The UK’s Energy Supply: security or independence?

Memorandum submitted by the Russia Foundation (UKES 46)

RUSSIA AND ENERGY SECURITY – ISSUES FOR THE UK AND THE EU

Introduction

1. Russia is one of the world’s most important producers and suppliers of energy resources. In 2008 it was the world’s largest producer of natural gas (21.3% of all production) and the second largest producer of oil (11.5% of all production). It holds the largest known reserves of gas (27% of world total) and the eighth largest known reserves of oil (4.5% of world total). [1] It also has some of the largest deposits of coal and uranium.

2. Russia is the largest supplier of energy to the European Union, accounting for 31% of gas imports, 27% of oil imports, 24% of coal imports and 30% of uranium imports. [2] Of these, gas is the most sensitive and strategically important. Whereas all the other commodities are mobile and traded globally, gas is still mainly supplied to the European market via fixed pipelines and recipient countries often lack alternative supply options. Dependence on Russian gas is particularly acute for countries in eastern and south-eastern Europe. Ten EU member states depend on Russia for more than 50% of domestic gas consumption, with four of them 100% dependent.

3. The UK meets a relatively small proportion of its energy requirements from Russian imports, accounting for only 2% of gas consumption. But, like the rest of the EU, the UK’s import requirement is rising fast as domestic production declines and long-term demand rises. The European Commission estimates that the proportion of EU gas consumption met from imports is set to rise from 60% to 73-79% by 2020 and 81-89% by 2030. [3] The Department of Energy and Climate Change says the UK’s gas import requirement may rise from 32% to as much as 70% by 2020. [4]

4. Against a background of rising external dependency for the EU as a whole, unpredictable or disruptive behaviour by a major energy supplier like Russia could have unwelcome consequences for the UK. Excessive market dominance or attempts to use energy resources as a tool of foreign policy could adversely affect prices and security of supply as countries more directly dependent on Russian energy seek alternative sources, including from countries currently supplying the UK market.

The Politicisation of Russian Energy

5. Although Russian leaders are careful to avoid describing their country as an "energy superpower", it is clear that they regard oil and gas as strategic resources of vital importance to Russia’s national strength. A willingness to use energy for political purposes was apparent from the earliest days of the post-Soviet era when the need to compensate for declining military and economic power was most acutely felt. President Yeltsin was willing to use supply cut-offs as a form of coercive diplomacy against the Baltic States in particular. But the politicisation of energy was non-systematic and sat alongside measures to liberalise the Russian energy sector and open it up to foreign investment.

6. A systematic process of politicisation was not attempted until near the end of Vladimir Putin’s first term as President. Putin had set out his personal belief in the strategic function of energy policy in an article published in 1999 when he was still head of the state security service, the FSB. He argued that "the natural resources complex" should become a decisive factor in "the strategy for Russia’s exit from its deep crisis and restoration of its former might on a qualitatively new basis". Energy policy should be designed to meet more than commercial and civilian objectives alone and should be "aimed at furthering the geopolitical interests and maintaining the national security of Russia". [5] This would be achieved by creating strong, vertically integrated energy companies answerable to the state.

7. The same message has been carried in numerous Russian government statements since around 2003. [6] The "Russia enjoys vast energy and mineral resources which serve as a base to develop its economy; as an instrument to implement domestic and foreign policy. The role of the country on international energy markets determines, in many ways, its geopolitical influence."Russia enjoys vast energy and mineral resources which serve as a base to develop its economy; as an instrument to implement domestic and foreign policy. The role of the country on international energy markets determines, in many ways, its geopolitical influence "Russia enjoys vast energy and mineral resources which serve as a base to develop its economy; as an instrument to implement domestic and foreign policy. The role of the country on international energy markets determines, in many ways, its geopolitical influence." "Russia enjoys vast energy and mineral resources which serve as a base to develop its economy; as an instrument to implement domestic and foreign policy. The role of the country on international energy markets determines, in many ways, its geopolitical influence." National Security Strategy of the Russian Federation up to 2020 National Security Strategy of the Russian Federation up to 2020National Security Strategy of the Russian Federation to 2020 sets out the broad role of energy policy in official doctrine: "The change from bloc confrontation to the principles of multi-vector diplomacy and the [natural] resources potential of Russia, along with the pragmatic policies of using them has expanded the possibilities of the Russian Federation to strengthen its influence on the world arena". Furthermore, the strategy identifies competition for the control of energy resources as a major potential trigger for military confrontation: "In case of a competitive struggle for resources it is not impossible to discount that it might be resolved by a decision to use military might. The existing balance of forces on the borders of the Russian Federation and its allies can be changed." "In case of a competitive struggle for resources it is not impossible to discount that it might be resolved by a decision to use military might. The existing balance of forces on the borders of the Russian Federation and its allies can be changed." "The change from bloc confrontation to the principles of multi-vector diplomacy and the [natural] resources potential of Russia, along with the pragmatic policies of using them has expanded the possibilities of the Russian Federation to strengthen its influence on the world arena"

8. Putin’s politicised vision of Russian energy has provided the blueprint for state policy for most of the last decade. The subordination of the energy sector to state control became a major plank of Putin’s strategy for strengthening the "power vertical" starting with the dismantling and expropriation of Yukos Oil, at the time Russia’s largest private energy company. Imprisoning or exiling independent oligarchs and seizing their assets removed rival centres of power and provided the new ruling elite with additional sources of revenue, patronage and political control. Action was also taken to diminish the role of foreign investors with regulatory harassment used to marginalise Shell and BP in the lucrative Sakhalin 2 and Kovykta projects. New restrictions on foreign ownership of strategic energy projects have been included in Russia’s Subsoil Law.

9. The trend towards greater state control has been accompanied by an increase in the use of energy supplies as a tool of foreign policy. A number of countries heavily dependent on Russian energy sources have experienced price rises or supply interruptions widely seen as political in motivation. Two distinct sets of objectives have been evident: firstly, to strengthen Russian influence over what President Medvedev has described as its "zone of privileged interests" by punishing neighbouring countries that pursue friendly relations with the west independent of Moscow; and secondly, to enforce the takeover of energy infrastructure beyond Russia’s borders in order to cement its position as a dominant energy supplier. Ukraine, Georgia and Belarus have been the principal victims, but at least one EU member state, Lithuania, has also been targeted.

Russian Energy Policy Priorities

10. Consistent with its strategic vision of energy policy as a means of strengthening the Russian state and advancing its geopolitical interests, the Russian government pursues a number of priority objectives. The most important of these are as follows:

11. Maintaining supply dominance – The Russian government is anxious to retain its role as a leading international supplier of energy and its dominance over the strategically important European gas market in particular. Its public justification for countering perceived threats to that position is the need to guarantee security of demand for its primary export and source of revenue, but the underlying motivation is political. Its dominant position within the European market allows it to use energy relations as a carrot to encourage friendly attitudes on the part of leading EU countries like Germany and Italy, and as a stick to use against post-Soviet countries that defy it.

12. Controlling the infrastructure of transit countries – A major element of Russian energy diplomacy is focussed on controlling the infrastructure of supply beyond its own borders. Attempts at infrastructure takeover have been a feature of supply interruptions and other forms of energy pressure against transit countries like Belarus and Ukraine. Lithuania became the target of an undeclared oil embargo after it refused to sell its Mazeikiu Nafta oil refinery to a Russian company. Pressure is currently being applied to Ukraine to merge Naftogaz with Gazprom.

13. Controlling new pipeline development – The Russian government seeks to dominate the geopolitics of pipeline supply to entrench its position within the European market. The Nordstream gas pipeline, connecting Russia to Germany through the Baltic Sea, is designed to segment the European market and marginalise existing transit countries in Eastern Europe. Likewise, Russian diplomacy in Central Asia, the Caucasus and the Black Sea region is aimed at preventing European countries from developing the infrastructure and relationships needed to access alternative sources of oil and gas. The South Stream pipeline, as a rival to the EU’s Nabucco project, is another element of this strategy.

14. Increasing strategic export options – Russian officials regularly warn that the adoption of European energy policies that conflict with its interests will force Russia to divert supplies to new markets and to China in particular. Until recently that option has been limited by the absence of the pipeline connections needed for Russia to export oil and gas to China in volume. That is beginning to change. The first Sino-Russian oil pipeline opened at the start of 2011 and is intended to supply fifteen million tons of crude oil per year. Construction of the Altai gas pipeline is currently on hold because of disagreement between the Russian and Chinese governments over price. But the intention is still to complete the project by 2015.

15. Preventing European energy market integration – The EU’s third energy package, by requiring the unbundling of energy production and transmission, represents a particular challenge to the Gazprom model of vertical integration and Russia’s efforts to become a leading player in the downstream European energy market. Considerable efforts have been made to discourage or stop real energy market integration that threatens to undermine strategies of monopoly and market segmentation that have worked to Russia’s advantage in the past.

16. Limiting the growth of unconventional gas supply – Russia has become a leading sceptic on the development of unconventional gas, such as shale gas and coal bed methane. Russia cites environmental and other criticisms as a way of undermining the idea that unconventional gas could become a major source of energy supply for the European market, but it is really concerned to minimise competition to its own conventional supplies. The growth of unconventional gas saw the US out produce Russia in 2009. The consequent increase in gas supply in the Atlantic basin in the form of LNG threatens to change the European market to Russia’s disadvantage.

17. Cartelising gas supply – Although Russia has observer status at OPEC, it has refrained from joining because technical factors give it less flexibility to vary oil production and because it is reluctant to accept the policy constraints of full membership. But it has taken the lead in trying to promote cartel-type arrangements between gas producing countries through the Gas Exporting Countries Forum. The Forum has been institutionalised and its agenda has become more ambitious. Although the nature of gas as a commodity makes it harder for producers to emulate the OPEC model, proposals to cooperate on price formation, market allocation, investment and new technology, like LNG, are clearly aimed at achieving cartel-like results.

18. Minimising rules-based international commitments – The Russian government aims to avoid binding international rules that restrict its behaviour as a producer and provider of energy. Although Russia signed the Energy Charter Treaty in 1994 and was bound by its terms pending ratification, its rules concerning protection of investment and the transit of third country supplies conflicted with the Putin vision of energy as a strategic asset to be controlled by the state. The Russian government refused to ratify the ECT and eventually withdrew from provisional application in 2009. It is also resisting the inclusion of ECT rules and other binding provisions on energy in the EU-Russia agreement that is currently under negotiation.

19. Attracting foreign investment and technology – Despite its suspicion of foreign involvement in its energy sector, the Russian government needs inward investment to develop new production. Its exiting gas fields in western Siberia are past peak production and new fields in the Arctic north can only be developed with western capital and technology. The capital investment requirement for the Russian energy sector over the next twenty years has been put at $2 trillion. [7] The already heavily indebted state energy companies, Gazprom and Rosneft, cannot generate the required funds, nor do they have the technology needed to drill or lay pipeline in the icy waters and permafrost of the Arctic north where the future of Russian energy production lies. This requirement conflicts with other Russian objectives, but the government hopes to attract foreign companies as junior partners in its major energy projects.

Policy Responses

20. The UK and its EU partners have a range of policy options at their disposal to encourage Russia to behave as a responsible energy supplier. These should be aimed at increasing competition and diversity of supply, strengthening the EU’s collective energy diplomacy, countering monopolistic behaviour and discouraging the use of energy supply as an instrument of foreign policy. Policy options include the following:

21. A stronger EU external energy policy – The EU is formally committed to strengthening the energy dimension of its external policy, but there is still a tendency for individual member states to behave unilaterally in the field of energy diplomacy. This makes it easier for Russia to increase its leverage through a policy of active bilateralism. Investment deals, new pipeline projects and long-term supply contracts are often negotiated without consideration for the common European interest. The energy diplomacy of the EU and its member states should be based on solidarity and a commitment to consult on issues of common concern.

22. A single EU energy market – The removal of technical and regulatory barriers to a competitive European energy market is one of the best ways to prevent suppliers establishing and exploiting a dominant position. The EU’s third energy package has now been passed and requires the separation of production and transmission activities. The EU needs to ensure its strict implementation and insist that third country companies are held to the same rules as EU companies. Steps should also be taken to accelerate the construction of the interconnectors required to create a genuine single market in which gas and electricity supplies can be transferred easily across borders to meet demand.

23. Closer energy ties in the Eastern Neighbourhood – Closer ties with transit countries in Eastern Europe should be aimed at promoting competition, infrastructure modernisation and greater energy independence. Ukraine, which recently joined the European Energy Community, is particularly important to the security of European gas supply. With EU help, the government of Ukraine should be encouraged to carry out market reforms, modernise and maintain national control of it supply network, diversify its supply options and develop its own oil and gas reserves.

24. Adoption of ECT commitments in a new EU-Russia agreement – Negotiations on a new agreement to replace the EU-Russia Partnership and Cooperation Agreement have stalled over Russia’s refusal to accept binding commitments on energy. The EU’s negotiating mandate is for an agreement that enshrines the principles of the ECT, such as investor protection, third county transit and binding and enforceable international arbitration. Whether these principles are accepted as part of a new EU-Russia Agreement or through Russia’s acceptance of a revised ECT, it is essential that the EU holds firm for a rules-based relationship that is at least as strong as existing ECT provisions.

25. Reciprocity of investment rights – Russian companies investing in the European energy sector enjoy the full protection of European commercial law, whereas property rights in Russia remain weak for foreign and domestic investors alike. EU governments should insist that energy cooperation must be based on reciprocal rights and obligations. Russia is seeking European support as part of Partnership for Modernisation and needs access to foreign capital and technology to modernise it energy sector in particular. The EU should be seeking a binding commitment from Russia to strengthen investor protection and the rule of law in return.

26. The development of unconventional gas – The rise in gas production from unconventional sources has already transformed the European market with LNG imports from the US increasing supply options. The International Energy Agency recently described the exploitation of unconventional sources as a "game changer" that could double global gas reserves. [8] European countries with significant deposits of unconventional gas include some, like Poland and Ukraine, which are currently heavily dependent on Russian supplies. The growth of unconventional gas production and supply in Europe and beyond could significantly alter the terms of trade with Russia.

27. Opening up the southern energy corridor – In the absence of Russia accepting third country transit rights, creating direct pipeline access to gas supplies from Central Asia and the Middle East is another means of strengthening Europe’s energy security. The Nabucco gas pipeline project has been delayed by doubts over its commercial viability and the availability of sufficient gas to fill it. But supplier countries are unlikely to commit without a clear sign that Europe intends to build the pipeline. Like Russia, the EU needs to conceive of pipeline projects in strategic rather than purely commercial terms.

Conclusion

28. The energy relationship between Russian and the EU ought to be based on a recognition of their interdependence. Russia needs access to the European market just as much as the EU needs Russia to behave as a responsible energy supplier. But the relationship has become unbalanced by the failure of the EU to take a coherent and collective view of its interests. The consequences for the UK are indirect, but real. The EU has the tools needed to create a more balanced partnership with Russia and strengthen the energy security of its member states. UK policy should be aimed at galvanising that sense of common purpose.

March 2011


[1] Data from the US Energy Information Administration.

[2] EU-Russia Energy Dialogue, Joint Report, November 2010.

[3] European Commission, Energy Infrastructure Priorities for 2020 and Beyond, November 2010, p21.

[4] DECC, Annual Energy Statement, July 2010, p8.

[5] English translation published in Problems of Post-Communism, vol.53, no.1, January-February 2006.

[6] Energy and the Russian National Security Strategy, Eurasia Daily Monitor, Volume 6, Issue 95, 18 May 2009. Eurasia Daily Monitor Volume: 6 Issue: 95

[7] ‘Russia unveils $2trln energy growth plan to 2030’, Reuters, 26 th November 2009 - http://uk.reuters.com/article/idUKGEE5AP25J20091126 .

[8] International Energy Agency, Global surge of activity follows successful production of ‘unconventional’ gas in US, 13 th January 2011 - http://www.iea.org/index_info.asp?id=1762 .

Prepared 26th May 2011