioned above, to how Russia organizes its energy sector which would be of little significance were it not for the fact that Russia is expected to be one of our main sources of gas, and oil, in the future. Although the UK 2007 Energy White Paper looks to alternative sources of energy to help reduce future consumption of hydrocarbons, both the Trade and Industry Secretary, Alistair Darling, and the Foreign Office acknowledge that, for the decades to come, the UK will need to import large quantities of gas. While the White Paper emphasize the UK’s commitment to the free operation of a competitive UK market in gas and the encouragement of market liberalization ‘abroad’ it also states that the UK will rely, like the rest of Europe, on Russia for much of its gas supply. The British Foreign Office points to Russia as having ‘an important role to play in ensuring global energy security’33. The Nord Stream pipeline will, as of 2010, directly connect the UK to supply from Russia for the first time. Gazprom is already operating in the UK via Gazprom Marketing and Trading (UK) Limited, which purchased Pennine Natural Gas Limited, and is supplying commercial enterprises in the Midlands with their gas needs. Gazprom is reported to have said that it ‘hopes to raise its market share (in the UK) to 10% by the end of the decade’34 The rhetoric of the UK government is still an emphasis on continued liberalization and on multilateral action, specifically through the European Union’s dialogue with Russia. Some recent actions, however, raise questions about the practice and efficiency of this approach. For example, since 2001-2002, the UK gas capacity markets have moved towards long term auctions which have replaced the previously preferred short term spot markets. As a result, 80% of capacity trading is now based on long term commitments of between fifteen and sixteen years. Short term capacity trading was considered to be insufficient incentive for the kinds of long term investment required by the capacity network. At the same time, the UK remains an active supporter of a competitive approach in the cross border market trade. Moreover, in the light of Russia’s increased control, via Gazprom, over supply and transportation of gas, their lack of willingness to ratify the Energy Charter Treaty, and their, thus far, marked intention not to support further liberalization of gas markets in Europe, the UK’s continued faith in liberalization as a key component in the provision of energy security is questionable. 32 Ibid British Foreign Office website, ‘Country Profile: Russia’: http://www.fco.gov.uk/servlet/Front?pagename=OpenMarket/Xcelerate/ShowPage&c=Page&cid=1007029 394365&a=KCountryProfile&aid=1019744935436 34 Katinka Barysch (2007), ‘Why the UK needs to back Commission Energy Plans’: http://centreforeuropeanreform.blogspot.com/2007/01/why-uk-needs-to-back-commission-energy.html 33 2. Russian historical background: re-nationalization and bilateralism Supply and export structures for natural gas within the FSU area are inherited from the Soviet Union, where the command economy dominated production and supply. After the break down of the USSR, new Joint Stock companies were established on the basis of the former Ministries. The largest gas monopoly within the FSU, Gazprom, emerged after the restructuring of the MinNefteGazStroi in 1989. After 1992, a Joint Stock Company, Gazprom, was created and later privatized. The state lost a majority of shares holding only 36% of Gazprom. However, the privatization project did not lead to major sector restructuring, like the unbundling of oil companies. Oil and gas privatization always remained purely Russian: Russian legislation of 1992 defined Gazprom as a natural monopoly and on these grounds limited foreign participation within Gazprom to only 10 percent. In 2005, an important reform was accomplished: in exchange for 51 % control by the state, Gazprom opened up to foreign capital up to 49 %. At the same time, Gazprom increased its involvement in the oil sector receiving a loan to purchase the Russian oil company Sibneft35. Gazprom’s intent being that the gains in the oil sector would compensate for the loss of gas sales in the internal market, which remains low due to Russia’s cross-subsidy system. The potential benefits from oil exports also remove the necessity to open gas networks to third parties in case of low rates of Gazprom’s own exports. In mid 2006, a new bill was adopted by the Russian Parliament, the State Duma, on gas exports. It iterates the export monopoly of Gazprom, including non-pipe gas, such as LNG and Condensate36. It also limits the action of private companies in gas trading. In addition, Gazprom elaborates on a strategy to establish a gas alliance with Central Asian producers, which would allow the company to dominate the international trade in gas, similar to Saudi Arabian state domination of their oil sector. Consequently, Gazprom would become the unique market player in Russian gas exports. In addition, Gazprom holds interests in infrastructures of the new EU Member States, especially in the Baltic States. Gazprom concluded long term contracts with Poland, where it reserves 100% of capacities. Consequently, if Poland wants, in the future, to switch supplier it would then have to consult with Gazprom. Gazprom’s logic in reinforcing long term contracts for the capacities are due to the concern of the potential discrepancy between long term contracts for supplies and short term agreements for transport capacity. In turn, long term contracts allow for, and encourage, much needed investment in the capacity networks. This logic explains Gazprom reluctance towards spot markets in gas trading and secondary short term markets for capacities. The capacity auctions are considered as the main danger for gas suppliers: an auction allows for extra benefits for traders but do not 35 36 RIA-Novosti, 29.09.2005. Neftegazovaya Vertikal, Lenta, 5.07.2006. have any positive impact on long-term capacity investments. In order to defend itself from market uncertainties, such as those related to the capacity auction system, Gazprom considers a strategy of gaining control of distribution markets in Europe. It provides an opportunity of market demand distribution. For instance, with the new system, Gazprom can play on the markets bypassing the intermediate European companies. For instance, on the basis of EU Competition law, the European Commission forced the companies to revise particular clauses of their contracts, which establish destination clause and the “most favored customer clause”37. At the same time, the European Commission can use its power of Competition law against Gazprom: being a monopoly inside its own country, Gazprom’s participation on the distribution markets can be restricted due to the reciprocity principle. The principle has been integrated in the EU internal market Directives in order to attribute a power for the EU Member States to restrict the degree of market opening for those countries, who did not liberalize their markets. The reciprocity principle might allow the European Commission to avoid Gazprom getting important shares in the distribution markets. The situation represents a major concern for Gazprom. Rather, the Russian monopoly perceives in that a deliberate strategy of decreasing Gazprom’s role in the EU markets. On the grounds of concerns related to the liberalization, the Russian State Duma considered legal steps towards reinforcing Gazprom as a response to the liberalization within the EU. Moreover, Gazprom always considered the liberalization within the EU markets as the main danger for the security of gas demand. The spot markets put under question long term pay back period for the gas infrastructure projects. Indeed, the long term contracts include the “take or pay” clause, which requires the buyer to pay for the gas regardless the actual demand. By contrast, spot markets integrate price flexibility and hence an insecurity for the investment return. Furthermore, the ownership unbundling, proposed by the European Commission in its latest energy package, contains a subsequent danger of loosing the Nord Stream pipeline and other infrastructures in Europe. In this context, Gazprom considers the monopolistic structure as necessary to ensure both security of demand for Russia and the security of supply for Europe. It involves a logic to control the whole chain of the gas market from the production to the distribution markets. 3. Gazprom and Centrica purchase: a test for the cooperation 37 L Hancher and I del Guayo, The European Electricity and Gas Regulatory Forums, in Barton, B., Barrera-Hernández, L.K., Lucas, A.R. and Ronne, A. (eds), Regulating Energy and natural Resources (edn 2006), 243-261. Conflicting approaches of the gas market regulation have been felt during the Gazprom’s strategy in getting EU distribution markets. Gazprom is largely present in the markets of the Baltic States and has concluded two important contracts with Italy and France at the end of 2006, where both countries committed to import Russian gas on the long term basis and to allow a partial access of Gazprom to their distribution markets. However, Gazprom failed the similar strategy in the UK. In 2006, it has offered to purchaise shares in Centrica, which, in turn, would create positive conditions for the long term investments in the Nord Stream pipeline going under the Baltic Sea. Notwithstanding the political support to the deal from the Prime Minister, the British Parliament has rejected the possibility of Gazprom’s investment in Centrica due to the lack of reciprocity. Moreover, the European Commission backed the opposition to the deal for the similar reasons. The British concerns regarding Gazprom are motivated by the ideological factor: as Gazprom opposes to a competition in Russia, it should be restricted to have nondiscriminatory approach in the fully competitive market. This argument becomes even more aggravated since the renegotiation of upstream oil and gas contracts between BP and Shell on one hand and Russia on the other, both resulted in favor of Gazprom. In addition to the ideological factor, some experts advance a security argument. For instance, British concern is based on the risk of under investments in Russia itself. According to the latest report of the International Energy Agency on Russian gas, Gazprom’s upstream investments have been significantly reduced in favor of the export transport capacities. It might result into the drastic decrease of production rate and then of the supplies to Europe. Gazprom’s representatives refute this threat by arguing the production rates increased in the recent years. Again a difference in interpretation arises: Gazprom point out that a decrease of upstream investments is possible in case of the downstream insecurity of demand. Consequently, a vicious circle of clashing approaches is formed: the UK opposes Gazprom’s participation in the downstream markets due to an uncertainty of upstream investments, Gazprom might reduce upstream investments in case of the demand insecurity. This puts under question the logic of the liberalization as a remedy for the security of supply. Conclusion The UK-Russia relations in energy relations are analyzed in the context of the transforming European gas markets. The latter are characterized by an ongoing liberalization and by attempts of creating spot markets. Historically, the UK has been seen as the reference country for the liberalization of gas markets, being an initiator of the idea in 1980s. Nevertheless, we have observed that the liberalization is a relatively recent process and, moreover, has been increasingly substituted by the long term market agreements (for instance, in the capacity trading). Hence, notwithstanding the general political opinion, the spot gas markets in the gas trade become rather an exception than a rule. However, Gazprom considers even a low level of liberalization as a peril for the security of demand. Indeed, two factors constitute the major worry for Gazprom: first, is the renegotiation of long term “take or pay” contracts by the spot markets, second is a possible ownership unbundling of gas transmission networks. Both factors create negative incentives for the investments and increase the level of uncertainty of the stable return. Consequently, in the long run, the liberalization can even constitute a risk for the security of supply for the consuming countries, the risk which stems from underinvestment. Therefore, risks stemming from the liberalization can be felt in the long run: investments in gas sector have a long pay back period. In this context, Gazprom moved towards a reinforcing a control over the gas chain from the upstream to the downstream. By contrast to its European partners, Gazprom refutes any competition logic and has moved to an opposing direction. It has established tougher control of both upstream and exports, which are hardly to be in the logic of the company’s strategy in getting the European distribution markets. Moreover, it remains unclear whether Gazprom can take on its own charge the LNG projects initiated by Shell and to ensure all Russian gas export without partially opening the access to upstream and to the networks. Therefore, steps towards a further reinforcing of the gas chain control are motivated by political values, which provoke a further reticence in the UK. As a result: Gazprom could not get into the distribution markets in the UK via the purchase of Centrica. Those political events did not interrupt, however, the trading of the Gazprom Marketing and Trading (UK). In summary, the UK-Russia energy relations rather depend on political values, which do not always reflect the economic reality. However, it remains impossible to separate the economic relations from the choice of political values. Whereas the choice between Russia and the UK remains opposite, the energy relations will remain difficult. Those difficulties might furthermore have an impact on both security of demand and supply of the two rather interdependent actors. Conclusion The energy security in international relations theories is related to a number of approaches, which are often overlapping and coexistent. Theorization involves prioritizing the changes and influence of economic structures and shows how political institutions are created to respond to these changes - not how they structure or affect economic forces. Also, theories explain the existing ideas related to economic policies, which can facilitate the ideological unity to socio-economic interests and by legitimating institutional change. The energy security definition involves a variety of interactions at international level. A different casual explanation of the “agent-structure” interaction: rational or irrational (ideology-driven) strategies of international actors, political or economic essence of the energy trade. An empirical observation links each perspective on energy security in their historical context. For instance, energy shocks of 1970s influenced the creation of the international organizations, such the International Energy Agency and the Energy Charter Treaty. The latter has been particularly promoted in aftermath of the victory of liberal values first in Europe and then in the world. The concept of sustainable development and a subsequent Kyoto protocol have been a result of perceived threats of the end of resources and climate change due to an excessive use of the fossil fuels. Similarly, economic and technological structures became more complex with penetration of new market players in gas and electricity sectors. More complex structures constitute in turn an additional difficulty for agents to assess losses and gains: failure of privatization in Russia, Californian syndrome, conflicts between liberal and national-control values. New categories of the actors’ motivations and structural constraints might appear within the instable and unforeseeable IR system.