House of Commons - Foreign Affairs

Select Committee on Foreign Affairs Second Report

5 Energy security

142. Russia is an energy giant. It is the world's largest gas producer, accounting for 22.0% of world output, and holds the world's largest gas reserves, comprising 26.6% of the global total at the end of 2005. Russia is the world's second-biggest oil producer, accounting for 12.1% of world output, and holds the world's eighth-largest reserves, representing 6.2% of the global total at the end of 2005. Russia also holds the world's second-largest coal reserves, representing around 17% of the proven global total.[313]

143. Russia is especially important as an energy supplier to the EU. This applies more than ever following the EU's enlargement to countries in Central and Eastern Europe which are particularly dependent on Russian supplies. In 2005, Russia supplied around 45% of the EU's net gas imports.[314] Russian supplies account for around 25% of EU gas consumption, over 25% of oil consumption and around 8% of coal.[315] The EU is expected to become increasingly dependent on imported gas, and Russian supplies are predicted to continue to rise in volume terms, but the growing availability of alternative supplies may mean that Russian deliveries fall as a share of total EU imports and consumption.[316]

144. The vast majority of Russian oil and gas supplied to the EU comes through pipelines across the transit states of Belarus, Ukraine and Moldova. Russia is simultaneously the major supplier of energy to these states' domestic markets, as it is to the three Transcaucasian republics of Armenia, Azerbaijan and Georgia.

145. Russia also has major energy interests in the Caspian region. In energy terms, the Caspian region comprises the Caspian littoral areas of Russia to the north and Iran to the south; the other three Caspian littoral states, Azerbaijan on the western side of the sea and Kazakhstan and Turkmenistan to its east; and the inland state of Uzbekistan, between Kazakhstan and Turkmenistan. The Caspian region is estimated to possess reserves of oil representing 4.3% and of gas representing 4.5% of proven global totals.[317] Russia buys Caspian energy supplies from states in the region, both for its own use and for re-export. With the exception now of Azerbaijan, Russia also controls almost all the export pipelines from the other former Soviet Caspian states, which run via Russia.

146. Overall, the CIS energy space comprises a delicate and less than fully transparent web of price and trading arrangements with Russia at its centre. Russia both receives payments from, and makes payments to, other CIS states, for both energy supplies and the use of transit pipelines. Most importantly, the CIS energy space still operates largely with below-market prices. The effort to move to world prices—driven primarily by Gazprom—is a key regional phenomenon, which has been complicating trade and pricing arrangements and acting as a source of friction between Russia and other CIS states for some time.

147. Energy dealings in the CIS space are overwhelmingly conducted by state-owned companies, which typically have close links to national political leaderships. In the case of Russia and gas, the key company is Gazprom, which accounts for 85-90% of Russian production.[318] The Russian state holds a 50%+1 share in Gazprom.

148. The difference between the nature of markets for oil and for gas affects considerations of supply in the energy security context. Oil can essentially be transported from any production location to any market, although not all transit options may be available immediately or without extra cost. By contrast, gas "commonly requires long-term contracts linking both producer and consumer, and connections between the two on a non-interruptible basis."[319] Owing to this difference, decisions regarding gas supply, including those taken by the UK and EU, are likely to be more acute than those regarding oil.

149. Among EU Member States, energy dependence on Russia varies widely. The UK is one of the EU members least dependent on Russian energy. This is owing partly to the UK's own North Sea resources, and partly to the UK's proximity to gas available from Norway. As regards gas, it is not possible to trace the exact sources of the UK's imports, because the UK takes supplies via two pipelines from continental Europe, but the CBI estimates that less than 2% of UK gas imports originate in Russia.[320] As regards crude oil, Russian supplies represent around 13% of the UK's total imports and around 9% of total UK consumption.[321] While UK energy imports are expected to rise in future as North Sea supplies decline, the DTI told us that "Russia is not expected to become a dominant supplier to the UK."[322] However, owing to the way in which the UK takes gas from continental Europe, the UK could be affected by any serious disruption in Russian supplies into the continental network.[323] Such disruption might also raise international prices, also affecting the UK.[324] The UK is most dependent on Russia as regards coal: over 50% of the UK's steam coal imports come from Russia, with 75% of total UK steam coal needs being met from imports.[325]

150. EU Member States also vary as regards the ownership and regulatory structures of their energy sectors, in ways that affect their approaches to Russia. As the sector in the UK is privatised and liberalised, the achievement of energy security goals by the Government depends to a great extent on decisions taken by private companies on a commercial basis.

Russia as an energy supplier

151. Since 2006, concerns about Russia's role as an energy supplier have risen dramatically up the political agenda in the EU and its Member States. The key trigger for this was a shut-off in Russian gas supplies to Ukraine at New Year 2006, which caused Ukraine to siphon off for itself Russian gas intended for onward westward transit.[326] This in turn caused drops in gas supply to some EU Member States of up to 40%. Russia shut off supplies to Ukraine because Ukraine would not accede to its demand, made during the last quarter of 2005, to pay $230 per thousand cubic metres for Russian gas from 1 January 2006, up from $50/thousand cubic metres. Ukraine had said that it was prepared to pay market prices, but only with a phasing-in period; its maximum offer for 2006 was $80/thousand cubic metres. Russia offered a three-month delay in introducing the full price hike, but this Ukraine rejected. After EU customers reported substantial falls in supply in the first days of 2006, Russia increased its supplies again into the Ukrainian network. Russia and Ukraine reached a complex and less-than-transparent deal on 4 January 2006 to resolve their immediate dispute. In January 2007, there was a second supply disruption incident which drew European attention, when Russia temporarily shut off oil supplies to Belarus as part of a complex bilateral dispute over oil transit and sales duties. The DTI told us that "The UK supports Russia's move towards market pricing for gas, but is concerned at the manner in which these price rises have been implemented."[327]

152. The January 2006 and January 2007 incidents highlighted the EU's dependence on Russian energy supplies, at the same time as raising doubts about Russia's reliability as a supplier. Moreover, Russia's actions in demanding price hikes and shutting off supplies were widely interpreted as being purely politically motivated, with the underlying price and debt issues under-appreciated.

153. The dominant Western interpretation of the January 2006 and January 2007 incidents gave rise to fears that Russia might use its energy supply position as leverage in unconnected political disputes, including with its EU customers as well as its CIS ones. This fear has encouraged some EU Member States to seek to secure Russian supplies through bilateral agreements, and to be wary of aggravating Russia on other issues. For example, in late 2006, Gazprom signed new long-term supply contracts with Eni of Italy and Gaz de France,[328] while Germany reportedly regarded the UK's diplomatic expulsions over the Litvinenko case as an overreaction and was reluctant about a supportive EU statement.[329] At the same time, the new insecurity surrounding Russian supplies has helped to drive a new effort to forge a common EU energy policy.

154. The EU had already identified a need for strengthened action on energy as part of the new EU policy agenda launched under the UK Presidency at the Hampton Court summit in October 2005. At Hampton Court, the EU's leaders said that the EU needed to "ensure a coherent and operational approach to the EU's relationship with major energy suppliers, for example Russia and OPEC".[330] The January 2006 supply disruption incident increased the urgency with which the EU promised to act in the energy field, including as regards Russia. In March 2006, the European Council called formally for an Energy Policy for Europe, involving increased consistency between policies and more coherence between Member States in the interests of meeting the objectives of security of supply, competitiveness and sustainability.[331]

155. Reflecting on recent developments regarding Russia's role as an energy supplier, our witnesses agreed that Russia used its energy position for political ends.[332] Mr Clark and Mr Roberts both drew our attention to an influential 2006 study by the Swedish Defence Research Agency which detailed over 50 examples of Russia using the energy lever since 1991.[333]

156. Our witnesses nevertheless stressed that, rather than a universally deployed tool of policy, Russia had used the 'energy weapon' only with respect to former Soviet states—although these include the Baltic states, now EU and NATO members. Mr Roberts told us that Russia "seems to use [energy] in very different ways with regard to whether it is addressing it to the former Soviet countries or to Western Europe [...] Russia has been a reliable supplier to Western Europe—to the traditional EU—but it has been anything but a reliable supplier to its former Soviet Union partners".[334] Moreover, Mr Roberts told us that "Russia […] will seek to remain a reliable supplier of oil and gas to its core EU customers."[335] Similarly, Mr Clark told us that "So far the coercive use of energy policy has been limited to countries that were formerly part of the Soviet Union and there are good reasons for believing that Russia would prefer it to stay that way."[336]

157. On the basis of the distinction they identified in Russian policy between treatment of former Soviet states and of EU customers, our witnesses were sceptical about the prospect of Russia cutting off supplies to its EU customers—or threatening to do so—in order to achieve political ends. Mr Roberts did "not think that Russia necessarily has any particular concept of using energy in that way as a sword of Damocles over its major customers in, to put it bluntly and use the old-fashioned term, West Europe."[337] Mr Clark told us that "the EU (with the exception of the Baltic states and possibly Poland) is unlikely to become the direct target of politically motivated supply interruptions".[338] Professor Hanson similarly suggested that:

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Professor Fedorov similarly had "serious doubts whether Russia may practically use gas supply to Europe as a kind of political lever".[340]

158. The likelihood that Russia will seek to remain a reliable energy supplier to its EU customers rests on the importance to the Russian economy and federal budget of the revenues generated by these sales. In 2006, oil and gas accounted for nearly 50% of Russian federal budget revenues, over 60% of exports and nearly 30% of GDP.[341] Meanwhile, the EU accounted for 81% of Russia's pipeline gas exports in 2005.[342] The value to Russia of its EU energy sales reflects the fact that EU customers—unlike their CIS counterparts—pay world prices for their Russian supplies. Mr Clark told us that Russia "would certainly hesitate to threaten its largest and most predictable revenue stream by cutting off oil and gas supplies to most of the EU."[343] Awareness of the importance to Russia of its sales to the EU has led the two sides to their official position that the EU and Russia are interdependent in energy, rather than the EU simply being dependent on Moscow.[344]

159. Given their belief that Russia would not deliberately target EU customers, or wish to unnerve them, our witnesses interpreted the January 2006 and January 2007 supply disruption incidents as miscalculations by Moscow. Professor Hanson told us that the "two hiccups in supply are best understood as unintended side-effects of badly-managed attempts to alter the terms of [Russia's] energy relationships with other CIS countries".[345] Mr Roberts suggested that "The problem that Russia may not understand is that in a globalised world, just because you have been reliable to one set of customers, it does not necessarily mean that they will continue to consider you as likely to be reliable in future."[346] Mr Roberts suggested that Russia "may not understand that its use of energy as a weapon against any state […] and as a tool of foreign policy in general has contributed greatly to consumer concerns."[347] Similarly, Dr Pravda told us that:

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160. Given Russia's attitude to its former Soviet neighbours, and the long-term and difficult process of shifting CIS energy dealings to market prices, the risk remains that EU energy supplies from Russia could again suffer disruption as a side-effect of disputes between Moscow and transit states—although Moscow may take greater care in future to insulate or at least warn its EU customers.[349]

161. Russia is seeking to avoid the potential difficulties that accompany its use of former Soviet states for energy transit by "implementing a policy of pipeline development expressly designed to reduce its reliance on transit states."[350] This involves the construction of energy export systems that can deliver Russian supplies more directly to Moscow's key customers. In gas, there are two key projects: the North Stream pipeline from Russia to Germany under the Baltic Sea, a joint project between Gazprom and the German companies Eon and BASF; and South Stream, a project to link Russia with the Balkans and thence to the EU, possibly via pipeline under the Black Sea to Bulgaria (see map).[351] The proposed North Stream pipeline has provoked environmental concerns in the Baltic and political outrage in Poland, in particular, among the bypassed transit states.

Map: Selected existing, planned and possible gas export pipelines from Russia and the Caspian region, October 2007

Source: Map prepared by Chris Isles of Platts, provided courtesy of Platts

162. In addition to Russia's potential to disrupt energy supplies to the EU, President Putin has appeared to threaten to divert Russian supplies to alternative markets, primarily China.[352] Our witnesses were sceptical about this threat. Although Russia does plan to increase energy exports to China, these plans largely rely on the development of new fields in Eastern Siberia and the Russian Far East. The pipelines are not in place that would allow the speedy eastwards diversion of large quantities of supplies currently coming to the EU. Professor Hanson told us that the prospect of Russia diverting supplies to Asia was "not a serious concern for the short or medium term […] Russia has few market alternatives over the next few years."[353] We conclude that Russia is dependent on EU energy markets for a considerable part of its revenue. We further conclude that the diversion of Russian energy supplies away from EU markets eastwards, including to China, is not a realistic prospect in the short or medium term. We recommend that the Government draw on these conclusions to continue to encourage its EU partners to take a robust and united approach to dealing with Moscow, in the energy field and beyond.

163. Russia's reliability as an energy supplier may be affected not only by its willingness to meet its commitments but also by its ability to do so—that is, by the quantity of its output relative to demand. As regards Russian gas, EU demand is expected to continue to rise, in volume if not as a share of total EU consumption. At the same time, Russia's own needs are increasing as its economy grows—Russian domestic gas consumption rose by over 1% a year over the period 2000-2005,[354] by the end of which Russian consumption was taking 405 billion cubic metres out of total production of 597 billion cubic metres.[355] The CSRC told us that "Russia's domestic energy needs are growing much faster than anticipated by the Kremlin."[356]

164. However, Gazprom's production is currently flat, and International Energy Agency analysis suggests that it could decline by around 25% by 2015.[357] Professor Hanson told us that Russia's "major gas fields are in decline".[358] The CSRC told us that:

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Other witnesses agreed that Gazprom is not investing sufficiently in the maintenance of production or, especially, in bringing new output on stream. Professor Fedorov told us that "the investment strategy of Gazprom is insufficient and Gazprom is under-investing in the development of new fields".[360] Our witnesses drew our attention to the way in which Gazprom is investing in non-core areas, such as the media and leisure industries, and pursuing what Mr Roberts called "a major focus […] on development of new export pipeline routes to core European markets, rather than on production increases capable of filling these pipelines."[361] As well as major acquisitions in Russia, Gazprom has also been pursing downstream ventures inside the EU, including investments in the UK.

165. The widening gap between increasing demand and faltering supply raises the prospect of what has been called the Russian 'gas deficit'.[362] Our witnesses were unanimous that the prospective shortfall in Russian gas production represents a serious energy security risk. According to Mr Clark, drawing on Professor Riley's work, by as soon as 2010 the gap between Russia's likely gas output and its export and other commitments could be equivalent to 84% of the gas Russia currently supplies to Europe outside the former Soviet Union.[363] Professor Fedorov characterised "whether Russia will be able to avoid or prevent a serious production crisis, especially in the gas industry, and whether it will be able both to fulfil export obligations and satisfy domestic needs" as "one of the basic problems of energy security for both Russia and Europe".[364] Professor Hanson concurred that "Russia's ability to maintain and increase the volumes of oil and gas deliveries to Europe is in doubt",[365] and Mr Roberts was of the view that "Russia's ability to meet anticipated gas demand from EU suppliers is so doubtful, that we may have to rethink how dependent we are going to be on gas and whether we can afford to be that dependent."[366]

166. The Minister for Europe offered one of the starkest assessments we received from any of our witnesses of the prospective Russian gas shortfall. The Minister said that he did "not think that it is a long-term issue. It has a much closer horizon than that […] the UK Government do not have a clear understanding of how Russia will meet the different demands on its supply to 2010."[367] The Minister expanded:

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167. As we encountered during our visit to Moscow in June 2007, Gazprom and Russian officials often deny that future production prospects are in trouble. Russia is planning to reduce the pressure on demand for its gas by switching domestic consumption towards coal. However, the CSRC told us that "Even with widespread domestic conversion from natural gas to coal consumption, as envisaged by the Russian government, Russia will find it increasingly difficult to fulfil all its export obligations without risking discontent at home."[369]

168. Russia decided in 2006 to begin to move to market prices for some domestic consumption. This should exert some downward pressure on consumption. However, the reductions required would be considerable: Mr Roberts told us of an estimate by an EU official that Russia would need to reduce domestic consumption by 20-30% by 2011-2012 in order to maintain its exports.[370] Moreover, higher energy prices will be politically sensitive, especially if they come at a time when the quantities available for supply are simultaneously under pressure. The CSRC warned us that "The consequences of gas shortages in 2015 may parallel those of bread shortages in 1905".[371] We do not rule out the possibility of gas shortages and/or price rises causing social discontent.

169. A key plank of Russia's plans to deal with the prospective squeeze on its gas supplies is to rely on increased imports from Central Asia, which Moscow can then re-export westwards. Moreover, this trade is one of the main mechanisms by which the oil and gas sector benefits the Russian budget. As already noted, Russia buys energy supplies from Central Asia at below-market prices; but it can re-export to the EU at world prices—which at present can be perhaps three times as high. Mr Roberts told us that "Russia's gas export policy is predicated to a very considerable extent on continued access to […] low-cost gas purchases from Central Asian producers."[372] However, Dr Pravda told us that "even with additional supplies from Central Asia, Moscow will find it extremely difficult to sustain energy exports while also meeting growing domestic demand."[373]

170. The CSRC told us that "Impending shortages of gas […] present new risks of supply disruption to [the] EU."[374] It also warned of the risk that CIS states dependent on Russian energy were most likely to fall down the widening gap between demand for and supply of Russian energy resources, since, as we have seen, Russia is prepared to prioritise its higher paying EU customers.[375] Dr Averre warned that the likely reduction in Russia's ability to export "may be more of a problem than the idea of holding countries to ransom."[376] Similarly, Ms Barysch told us that "Our main concern at the moment is not that Russia cuts off the energy to us, but that it will not be able to deliver as much gas to us in the future as we would like to buy".[377] We conclude that the prospective shortfall in Russian gas production represents an urgent energy security concern for the EU, and a greater one than the risk of Russia disrupting supplies for political reasons. The intensified competition for Russian gas which appears to be in prospect between Russian domestic consumers, Russian CIS customers, and the EU, has the potential to aggravate a number of political relationships. We welcome the Minister for Europe's apparent awareness of the urgency of the problem. We recommend that the Government work to achieve a common understanding of the likely Russian gas shortfall with both EU partners and Moscow, and that it inform us in its response to this Report of the steps being taken in this regard.

171. Our witnesses largely attributed the shortfall in productive investment in the Russian gas sector to the dominance there of the Russian state, in the shape of Gazprom. Our witnesses pointed to developments in the Russian oil sector as foreshadowing the pattern that seems likely to unfold in gas. Having been below 20% in 2004, state ownership of the Russian oil industry (by output) is expected to exceed 50% in 2007.[378] However, Professor Hanson told us that "growth of output and export volume of oil has slowed strikingly" over recent years.[379] According to Mr Clark, the two main previously private oil firms, Yukos and Sibneft, were achieving returns on total assets of over 30%. By contrast, Gazprom and the state oil firm Rosneft, which have largely taken over these two firms' assets, achieve returns of less than 10%.[380]

172. Despite its apparently negative impact on output and efficiency, our witnesses agreed that a growth in the role of the state has been a key phenomenon in the Russian energy sector in recent years. Mr Clark told us that "The dominant trend in Russian energy policy since 2003 has been a reassertion of state control and the subordination of private sector companies both foreign and domestic."[381] The DTI agreed that "The last five years have seen a concerted increase in state control of the energy sector in Russia."[382]

173. As regards domestic Russian companies, the most high-profile development has been the break-up and effective state takeover of the formerly private Yukos, accompanied by the prosecution and imprisonment for fraud and tax evasion of former Yukos head Mikhail Khodorkovsky and other Yukos executives.[383] Professor Hanson told us that "the Yukos affair marked a change of trajectory in Russian economic policy".[384]

174. Foreign energy companies in Russia—including UK firms—have also been affected by the trend towards increased state control. As already noted, the UK has been the largest investor in the Russian energy sector.[385] However, in December 2006, Shell agreed under administrative pressure to sell Gazprom a controlling stake in the Sakhalin II oil and gas project in the Russian Far East, where Shell had previously been the largest partner.[386] In June 2007, under similar circumstances, TNK-BP—BP's Russian joint venture—agreed to sell its controlling stake in the vast Siberian gas field Kovykta to Gazprom.[387] The Russian Government has recently approved legislation limiting foreign investment in 40 strategic industries, including the energy sector; this is to be supplemented by a subsoil law, currently under development, setting out conditions for foreign ownership of mineral resources.[388]

175. The FCO told us that:

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However, there are no signs of major international energy companies pulling out of Russia. There are also indications that Moscow may still recognise the Russian sector's need for foreign investment, equipment and expertise, albeit now under the overall control of the Russian state and with foreign companies probably obliged to accept the precarious status of minority partner. For example, having said in 2006 that foreign firms would be excluded from the project except as contractors, in July 2007 Gazprom—which owns the field—agreed that France's Total could take a 25% stake in the company running the project to exploit the huge Shtokman gas field in the Arctic.[390] The CBI expressed the hope that the new law on strategic industries might at least provide greater clarity and certainty about foreign participation, as opposed to the ad hoc decisions which have been typical recently.[391]

176. Given the apparent detrimental impact of Russian state control on efficiency and output in the Russian energy sector, we conclude that EU consumers have a direct interest in liberalisation in the sector and in Russia remaining open to meaningful foreign participation in the development of its energy resources. Although large global energy companies are likely to remain interested in the Russian sector under almost any conditions, we recommend that the Government continue to impress on Moscow the mutual benefits that can come from the existence of transparent and stable conditions for foreign investment in the Russian energy sector.

Supply diversification

177. The prospective shortfall in Russian gas output suggests a need for the diversification of energy sources away from Russia. The possibility of further disputes between Russia and CIS states which may affect energy transit suggests also the wisdom for the EU of diversifying deliveries away from routes controlled by Russia. Energy supply diversification is also advisable in general terms, to provide insurance against technical problems, theft, sabotage or terrorism. Supply diversification should also exert downward pressure on prices for consumers.

178. Both the EU and the UK have explicitly committed themselves to the goal of energy supply diversification. At the EU level, in June 2006 the European Council said that it "underlines the need to further diversify sources of energy supply". The European Council said that it would "give full support to infrastructure projects compatible with environmental considerations and aimed at opening up new supply routes with a view to diversifying energy imports which would benefit all Member States".[392] In March 2007, under the new Energy Policy for Europe, the European Council adopted an energy Action Plan for 2007-2009 which aims, among other objectives, to enhance security through the "effective diversification of energy sources and transport routes, which will also contribute to a more competitive internal energy market".[393] As for the UK, the FCO told us that "the Government supports diversity of supply—both of source and export route."[394]

179. The Caspian resources of Azerbaijan and Central Asia are one of the main areas of attention for Western energy importers seeking to diversify their supplies. In its energy Action Plan for 2007-2009, the EU listed as an "essential element" "intensifying the EU relationship with Central Asia, the Caspian and the Black Sea regions, with a view to further diversifying sources and routes."[395] For companies in particular, including EU and UK firms, the Caspian is of interest because its energy resources are, on the whole, available for international development to a greater extent than are those of the OPEC states in the Gulf.[396] However, until recently, there was no westward pipeline export route for Caspian energy resources which was not controlled by Russia. The only non-Russian export pipelines comprised a line taking gas from Turkmenistan into Iran, and a recently-completed oil pipeline running from Kazakhstan to China. However, over the last two years, Azerbaijan has achieved an export capacity for both oil and gas which is independent of Russia, instead transiting Georgia into Turkey (see map). Azerbaijan is now supplying both those countries, and it is planned that excess supplies sent to Turkey can be delivered thence onwards to the EU. BP is a leading partner in both the Baku-Tbilisi-Ceyhan oil export pipeline and the Baku-Tbilisi-Erzerum gas pipeline.

180. From a geopolitical perspective, three especially important strands can be distinguished in the current efforts by Western states and companies to pursue supply diversification in the Caspian region:[397]

Increasing transit capacity to the EU through Turkey: Many of the schemes for the delivery of increased supplies to the EU rely on expanding both the quantities taken by Turkey and the transit options for onward delivery from Turkey to the EU. The key scheme in this regard is the Nabucco gas pipeline, which would run from Turkey up through the Balkans to Austria (see map). Mr Roberts told us that "If there is one project that holds the key towards major EU diversification from specific dependence on Russian supply it is Nabucco."[398] It is envisaged that Nabucco would carry re-exports from Turkey—which might have come originally from Iran and Russia—plus supplies from Azerbaijan, plus eventually perhaps from Turkmenistan, depending on the development of trans-Caspian transit.[399] The start of Nabucco's construction is foreseen for 2009, with completion in 2012. As part of its energy Action Plan for 2007-2009, in March 2007 the European Council confirmed Nabucco as one of four "priority projects of European interest".[400] In September 2007, the European Commission appointed a former Dutch Foreign Minister, Mr Jozias van Aartsen, as the EU's coordinator for the project. Prospects for progress appeared to improve further as Hungary confirmed its commitment, and as companies from Germany and France—which have previously often dealt bilaterally with Russia—expressed interest in joining the consortium developing the project.[401]
Securing Central Asian supplies: While the resources in Azerbaijan which are now coming on stream represent an important new potential source of supply, resources on the eastern side of the Caspian, above all in Turkmenistan, have the potential to alter supply prospects even further. In his evidence to us, the Minister for Europe mentioned Turkmenistan as one of the places hosting "reserves that we think can form an important part of a UK energy mix that gives the diversity that is an important part of security."[402] Following the death in December 2006 of Turkmenistan's former dictator Saparmurat Niyazov, there have been signs that his successor, President Gurbanguly Berdymukhammadov, may be more open to cooperation with Western companies and countries on the development of Turkmenistan's energy resources.[403]
Trans-Caspian pipeline: Oil can be—and is—shipped across the Caspian from east to west, but the transit of large quantities of gas would probably be most efficiently achieved via pipeline, probably to link into the Baku-Tbilisi-Erzerum line that now runs westwards from Azerbaijan. A route from Turkmenistan would be shortest and geologically easiest, and the change of leadership in Turkmenistan has again renewed interest in this long-discussed scheme.[404] Mr Roberts told us that the EU is commissioning a feasibility study on pipeline versus shipping for gas across the Caspian.[405] For its part, the FCO described the prospect of transporting Central Asian energy resources from the eastern side of the Caspian westwards through the Azerbaijani pipelines as a "major prize for the future".[406]

181. Under current circumstances, Russia will be resistant to Western plans to secure Caspian energy supplies for the reasons outlined below:

As regards transit through Turkey, although it has been suggested that Russia might seek to use Nabucco to deliver its own output, the more likely scenario is that the West's Nabucco and Russia's South Stream pipelines become competing projects.[407] There is unlikely to be sufficient Caspian gas to supply both lines.
As regards Central Asian supplies, as outlined in the preceding section Russia is relying on these to help it fulfil its own gas export commitments, and it has already contracted to buy large quantities of Central Asian output. This makes Russia and the EU direct competitors for the same Central Asian energy resources. For CIS energy suppliers, the strong incentive to participate in non-Russian schemes is that EU customers will offer world prices, while the development of alternative export options could allow the application of pressure on Russia over transit fees. Mr Roberts told us that "Russia feels threatened by any opening of Caspian gas to hard cash markets."[408]
As regards trans-Caspian transit, Russia opposes such schemes, preferring to see deliveries continuing to take place via Russia. Indeed, the Caspian states have been split into a camp opposed to trans-Caspian transit, comprising the northern and southern littoral states of Russia and Iran, and a camp with interests in the development of such transit, comprising Azerbaijan to the west and the Central Asian littoral states to the east.[409] Moreover, the legal status of the Caspian sea and the division of rights to its use have not been finally settled between the littoral states, despite years of on-off talks. It is possible that Russia could use this issue to delay or disrupt, perhaps physically, the development of any Western-sponsored trans-Caspian pipelines.[410] Mr Roberts told us that "Russia opposes trans-Caspian pipelines and probably has both the means and determination to stop them."[411] At a Caspian summit in October 2007, Russia secured a declaration that the construction of any trans-Caspian pipeline would require the consent of all the littoral states.[412]

182. Overall, Caspian diversification schemes will unavoidably weaken Russia's relative position with regard to its neighbours and the EU, even if they have no direct impact on Russia's own energy exports. Mr Clark told us that "Nothing would do more to change the strategic equation of EU-Russia energy relations than the opening of a new energy transit corridor to the Caspian and Central Asia."[413] The CSRC told us that, as a result, "Russia will seek to maintain a stranglehold on Central Asian supplies and transport routes—and will treat diversification schemes with hostility."[414] For his part, the Minister for Europe felt it was "clear that Russia […] wishes […] to get involved in a process that reduces the international market's capacity to exploit multiple export routes out of that part of the world."[415]

183. The non-Russian CIS Caspian states are likely to view possible participation in Western-sponsored supply diversification schemes through the prism of their relations with Russia. Given Russia's hostility towards the development of Caspian alternatives to its supplies and transit routes, fear of aggravating Moscow is likely to make such states cautious. For example, as regards Kazakhstan's attitude to the development of a trans-Caspian pipeline, Mr Roberts told us that "Kazakhstan needs very strong EU political support […] Kazakhstan will be careful not to damage its relations with Russia until it believes that the EU is committed to do more than financing studies."[416]

184. Mr Roberts drew our attention also to the potentially delicate position of Turkey in the geopolitics of EU energy supplies. Turkey is the key transit state both for Western schemes to secure Caspian supplies independently of Russia, and possibly for the southern strand of Russia's plans for its energy deliveries increasingly to bypass states in the Western CIS, the Baltics and Poland. Turkey maintains good relations with Russia, but may find itself caught between Russian and EU demands for the use of its energy transit network. Mr Roberts warned us that "the time is fast approaching when the EU and Turkey will have to make some very tough choices."[417] Turkey's position is especially relevant for the UK given London's strong and consistent support for Turkish membership of the EU. We welcome signs on the part of the EU and its Member States of increasing commitment to energy supply diversification schemes. However, we conclude that Russia and the EU could come to be direct competitors for Central Asian energy resources. Under current circumstances, the EU's aims of achieving supply diversification through independent access to non-Russian Caspian energy resources may also aggravate Russia. We recommend that in continuing to pursue supply diversification, including at the EU level, the Government take full account of the geopolitical sensitivities involved and seek greater integration of sectoral and foreign policy considerations.

International energy regimes: G8, EU and the Energy Charter Treaty

185. The evidence presented in this chapter so far suggests a need, from the UK and EU perspectives, for transparency in the Russian energy sector, as regards output prospects and trade and price arrangements with other CIS states; and for liberalisation and foreign participation in order to boost investment and future output prospects. Our discussion of supply diversification focused on the achievement of new sources and export routes; but a third diversification mechanism would be the ending of Russian state control of the existing Russian export pipeline network and its opening to alternative owners or operators. This further points to the need for liberalisation of the Russian sector.

186. There are a number of international regimes designed to promote transparency, liberalisation, fair competition and security of investment and supply in the energy sector. The EU, and the UK, have been engaged in trying to secure Russian compliance with these regimes.

187. At their summit in June 2006, under Russia's chairmanship, the G8 countries declared a set of Global Energy Security Principles including: effective market access and investment at all stage of the supply chain; open, transparent, efficient and competitive markets in all aspects of energy; transparent, equitable, stable and effective legal and regulatory frameworks; and the promotion of transparency and good governance in the energy sector.[418] The CBI told us that the G8 principles "are important steps in providing for a firm framework for future energy security".[419] However, only days after the summit, President Putin approved a new Gas Export Law confirming Gazprom's export monopoly. The DTI told us that this law, plus developments in the domestic Russian sector and Moscow's attitude to the Energy Charter Treaty and its Transit Protocol, discussed below, "appear inconsistent with some of the St Petersburg principles."[420] In its 2006 Annual Report, the FCO commented that "there remains much to do to ensure [the G8] principles are applied and put in place consistently across G8 member states."[421]

188. The Energy Charter Treaty (ECT) was signed in 1994 and entered into force in 1998, on the basis of an EU initiative. The CBI told us that the ECT "plays an important role in creating a legal foundation for energy security, based on the principles of open, competitive markets and sustainable development."[422] The ECT includes provisions for: the protection of foreign investments in the energy sector; non-discriminatory trade in energy products, materials and equipment and reliable cross-border energy transit flows; a binding dispute resolution mechanism, both between participating states, and between foreign investors and host states; and the promotion of energy efficiency and environmental considerations. The European Communities comprise one of the ECT's 52 signatories, along with the UK. Russia also signed the ECT. However, Russia has not ratified the Treaty. In Moscow's view, the ECT is one of the international regimes to which Russia signed up in the 1990s when the country was weaker, and which no longer meets Russia's interests.[423] At the EU-Russia summit in Finland in October 2006, which failed to make a breakthrough on EU-Russia energy issues, President Putin said that Russia is "not against the principles laid down in the Energy Charter but […] believe[s] that certain provisions need to be further specified".[424]

189. The Energy Charter Conference, which groups ECT signatory states, agreed in 1999 that negotiations should start on a Transit Protocol to be appended to the ECT. Most of a Transit Protocol text was agreed by 2002, but the Protocol has not been finalised, owing to a lack of agreement with Russia. Under the text of the draft Protocol, Russia would have to relinquish its monopoly control of its export pipelines. Professor Fedorov told us that there was "very little probability" that Russia would agree to the Transit Protocol.[425]

190. Both the UK and the EU have been seeking Russian ratification of the ECT and acceptance of the Transit Protocol. For example, in March 2006, the European Council called for "decisive efforts" to complete the negotiation of the Transit Protocol and secure Russian ratification of the ECT.[426] At the European Council in June 2006, these goals remained an EU "priority".[427]

191. Mr Clark pointed out that even without ratifying the Treaty, Russia is bound by its provisions, since Moscow did not state on signing the document that it would not be applying the Treaty provisionally, pending ratification.[428] It is the contention of GML Limited, the majority shareholder of Yukos, that Russia's actions regarding Yukos contravene its existing obligations under the ECT and constitute grounds for a compensation claim which GML is currently pursuing under the terms of the ECT.[429]

192. Encountering Russia's resistance to ratifying the ECT, the EU came to the view in the course of 2006 that the way forward should be to try to incorporate a substantive agreement on energy matters, including much of the content of the ECT and the draft Transit Protocol, into the new overarching EU-Russia agreement which was foreseen to replace the existing EU-Russia Partnership and Cooperation Agreement (PCA). The PCA expires in December 2007, and talks on its successor were originally expected to start in late 2006 or 2007.[430] The EU appeared to see the negotiation of a new agreement with Russia along these lines as a possible means of securing Russian ratification of the ECT itself.

193. The Government supports the EU's approach to the new EU-Russia agreement on energy matters. The FCO told us that "In its approach to the negotiation of a successor Partnership and Co-operation Agreement (PCA) between the EU and Russia, the Government attaches importance to a component on energy that includes legally binding dispute resolution mechanisms."[431] The Government's Energy White Paper of May 2007 said similarly that London would "ensure that negotiations on a new set of Partnership and Cooperation (trade) agreements with third countries (beginning with Russia in 2007) reflect [the ECT's] principles".[432] Mr Roberts told us that the incorporation of much of ECT into the new EU-Russia agreement might represent "an intelligent way forward", if it allowed Russia to claim that it had successfully deflected the ECT itself—but only as long as the provisions in any new EU-Russia agreement remained legally binding, as under the ECT itself.[433] However, the EU's wish for a legally binding agreement substantially the same as the ECT returns the argument to the existing standoff with Russia over the ECT itself. Mr Roberts told us that it was "extraordinarily difficult to see" how such an agreement could be negotiated.[434] Talks on a successor to the EU-Russia PCA have in any case not yet been launched, for unconnected reasons.[435]

194. The EU appears latterly to be attempting a third strategy to encourage Russian acceptance of ECT principles. This strategy is based on the notion of reciprocity. The strategy relies on Gazprom's known wish to expand its presence in the downstream sector within the EU in order to try to force in return a greater opening of the Russian sector to participation by EU firms. Already in March 2006, the European Council talked of "the need for secure and predictable investment conditions for both EU and Russian companies and reciprocity in terms of access to markets and infrastructure as well as non-discriminatory third party access to pipelines in Russia".[436] The EU's plans to pursue the principle of reciprocity with respect to Russia come as part of plans for further integration and liberalisation of the EU's own energy market, under the new EU common energy policy. Under proposals unveiled by the European Commission in September 2007, third country companies wishing to acquire a significant interest in an EU energy transmission network would be obliged to comply with the same requirement to 'unbundle' their generation and supply activities from their transmission activities as is proposed for EU firms. That is, if Gazprom wished to buy into an EU transmission network, it would have to divest ownership—or, at the least, control—of its generation and supply activities. Furthermore, any acquisition of control over an EU transmission network by a third country firm would be subject to an agreement between the EU and the relevant third country.[437]

195. The DTI told us that the Government is "supporting the Commission in securing effective implementation of a competitive, liberal energy market."[438] Furthermore, the Commission's approach to third country investment in the energy sector appears to be broadly in accord with that of the UK. The FCO told us that the Government has "reaffirmed the openness of the UK to all foreign investors who are prepared to operate within markets governed by competitive, liberal market principles".[439]

196. The fate of the Commission's September 2007 proposals remains unclear. The proposals are subject to the agreement of the Member States and the European Parliament, and several EU states oppose full 'unbundling'. The precise implications of the Commission's proposals for companies such as Gazprom—for example as regards investments in the EU which have already been made—and how exactly the proposals would be enforced remain subject to clarification. However, the Commission's proposals appear to represent a potentially fruitful way forward, by relying on Russia's own interests and seeking solutions to EU-Russia differences over energy within the energy sector itself,[440] without necessarily abandoning the EU's own liberal principles in favour of protectionism. We recommend that in its response to this Report, the Government inform us of its initial response to the European Commission's latest proposals for the energy sector, its assessment of the likelihood of their acceptance by other EU actors, and its assessment of their likely impact on EU efforts to win greater Russian compliance with international regimes governing the energy sector according to liberal and transparent principles. We further recommend that the Government continue to impress on its EU partners the way in which bilateral dealings with Russia in the energy sector can undermine the EU's declared common interest in encouraging Russian compliance with shared international energy regimes. We recommend that the Government therefore continue to encourage its EU partners to act in accordance with a credible common EU energy policy towards Russia.

Environmental linkage

197. The FCO told us that "Russia has been slow to recognise the impact which climate security will have on its economy."[441] The lesser urgency which is felt in Russia regarding climate change is due partly to the fact that Russia easily meets its emissions target under the Kyoto Protocol. This is thanks to the drastic post-communist fall in economic output which occurred after 1990, the Kyoto baseline date. The CSRC also told us that in Russia "The state places more emphasis on economic growth than countering pollution."[442] According to the CSRC, "Spending on environmental protection is inadequate" and "[s]ince 2000 environmental controls and monitoring capacity have in fact been reduced."[443]

198. Russia remains the world's third largest greenhouse gas emitter. As such, it will be vital to secure Russia's participation in the international emissions regime which is foreseen for the period following the expiry of the Kyoto Protocol in 2012. Given Russia's international position, its participation may also help to encourage other emerging economies to join the new regime.[444] Russia is therefore one of the major energy users being targeted by the FCO as it works to deliver the Government's international climate change strategy for 2007-09.[445]

199. Russia's greenhouse gas emission levels are sustained partly by inefficiencies in the energy sector. As regards energy production, the International Energy Agency has estimated that gas lost in transmission or flared at source in 2004 was equivalent to just over one-third of Russia's annual gas exports.[446] As regards energy use, Russia uses around three times as much energy per unit of output as in the OECD.[447] We concluded above that potential shortfalls in production represented the most urgent energy security risk for the EU as regards Russian gas. The loss of gas through flaring and other wastage in the Russian production process further reduces the amount potentially available for Western export. In this light, customers in the EU have a direct interest in reducing gas wastage and improving the efficiency of energy use in Russia, in addition to their interest in the downward pressure on greenhouse gas emissions which such reduction could bring.[448]

200. Under its Energy Strategy to 2020, Russia has targeted a 50% reduction in energy consumption. Some downward pressure will be exerted on energy use as prices are decontrolled.[449] However, according to the FCO, "substantive practical action by Russia is absent".[450] It seems more likely that, in the absence of reform, the potential environmental impact of inefficiencies in Russia's energy sector will increase as Russia's economy continues to grow. Under these circumstances, the FCO has identified "significant gains to be made in energy efficiency in Russia."[451]

201. Compared to its attitude to climate change as such, "Russia has been quicker to recognise the benefits of improved energy efficiency", the FCO told us.[452] The FCO focuses much of its work on climate security in Russia on the energy sector, implementing a number of relevant Global Opportunity Fund projects. DFID is also funding work by the European Bank for Reconstruction and Development on investment in energy efficiency projects in Russia.[453] Energy efficiency issues are also to be addressed in the UK-Russia Energy Forum established in February 2007. We conclude that the FCO is correct to have identified the potential for significant improvement in energy efficiency in Russia. We support the FCO's project work in this area, and a strategy of using Russia's interest in enhancing the efficiency of its energy sector as a means of further engaging Russia in the wider climate security agenda. We recommend that the FCO seek opportunities to expand work with Russia in the energy efficiency field, through both bilateral and multilateral mechanisms.

Whitehall cooperation

202. The evidence presented in this chapter has demonstrated the close linkages that exist between sectoral and foreign policy considerations in UK and EU energy security policies regarding Russia. In his evidence to us, the FCO official Mr Damian Thwaites told us that he had:

daily contact with colleagues in the DTI—now the Department for Business, Enterprise and Regulatory Reform—on the issues. There are a lot of official contacts by way of ad hoc meetings and work under the aegis of the Cabinet Office. Those are very strongly co-ordinated. A lot of collective Whitehall work went into producing the Energy White Paper in which the FCO actively participated.[

454

203. We were pleased that, by agreement of all three parties, the then DTI—rather than the FCO—submitted the Government's evidence to our inquiry on energy security matters. We commend the cross-departmental cooperation which is taking place on energy security matters. We recommend that the Government continue to foster a cross-departmental approach to energy security and that it advocate the benefits of this approach to its EU partners and the EU institutions.

313 Ev 48 Table Five [Mr Roberts], Ev 56 [Mr Clark], 126, 129 [DTI]; International Energy Agency, Key World Energy Statistics 2007, via www.iea.org Back

314 Calculated from Ev 45 Table One [Mr Roberts] Back

315 Ev 128-130 [DTI] Back

316 Ev 128 [DTI] Back

317 Ev 41, 48 Table Five [Mr Roberts] Back

318 Ev 111 [Professor Hanson], 131 [DTI] Back

319 Ev 40 [Mr Roberts] Back

320 Ev 170; see also Ev 127 [DTI]. Back

321 Ev 128 [DTI] Back

322 Ev 126 Back

323 Ev 127 [DTI], 170 [CBI] Back

324 Q 87 [Mr Clark] Back