House of Commons - Foreign Affairs

Select Committee on Foreign Affairs Written Evidence

Written evidence submitted by the Department for Trade and Industry

BACKGROUND

1. Russia is the world's second largest crude oil producer behind Saudi Arabia (accounting for 11.4% of global production), and the largest non-OPEC producer. It holds just over a quarter of the world's proven natural gas reserves, the world's eighth largest proven oil reserves, and the world's second largest coal reserves after the USA.

2. In 2006, net imports from all sources accounted for 8% of the UK's crude oil consumption, 12% of gas demand and 77% of coal demand.[24] Crude oil, petroleum products and coal are traded in global markets in which importers choose the most competitive supplier for their needs, and are able to switch suppliers relatively easily. Gas markets are generally regional and constrained by expensive cross-border pipeline infrastructure, although global gas markets are developing with the growth of trade in Liquefied Natural Gas (LNG). At present, imports of energy from Russia do not make up a significant proportion of our imports. This picture will evolve in future, but Russia is not expected to become a dominant supplier to the UK.

UK AND EU IMPORTS OF RUSSIAN GAS

3. The UK currently imports around 12% of net annual gas consumption. The chart below shows gross UK gas imports since 2002.

Source: DTI

4. In 2006 the majority of UK imports were sourced from Norway. Additional imports included LNG from Algeria, Trinidad & Tobago and Egypt, piped gas from the Netherlands via the BBL pipeline and piped gas from the continent via the IUK interconnector. It is not practical to attribute imports of piped gas from continental Europe to their ultimate sources because the various streams of gas are comingled before they reach the UK, but it is likely that gas arriving through the interconnector includes gas originating in the Netherlands, Norway and possibly Russia. The interconnector link between the UK and continental Europe makes continental European gas supply security important to the UK's own security of supply.

5. UK gas retailers' contractual arrangements for gas supply are subject to commercial confidentiality. However the Government does not believe that any major UK suppliers have direct import contracts with Russia for physical supply. There may be commercial arrangements for "virtual" imports from Russia, either along contractual supply chains or via swap arrangements.

6. By 2010 the UK is expected to import up to a third or more of its gas, rising to around 80% by 2020. Where the gas actually flows from will reflect commercial decisions. However it is likely that piped gas from Norway, from continental Europe via the IUK and BBL interconnectors, and LNG from Qatar, Egypt, Nigeria, Trinidad & Tobago and Algeria will all contribute to the mix. By 2020 we could expect around a quarter of average winter demand to come from continental Europe, a further quarter from Norway and the remainder from LNG and domestic storage. The chart below from the December 2006 DTI/Ofgem Joint Energy Security of Supply Working Group provides more detail on estimated future gas supply sources.[25] However, assessment of future supply sources is inevitably approximate; new field discoveries or import infrastructure developments could substantially alter these forecasts.

7. The EU currently imports around half the gas it needs, with half of these imports (around 25% of EU gas demand[26]) imported from Russia. By 2030, the EU's dependence on imported gas is expected to be around 65—85%.[27] The EU is likely to import a mixture of piped gas and LNG from a wide variety of sources including Norway, North Africa, the Caspian, the Middle East and Latin America. The IEA Reference Scenario presents data that suggests Russia's market share of imports could drop, so Russia would supply around a fifth of total EU gas demand, compared to a 25% share today; with an expanding EU gas market, this would still be consistent with an increase in the volume of Russia's gas exports to the EU. IEA forecasts also suggest that Africa could overtake Russia as the main supplier to Europe, with the Middle East and LNG from South America also important suppliers.[28]

UK AND EU IMPORTS OF RUSSIAN OIL

8. Since 2004, UK crude oil imports from Russia have been broadly 7 million tonnes per year, representing about 13% of the UK's total crude oil imports, and 9% of the UK's total crude oil consumption. Most UK crude oil imports come from Norway as UK refiners prefer to use North Sea grade crude for its low sulphur content. As a result of commercial decisions, 64% of the UK's own crude oil production is exported, meaning that the UK's net imports of crude oil in 2006 were only 6.2 million tonnes (8% of consumption).

Crude oil imports by country of origin

Source: HM Revenue and Customs

9. The UK is expected to become an increasing net importer of oil from 2009, and by 2020 net imports could be accounting for around two-thirds of the UK's oil consumption. These imports will be sourced from the global market so it is not practical to predict the proportion that will come from a particular producing country. However, with Norwegian production also declining, more of the UK's oil is expected to be sourced from outside the North Sea. UK refineries will have the option of importing similar quality crude to the North Sea, for example from producers in West Africa and the Caspian, or upgrading facilities to refine lower quality crude oil supplies from Russia or the Middle East.

10. The EU-27 imports over 25% of its total oil consumption from Russia.[29] This percentage may well increase as North Sea oil production declines. The IEA forecasts that Russia's global oil exports will increase from around 350 million tonnes in 2005 to 400 million tonnes by 2015.

UK AND EU IMPORTS OF RUSSIAN COAL

11. In 2006 UK coal consumption for electricity generation was 57 million tonnes (Mt), consistent with the 50-60 Mt per year used during 2000-05. UK imports of steam coal[30] from Russia have increased from a very low level in 2000 to 22.5 Mt in 2006, a little over half of the total imports of 44 Mt. These increased imports have replaced indigenous output rather than displacing coal from other exporting countries. Reserves of coal are large and well dispersed (as the graph below indicates); Russia is estimated to hold 17% of global proven coal reserves.[31] Coal is traded in a well-functioning international market where it is relatively easy to switch supplier. Russia does not export significant quantities of coking coal[32] to the UK.

Steam coal imports by country of origin 2000-06

12. The rapid increase in growth of Russian imports has had three principal drivers (although the reliability of Russian exports, an important factor with UK importers, has also contributed):

— Increases in the cost of shipping coal have adversely affected the competitiveness of southern hemisphere producers;

— Congestion at those UK ports capable of taking large ships has favoured the smaller ships used by Russian exporters;

— Russian coal is low in sulphur compared to UK coal, helping generators meet emissions targets.

All three drivers should decrease in importance over the next few years as more ships enter into service, port expansion takes place in both the UK and Russia, and plant is fitted with flue gas desulphurisation equipment.

13. Most EU countries are now net importers of coal, with only Poland retaining a significant export trade. The EU currently imports 8% of its coal from Russia.[33] Over the next 25 years EU coal imports are expected to grow by around 40%.[34]

RECENT ENERGY POLICY DEVELOPMENTS IN RUSSIA

International

14. At the 2006 St Petersburg G8 summit heads of state agreed the St Petersburg principles on Global Energy Security, which included the following commitments:

— Effective market access and investment in all stages of the supply chain;

— Open, transparent, efficient and competitive markets in all aspects of energy;

— Transparent, equitable, stable and effective legal and regulatory frameworks;

— Promotion of transparency and good governance in the energy sector.

15. A new Gas Export Law confirming Gazprom's export monopoly was approved by President Putin only days after the St Petersburg summit. Russia has signed but not ratified the Energy Charter Treaty, which provides a rules-based framework for trade, investment and transit of energy products and services backed up by legally binding investor-to-state dispute resolution mechanisms. Russia cites the lack of an agreed Transit Protocol as the reason it will not ratify. Negotiations on the Transit Protocol are ongoing but reached a stalemate last autumn due to disagreements between the EU and Russian delegations. There is also considerable speculation that an unwillingness to provide transit to Central Asian gas supplies (currently under effective control by Russia), could be another significant reason for failure to ratify. These international policy developments, and a number of other domestic energy policy developments (see paragraphs 16 and 17), appear inconsistent with some of the St Petersburg principles.

16. Energy is a key element of Russia's relations with its near abroad. Russia has contracted nearly all the gas export potential of Turkmenistan, Kazakhstan and Uzbekistan. Such Central Asian imports are likely to become increasingly important to Russia in future as production from the largest domestic gas fields declines. At present these countries do not have independent access to European gas markets because all the pipeline routes are controlled by Gazprom.

17. Russia increased prices charged for gas sold to several FSU neighbours between 2006 and 2007. For example the price charged to Ukraine rose from $95 per thousand cubic metres (tcm) to $130/tcm, to Belarus from $46/tcm to $100/tcm, and to Georgia from $110/tcm to $235/tcm. 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. Negotiations on changes to energy pricing and transit tariffs have also resulted in Russia reducing supplies to or through individual countries. During a dispute on the price of gas sold to Ukraine in January 2006 Gazprom substantially decreased gas flows to Ukraine, leading to some countries in Western Europe reporting declines in gas received of up to 40%. Between 8 and 11 January this year Russia stopped pumping crude oil through the Druzbha ("Friendship") pipeline which crosses Belarus to central Europe, in response to a complex dispute over export and transit tariffs for crude oil supplies from Russia to Belarus.

Domestic

18. The last five years have seen a concerted increase in state control of the energy sector in Russia. The gas sector is entirely dominated by Gazprom, in which the Russian state has a stake of 50% + 1 share. Gazprom is responsible for around 85% of output and has monopoly control of the gas transportation and transit network. State ownership in the oil sector grew from 18% in 2005 to 36% by 2006. Much of this increase was the result of the acquisition by state-owned Rosneft of many of the assets of Yukos (formerly Russia's largest oil company but declared bankrupt following claims of unpaid taxes) and the acquisition of Sibneft (from Roman Abramovich). Foreign investment projects such as the Sakhalin II project in Russia's Far East and the Kovytka project in East Siberia have experienced unstable regulatory environments. Following drawn out negotiations with potential partners for the massive Shtokman project, Gazprom announced that foreign company involvement would be limited to contractor roles rather than full partners. A Subsoil Law limiting overseas investment in oil, gas and coal projects is under development, and a Strategic Sectors Bill limiting foreign investment in a range of sectors is also under discussion. These policies and developments are all examples of the policy of re-asserting state control over natural resources.

19. There is also evidence of modest energy market reform, possibly motivated by domestic energy supply concerns. IEA analysis suggests that without major new investments Gazprom's production could decline by about 25% by 2015. Domestic supply is already tight, and a booming economy combined with poor energy efficiency is likely to exacerbate this. Economy Minister German Gref has admitted that gas supply is becoming a serious constraint on economic growth. In December the Russian cabinet agreed to raise domestic industrial gas prices from their current low level to market prices by 2011, as required by Russia's WTO accession agreement with the EU. A trial gas trading scheme involving sale of 10 bcm gas per year at unregulated prices has also been established, resulting in prices around 30% to 40% higher than the regulated tariff. Electricity sector reform is proceeding, with state electricity monopoly RAO UES due to be disbanded in 2008. Its generating assets are currently being spun off in a series of IPOs.

UK GOVERNMENT POLICY

International Energy Markets

20. Russia's role in supply of energy to the UK and EU should not be seen in isolation; the Government's approach to Russia forms an integral part of a broader international energy strategy. The Government believes that international energy policy should be driven by a robust and objective assessment of risks to energy security. A number of factors have the potential to affect the UK's security of energy supply:

— Closed markets in which oil and gas reserves are under the control of state entities are likely to lack competition and hence lack incentive to exploit resources efficiently, potentially leading to underinvestment, lower production and higher prices.

— Market power through concentration of reserves or control of transportation infrastructure enables some countries to exert significant influence over prices.

— Inadequate information about the production, consumption and stocks of fuels, and about the direction of policy, can exacerbate fluctuations in oil and gas prices. This volatility can deter long-term investments.

— The threat of terrorism, accident and natural disaster can compromise the working environment in the energy sector, increase the likelihood of supply disruptions, hamper investment and increase the costs of oil and gas production.

— Producer countries may make politically rather than economically motivated supply or investment decisions.

21. The best way to manage these risks and maintain energy reliability is through diversity of energy source, suppliers, and transit routes. Competitive markets help achieve diversity as companies themselves seek flexibility and diversity in order to manage risks. In the UK this market-based approach is leading to around £10 billion investment in new gas import, storage and pipeline capacity in the period 2005-10, enabling a significant diversification of gas import source, supplier and route.

22. The UK will also take a lead influencing role in the international community. This approach builds on the success of our 2005 G8 presidency, during which G8 members agreed on the need for urgent action to tackle the twin challenges of energy and climate security, and on our support for the EU's common external energy policy, initiated during our 2005 EU presidency. Our international strategy stresses the need to promote open, competitive energy markets worldwide, to develop global frameworks to tackle climate change, and to promote energy efficiency and deployment of low carbon technologies. Working to promote these principles worldwide will help mitigate against the risks described above. Our international agenda is active on three fronts:

— Bilaterally, we are building stronger political relationships with energy producers to ensure UK energy suppliers have fair access to energy supplies.

— Within the EU, we are supporting the Commission in securing effective implementation of a competitive, liberal energy market. As well as addressing anti-competitive behaviour, this will provide clear signals to potential infrastructure investors and ensure more reliable UK access to gas coming into European networks.

— Multilaterally, we are working to strengthen the dialogue between consumers and producers so there is a better common understanding of the mutual benefits of investment in exploration and production, rapid deployment of cleaner and more efficient technologies, and open trade in energy.

BILATERAL ENERGY RELATIONS WITH RUSSIA

23. The UK's approach to Russia focuses on areas of clear mutual interest such as improving energy efficiency, on using the UK's own experience of energy market liberalisation to promote energy sector reform, and on emphasising the importance of a stable investment climate in the Russian energy sector. The Secretary of State for Trade and Industry visited Moscow in February of this year and discussed these issues with Minister for Energy and Industry Viktor Khristenko, Minister for Economics and Trade German Gref, and Finance Minister Alexei Kudrin. During the visit Mr Khristenko and the Secretary of State also agreed to establish a UK-Russia energy forum to strengthen mutual understanding in these areas, looking in particular at energy efficiency, measures to tackle gas flaring (the burning of "waste" gas produced in conjunction with oil) and conditions for mutual investment. The UK-Russia forum will also provide a vehicle to reinforce the EU's messages towards Russia. In parallel the Government is actively developing relations with other major producers such as Algeria and Qatar, emphasising the benefits of competitive energy markets to producers and consumers alike.

24. The UK Government has maintained close contact with all the UK companies affected by the Russian government's policy of re-asserting state control over natural resources and has lobbied the Russian authorities consistently, including at the highest levels, for the rule of law and international standards of corporate governance to prevail. Establishment of the UK-Russia energy forum, providing opportunities for regular personal contact between UK and Russian ministers, is a means of ensuring these concerns are understood.

Russian presence in UK energy sector

25. The Government welcomes overseas investment in the UK, including in the energy sector. This openness to overseas investment has contributed to the much of the new gas import infrastructure delivered over the past few years. We are confident that the UK's regulatory and competition framework will protect consumers, regardless of the ownership of companies. The UK's energy markets are regulated by Ofgem, whose principal objective is to protect the interest of consumers. In general, all businesses, both UK and foreign owned, can only participate in the gas and electricity sectors if they have a licence. Ofgem issues and enforces these licences. Attached to these licences are various industry and best practice codes to ensure consumers get the best deal. If Ofgem finds a business in breach of its licence, it can be fined up to 10% of its turnover. Ultimately, Ofgem could revoke a business's licence. Commercial considerations also provide a strong imperative for energy companies to respect consumers' interests; any company perceived as an unreliable supplier would be likely to lose market share rapidly. Any foreign company bidding for a UK energy company would also be subject to the same regulatory control of mergers as any other takeover with the relevant competition authorities considering the case on grounds of its impact on competition in the relevant market.

26. The Government is aware of two Russian-owned companies operating in the UK energy market. Gazprom Marketing and Trading Limited (GMTL), a wholly-owned subsidiary of Gazprom, is a licensed gas shipper and is licensed to supply non-residential consumers through its purchase of Pennine Natural Gas. GMTL currently has around a 1% share of the UK non-residential market, but has announced plans to grow their market share to around 20% by 2015 but has not set out whether it plans to achieve this through organic growth or acquisition. GMTL also has modest activity in Belgium and France and aims to become a trader and supplier throughout North West Europe. Russian coal producer Kuzbassrazrezugol is involved in the project to re-open the Hatfield colliery and to build a carbon-capture ready 1 GW power station at the site.

EU ENERGY RELATIONS WITH RUSSIA

EU external energy policy

27. EU Member States have agreed the principle of "speaking with a common voice" on external EU energy policy several times over the past 18 months, most recently at the Spring European Council 2007 in the context of agreeing an overarching EU Energy Action Plan. The UK was instrumental in launching this debate during our Presidency and mandated the Commission to present a detailed paper on External Relations for discussion at the informal European Council meeting in Lahti in 2006, which President Putin attended. This paper focused on the need for a coherent, coordinated European voice on energy, and effective use of all available multilateral, inter-regional instruments and bilateral arrangements.

28. Since the agreement to "speak with a common voice", the focus has now shifted towards implementation. In reality this means ensuring that the EU position is agreed by all Member States and that our energy objectives are reflected in all of our EU external relations. Whereas this happened previously on an ad hoc basis it is now happening more systematically across all of our EU external relations, although further progress remains possible. EU external energy policy will be most effective if combined with a fully functioning internal market, providing greater resilience to supply disruptions through access to energy sources from across Europe, and clear signals to encourage new infrastructure investment. The UK is active in promoting recognition of this link among Member States.

Diversification

29. A key tenet of the EU's external energy policy is the need to diversify our energy sources, so that in the case of interruption from one source, either intentional or unintentional, we have others to draw upon. The diversification can be taken to mean both types and sources of energy. The UK has played an active role in promoting agreement to both of these principles among our fellow Member States and is continuing to do so through active involvement in discussions at the European level. In particular, the UK has used the current review of European Neighbourhood Policy to stress the importance of a coherent EU energy policy towards the Caspian region, focussing on promoting the transparency and clear regulatory frameworks which are a pre-condition to development of any new energy infrastructure in the region.

EU energy policy towards Russia: the post-PCA agreement and Permanent Partnership Council on Energy

30. The EU and Russia are mutually dependent in the energy sector. Oil and gas export revenues contribute around half of the Federal budget. As Russia's most significant energy export market the collective negotiating power of the EU is significant, although differences in approach to Russia have the capacity to reduce the EU's ability to harness this advantage.

31. The EU-Russia energy relationship forms part of the wider EU-Russia relationship enshrined in the EU-Russia Partnership and Cooperation Agreement. The EU and Russia are shortly to begin negotiations on a successor to the current agreement, known as the post-PCA. The UK is stressing that energy aspects of this agreement should reflect the St Petersburg and Energy Charter Treaty principles and be backed up by legally binding dispute resolution mechanisms, while continuing to press in parallel for Russian ratification of the Energy Charter Treaty.

32. EU-Russia energy dialogue is also promoted through the EU-Russia Permanent Partnership Council (PPC) on energy, established during the UK's presidency of the EU in 2005. The PPC comprises meetings between Russian and EU Presidency energy ministers to identify areas for joint work between the EU and Russia, supported by working groups of Russian and EU Member State officials. The 2006 PPC agreed to combine the existing four working groups into three, focussing on energy efficiency, market developments and energy strategies, forecasts and scenarios. The UK views the PPC process as a valuable opportunity to increase mutual understanding between the EU and Russia in energy, and to identify and deliver joint work in areas of common interest. We are therefore pleased to have retained the chair of the market developments working group, due to meet for the first time this June.

Russian investment in EU energy markets

33. Russia has extensive interests in downstream EU energy markets through Gazprom's joint ventures with several EU energy majors. It has been a long standing UK Government objective to have in place a fully functioning internal energy market for gas and electricity at the EU level. A key and necessary feature of the internal market is strong and independent regulation so that large players cannot abuse their positions and new players can enter the market. European legislation requires that independent national regulators be established by July 2004; DG Competition in the European Commission is the relevant authority for cross-border mergers and take-overs and will act alongside DG Transport & Energy in energy matters. At the recent Spring Council, Member States asked the Commission to bring forward further measures to improve the functioning of the internal market, including strengthening the powers of regulators across the EU. This included an assessment of the impact of vertically integrated energy companies from third countries on the EU's internal market.

MULTILATERAL FORA

International Energy Agency

34. Energy security was a key theme of this year's IEA Ministerial on 14 May and 15 May, which included discussion of the IEA's increasing work on gas security and development of responses to gas supply disruptions. The IEA has identified Russia as a priority country for its outreach strategy, together with China and India, and all three were invited to the Ministerial meeting. Over the next year IEA experts will focus on developing relations with Gazprom, carrying out detailed work with Russia on energy efficiency indicators, promotion of clean energy in the district heating sector and encouraging Russian industry participation in the IEA's Coal Industry Advisory Board.

G8, EBRD, IEF

35. Russia's agreement to the St Petersburg energy security principles was a welcome step. We continue to work through the G8 to advocate full compliance with these principles by all partners. The UK also contributes to energy efficiency work in Russia through our contribution to the EBRD's Sustainable Energy Initiative, which has a substantial programme of clean energy investment in Russia. Projects funded by the UK of particular interest include work on clean coal technology and market demand for energy efficiency investment within Russia. With energy interdependence increasing, we also attach a high importance to developing the global dialogue between producers and consumers through the International Energy Forum's work in promoting greater market stability, transparency and understanding.

May 2007