House of Commons - Trade and Industry

Select Committee on Trade and Industry Written Evidence

APPENDIX 51

Memorandum Ambassador Keith C Smith (Retired), Center for Strategic and International Studies, Washington DC

EXECUTIVE SUMMARY

— Developments in Russian energy and foreign policy have highlighted the need for caution on the part of all Western countries when negotiating long-term agreements with Russian energy companies. These energy companies are being used as foreign policy instruments of a government that is more authoritarian than at any time since 1991.

— Part of Moscow's geopolitical strategy is to increase European dependency on Russian oil and gas resources, therefore maximizing the Kremlin's political influence, a goal of at least equal importance to revenue earning.

— Gazprom's monopoly practices in West and East Central Europe, as well as in Central Asia are in direct conflict with the competition policies of the EU and those of the UK Government.

— The recent "gas war" between Ukraine and Russia does not reflect a policy change in Moscow. Since 1990 Russia has used its energy resources in an attempt to affect the foreign and security policies of its neighbours.

— The EU and the United States have been slow to recognise that the energy policies of the Kremlin pose risks to Europe and particularly to economic independence of the Central European states. These policies are also not in the long-term interest of Russia itself.

— The British Government and the EU should require Russia to adhere to the Energy Charter and to World Trade Organization (WTO) principles by making its energy policies and actions more transparent and based on competitive business practices.

— Any increase in the share of UK gas imports originating in Russia should be contingent on Russian companies adhering to Western competition practices in energy production and transportation, and on the Russian Government granting access to UK and other foreign energy investors on a reciprocal basis.

1. A DELAYED WAKE-UP CALL

1.1 Russia's tough stance toward Ukraine on natural gas prices was viewed by too many in Europe and the United States as raising new issues concerning Russia's foreign economic policies and of the growing European and US dependency on energy imports. For many new EU member states and for countries such as Ukraine, Georgia, and Moldova, however, this is an old problem. Central European attempts to flag the issue in Western capitals have until now been brushed aside. The rapid approval by the EU Commission of the Russian-German undersea gas pipeline project without an in depth review of its significance for the rest of Europe was a serious mistake. The concerns of the Central Europeans should have been examined in more detail. The pipeline agreement and attached protocols between Germany and Russia will result in increased Gazprom control over Germany's gas companies and can negatively affect neighboring countries' ability to diversify their energy sources. The UK Government would be wise to analyse closely the political and security implications of Russia's non-transparent and monopolistic foreign energy policies.

2. RUSSIA'S USE OF ITS "ENERGY WEAPON" HAS BEEN IGNORED FOR TOO LONG

2.1 There is much more at stake for Europe than its own energy supplies. Moscow's increasing control of the energy infrastructure and markets in Central Europe has long-term implications for the security, and not only energy security, of all of Europe. The comments of former Kremlin economic adviser, Andrei Illarionov, citing Russia's increasing tendency to use energy as a weapon in its relations with other countries should act as a wake-up call to Western governments, and particularly members of the EU. [119]They can no longer afford to be complacent regarding Russia's willingness to use its considerable energy resources for political influence, a situation that dates back to 1990, when Moscow cut energy supplies to the Baltic States in a futile attempt to stifle the independence movement. The "energy weapon" was again used against the Baltic States in 1992, in retaliation for Baltic demands that Russia remove its remaining military forces from the region.

2.2 In 1993 and 1994, Russia reduced gas supplies to Ukraine, in part, to force Kiev to pay for previous gas supplies, but also in an attempt to pressure Ukraine into ceding to Russia more of the Black Sea Fleet, and to gain control over Ukraine's energy infrastructure. [120]Belarus, Poland and Lithuania, suffered supply disruptions in 2004 from the Kremlin's politically motivated attempt to take over Belarus' gas pipeline system. As recently as 1998-2000, in an attempt to stop the sale of Lithuania's refinery, port facility, and pipeline to a US company, Transneft stopped the flow of oil to Lithuania nine times. None of these examples of Moscow's using oil and gas shipments to strong-arm its neighbors resulted in complaints from Brussels or Washington.

3. THE EU HAS FOR TOO LONG IGNORED NONTRANSPARENT ENERGY POLICIES

3.1 The EU, and particularly the large gas importers like Germany, Holland, and France, have ignored the lack of transparency and competition in Russia's energy sector. The Russian pipeline monopolies of Gazprom (natural gas) and Transneft (oil) have been allowed to flout the open-market requirements of the WTO and the EU's own Energy Charter. The EU's agreement with Russia on WTO in effect gave Moscow's increasingly monopolistic pipeline and production companies carte blanche. Russia will be able to increase its market power and its political leverage in Europe through the construction of the expensive Northern Europe Gas Pipeline, which will go under the Baltic Sea from Russia to Germany. The construction of the Yamal II pipeline would have been a much cheaper alternative and would have given both Central and Western European consumers greater energy security. [121]

3.2 The West ignored Gazprom's takeover, with Ruhrgas' help, of domestic gas facilities and markets in all three Baltic States. It disregarded Transneft's recent warning to Kazakhstan that it would not be allowed to supply oil to Lithuania's Mazeikai Refinery through the Russian pipeline system, even though Astana has the legal right to do so, based on the transit agreement from last fall. [122]Russia has stopped all piped shipments of oil to Latvia for the past two years in an effort to gain control over the oil port at Ventspils. Now, Moscow is again attempting to keep non-Russian companies from buying Lithuania's Mazeikai Nafta Refinery and the port at Butinge. Should this use of raw energy power not be a subject for discussion within the EU and between the EU and other importing countries such as the United States and Japan? EU member governments need to take the initiative and examine the effects of becoming more energy reliant on an increasingly authoritarian Russian government that has no compunction about using its energy leverage to achieve political goals.

4. THE WEST DOES HAVE LEVERAGE WITH RUSSIA

4.1 It is a mistake for governments in the West to believe that they need Russian energy supplies more than Russia needs the oil and gas revenue that comes from Western markets. Russia cannot develop its vast energy fields without Western capital or advanced technology. Unfortunately, to date, there has been little inclination by either European Governments or the United States to use their considerable leverage to encourage Russia to play by transparent, competitive rules that guide business in the West. The pipeline monopolies of Transneft and Gazprom are contrary to the Energy Charter signed by the EU and Russia. Where is the pressure on Russia to ratify and implement the charter—even the transit protocol section of the Charter? [123]Following the destruction of Yukos, Russian officials declared that private companies would not be allowed to build pipelines in the country. [124]Yukos had planned to build, with other private Russian energy companies, pipelines to China and to supply Europe through an oil line to Murmansk. The Putin Government has taken the issue of private pipelines off the agenda.

5. FORMER INTELLIGENCE OFFICERS MAKING ENERGY POLICY

5.1 Russian energy policy is increasing formed by former intelligence officers (siloviki) in the Putin administration and in Russia's energy companies. The head of Rosneft and a former KGB associate of President Vladimir Putin, helped engineer the breakup of Yukos and his company's seizure of the most valuable assets of Yukos. [125]Former KGB and GRU officers sit on the boards of almost all the country's major energy companies. In 1999, Moscow even sent out a former KGB/FSB officer as ambassador to Lithuania, in an attempt to provide behind-the-scenes support to Lukoil's negotiating position. Before assuming the job, the ambassador had been the FSB's official liaison officer with Lukoil. The siloviki generally oppose any weakening of the state through the growth of a transparent private sector. Putin's use of a former East German Stasi officer, and now Dresdner Bank official, to direct the financing of the undersea Baltic pipeline system only added, perhaps unfairly, to suspicion that the project is more politically than commercially motivated. [126]The increasing influence of the intelligence community is setting back Russia's own development as a democracy and as a market economy providing long-term benefits to Russia's own population.

6. CEDING TOO MUCH CONTROL TO GAZPROM

6.1 For too long, Europe's energy relationship with Russia has been directed by only a few member states, particularly Germany, France and Italy. Former German Chancellor Gerhard Schroeder personally directed negotiations with President Putin over the Baltic Pipeline and is now a Chairman of the pipeline company. But the United States and its Western allies have also been more eager to secure additional energy supplies from Russia than to pressure the Kremlin into reforming its economy. The EU and the United States have for too long ignored the noncompetitive and political aspects of Russia's energy export policies. This is due in part to competition by Western companies for exploration and production rights in Russia.

6.2 How much thought has been given in Berlin, London and Brussels to the potential power of Gazprom to control the gas markets in Central Europe following the completion of the Baltic pipeline system? Under the German-Russian agreement, Gazprom will be able to buy significant shares in Germany's gas companies. Will this allow Gazprom to veto shipments of gas from Germany to Poland if the Poles have a dispute with Gazprom over price or availability? Could the increased power of Gazprom be used to stop liquid natural gas (LNG) receiving plants from being constructed in Poland, Latvia, or even in Germany? If the EU decides to implement its long-awaited requirement for member states to have more gas storage, will this be possible now that the EU has blessed the Baltic pipeline system designed to bypass Poland and the Baltic States? What about Russian purchases of gas from Turkmenistan, Uzbekistan, and Kazakhstan that are clearly designed to deny the West the ability to buy directly or at prices negotiated between producer and consumer, rather than working through Gazprom? [127]Are these moves by the Kremlin compatible with WTO membership or the EU's own competition policies? It is hard to imagine that they are.

6.3 Gazprom is now attempting to pressure Bulgaria into breaking a binding agreement on gas price and availability that is in force until 2010. [128]A test for the EU will be whether it backs up this soon-to-be Member State with political support. So far, there is no sign that Brussels will intervene. Poland, understandably, has proposed that NATO should put the issue of energy security on its agenda. Energy security is certainly more than a national security issue. It can effect the strength of the entire Alliance. The Atlantic Council and NATO foreign and defence ministers should examine the issues surrounding Russia's aggressive energy policies.

7. NO BIG WINNERS IN THE "GAS WAR"

7.1 That brings us to the Russia-Ukraine "gas war" that was allegedly resolved to the satisfaction of both sides on 4 January. Russia's political agenda in using gas prices to punish the pro-Western Yushchenko government is clear from statements made by Russian supporters of Gazprom's hard line, and from remarks by Russia's few remaining reformers. Few people familiar with political and economic relations between Russia and Ukraine believe that this agreement will last very long. [129]Moscow's requirement that all gas to Ukraine be contracted through the nontransparent company RosUkrEnergo, the direct successor to the even less-transparent EuralTransGas, raises questions about the reliability of future European gas supplies that originate in Central Asia. It is not a good omen that most of the bilateral agreements signed on January 4 remain secret. In light of past actions, no one should have been surprised by Moscow's tough approach to Kiev, and the Kremlin has succeeded in weakening public support in Ukraine for President Yushchenko as a result of the agreement. The agreement also increased the likelihood that Ukraine's gas pipeline will fall under Gazprom control within the next year.

7.2 One can certainly make a good case that Russia has the right to charge world market prices for its exports. An equally good case can be made that it is in the long-term interest of Ukraine and other importers to move in the direction of paying world prices. Once market prices are reached, Moscow's political leverage will decrease. A four-fold overnight increase in price from $50-$230 per 1,000 cubic meters, however, is not justified, particularly in light of the 2004 agreement between the Kuchma government and Gazprom, which locked prices in until 2010. [130]

7.3 More importantly, no one knows what the real market price of Russian gas and oil would be if a transparent situation existed within Russia's exporting companies. If Russian consumers were forced to pay prices that were significantly more than one-tenth of what Moscow claims to be the world market price, domestic demand would drop and additional Russian oil and gas would be placed on the international market. Does the $47 per 1,000 cubic meters charged to Belarus have any relationship to the market, or does the Kremlin consider it an "internal price?" These are all questions that need greater discussion in London, Brussels and Washington.

8. THE WEST SHOULD HOLD RUSSIA AND ITS COMPANIES TO HIGHER STANDARDS

8.1 Western acceptance of Russia's "neo-colonial" policies in Eastern Europe, the Caucasus and Central Asia are not in the long-term interest of Russia itself. Acquiescing to Moscow's more "robust" regional policies has only contributed to greater tension in Russian-East European relations and slowed the development of democratic governments in the Caucasus and Central Asia. This in turn strengthens non-democratic elements in Russia that believe that the country's strength depends on control of the neighbourhood—a rather large neighbourhood at that.

8.2 The UK, other EU member governments and the United States need to quickly rethink their energy and non-energy policies with Russia. The two cannot be separated. The world does Russia no favour by ignoring the monopoly and uncompetitive nature of this energy relationship. The West does have the economic and political leverage to force Russia to become more transparent and commercial in its foreign energy policies. It cannot allow Moscow to threaten the security of Europe, particularly the new democracies of Central Europe, through neglect or unwillingness to face down the new increasingly imperial mindset in the Kremlin.

(Note: The views expressed in this paper are those of the author and do not necessarily represent those of the Center for Strategic and International Studies)

Biographical Note: Ambassador Keith C. Smith is the author of Russian Energy Politics in the Baltic States, Poland and Ukraine (CSIS December 2004), and is currently Senior Associate in the Europe Program at the Center for Strategic and International Studies in Washington DC. From 2000 to 2002, he was a consultant on international energy affairs to the Williams Company, one of America's largest integrated energy companies. Mr. Smith retired from the US Department of State in 2000, where his career focused primarily on European affairs. From 1997-2000, he was US ambassador to Lithuania. His additional posts in Europe include Hungary (twice), Norway, and Estonia.

16 March 2006