The Merits of Dual Pricing of Natural Gas by Russia

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The Merits of Dual Pricing of Natural Gas by
Russia

• David Tarr and Peter Thomson

Prepared for the World Bank Institute Course in
Moscow, Russia Trade Policy and WTO Accession
for Development in Russia and the CIS  March
28-April 8, 2005
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1. WTO Negotiation Context

• Demand for unified pricing by the EU of gas and
  some support by the US.
•  Why the USfertilizer producers complained about
  competition from Russian exporters with lower
  costs. But US took a back seat to the EU.

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• An effort to obtain cheaper prices for European
  consumers. The EU indicates that this is part of
  their strategy for integrated, competitive energy
  markets in Europe.
• Set back discussions-Russians reacted very
  strongly and very negatively. It would not agree
  to unified gas pricing in Russia and Europe.

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• The World Bank saw the need for good analysis.
  The Financial Times and all major Russian
  newspapers (except Commersant) reported on a
  draft version of the paper in March 2003. But
  inaccuracies in the stories.

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2. Russians call the demand WTO-Plus

• A subsidy must be specific to an industry or
  group of industries. The price of gas is the same
  to all Russian users, so it is not a subsidy.

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3. Optimal Export Price

• Russia has market power in European markets. 66
  of European imports are from Russia, and Russia
  supplies Europe with about 27 of all its gas.
•   Cf. OPEC share of world oil markets is 33.  
• The Russian and European markets are segmented.
  Pipelines deliver the gas, so gas sold in Russia
  cannot be resold in Europe.

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• These two facts together imply that Russia cannot
  supply significantly more in Europe without
  lowering the price there. (Gazprom sells three
  times as much gas in Russia as it does in
  Europe.)
• That is, there is no world price at which
  Russia can sell all it wants. Russian sales
  determine the market price in Europe in an
  important way.
• Then there is an optimal markup over marginal
  costs for Gazprom on its European sales.

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• If gas suppliers play a Cournot game in Europe,
  the optimum is defined as

where
market elasticity of demand in Europe and
the market share of Gazprom in Europe, and the
ratio is the perceived elasticity of demand by
Gazprom in Europe.
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• The optimal markup of Gazprom in the Europe
  market, increases with the market share s and
  decreases as the absolute value of market
  elasticity of demand increases. The optimal price
  also increases as marginal costs c, or
  transportation costs t increase.
• Figure 1 depicts the optimum for Gazprom in
  Europe on the left hand side.

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• Gazprom earns rents on present sales in Europe
  equal to the value DDEE (P-costs)Q about 6
  billion per year (5 billion in 2000, 7.5
  billion in 2001).
• Triangle of deadweight loss equal to about 2.5
  billion per year, if we assume an elasticity of
  -1.5. (Estimate increases with the elasticity,
  but it cant be lower than unity assuming that
  Gazprom is optimizing.) European consumers would
  gain more dollars than Gazprom would lose if
  Gazprom lowered the price to marginal costs.
  Triangle of deadweight consumption losses.

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Price LRMC in Europe would result in the EU
gaining 2.5 billion per year more than Gazprom
loses.

• One question is there a cooperative solution
  that allows both Russia and Europe to be better
  off? There are 2.5 in potential gains. A
  cooperative solution may appear infeasible (there
  are over 20 countries involved (Eastern Europe,
  the Baltics, Turkey in addition to the EU
  countries). But the question can be posed
  non-cooperativelycan Gazprom design a price
  policy that would allow it to capture the
  additional 2.5 billion from the EU?

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4. Optimal Domestic Price

• Gazprom is close to a monopoly domestically in
  Russia. The World Bank supports competition in
  the Russian gas market. But while Gazprom is a
  monopoly, the price should be regulated to
  prevent monopoly restriction of output. There is
  an offsetting consumer interest on domestic sales
  from the Russian perspective which is not present
  on foreign sales.

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• Price equal to the long run marginal costs LRMC
  (including environmental costs) is the efficient
  price.
• No world market price for gasif there were, the
  appropriate price in Russia would be the world
  price, since that would be the opportunity cost
  of the gas.

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• We estimate that LRMC is about 40 per TCM in
  Russia, but current prices are about 20 per TCM.
  Thus, prices should double in Russia to be
  efficient.
• Price increase are required to maintain
  production. Output is forecast to fall by 7 per
  year unless investments increase. Presently,
  Gazprom invests about 2-3 billion per year, but
  8-9 billion per year is required over the next
  few years in order to maintain production.

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5. Comments and Criticisms

• The whole point of the note is to clarify the
  issues for Russia and the WTO members. We explain
  that the WTO members are not helping Russia by
  demanding a single price for gas in Russia and
  Europe. If WTO members wish to continue the
  demand, that is their choice, but they should be
  aware of the costs they are imposing.

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• Isnt the LRMC higher, so the difference in price
  between the two markets is smaller?
• Gazprom estimates LRMC at 35. It is in their
  interest to have a high LRMC for discussions with
  their regulatory authority, so I would be wary of
  an estimate very much higher than Gazproms own.

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• Hotelling rule from exhaustible resource models
  would call for a depletion premium to be added to
  the LRMCso efficient price is greater than 40
  TCM?
• The depletion premium is inversely related to
  the size of the reserves. With over 80 years of
  proven reserves remaining, it would be close to
  zero.

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• Moreover, these models imply that the value of a
  unit of remaining resources should increase over
  time. But in the last 125 years, the real price
  of exhaustible resources has not
  increasedcontradicting these models. Either
  additional discoveries or technological advance
  has mitigated the impact of finite availability
  on their scarcity value in production and
  consumption.

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• Environmental costs should increase the efficient
  price in Russia.
• We agree, but gas is probably the cleanest of
  the various energy sources. There are no
  pollution costs of production of natural gas,
  only greenhouse gas effects of consumption, as
  with all fossil fuels. If we are putting
  pollution taxes on the cost of energy, gas would
  have a relatively low tax since other energy
  sources are much less environmentally friendly.

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• Biggest environmental issue is to allow the oil
  companies access to the pipelines, so they stop
  flaring associated (by-product) gas. About 20
  Billion cubic meters (BCM) out of 580 BCM of
  production is flared annually in Russia.

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• The markup over marginal costs in Europe should
  be tempered by consideration of long run
  competitive pressures.
• I agree that the price should be based on
  dynamic considerationsthe most appropriate model
  is the dominant firm with a competitive fringe.
  The dominant firm will lower the short run markup
  over marginal costs to deter entry. But it is
  reasonable to assume that Gazprom maximizes
  profits and takes this into account.

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• I assume a perceived elasticity of 1.5 in
  Europe. The markup is a function of the
  elasticity. Elasticities could be lower, then the
  estimated losses of profit of Gazprom are
  overestimated.
•   The loss of profits are simply the rents on
  current sales therefore they are independent of
  the elasiticities.

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• Gazprom will become more profitablecan it be
  taxed.
• We estimate that Russia will collect 6 billion
  in taxes from Gazprom in 2003. (excise tax,
  wellhead tax, export tax and profits tax). Only
  0.3 billion in profits since Gazprom is not very
  profitable. So it is being taxed. Moreover, it is
  necessary to increase profits to expand
  investment.

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• Doubling domestic prices will create hardship.
• We agree that in a cold climate these are life
  threatening issues. The Bank is working on a well
  targeted safety net for poor consumers to prevent
  severe hardship as energy prices are raised. But
  cutoff of supply from lack of production will
  also create hardship.

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• Why does Russia charge lower prices to the CIS
  than in Europetrying to be nice politically or
  economic reality?
• Application of the same model (price
  discrimination in three segmented markets (home,
  Europe and CIS) would imply a lower price in the
  CIS than Europe. Prices are breakeven in the CIS,
  and Gazprom shows it is willing to give this
  market up.

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6. Press reports and recent developments
New EU Position

• The EU now argues for competition in Russian gas
  markets and especially non-discriminatory and
  transparent access to the gas pipelines. This is
  a long standing position of the World Bank, part
  of SAL II and SAL III.

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• Competition among Russian companies will drive
  down the price in Europe to LRMC in Russia.
• The Russian government can still extract the
  monopoly profit by imposition of an export tax,
  but only an export tax regime (or monopoly
  exporter) will be able to extract the monopoly
  profit once there is competition in the Russian
  gas market.

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• EU-Russia protocol on Russias WTO accession of
  May 2004 reportedly calls for Russia to raise
  domestic prices to roughly what we believe is
  LRMC, but does not require.

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Figure 1 Optimal Pricing of Russian Natural Gas
in Europe and in Russia
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Figure 1, footnote 1
Optimum in Europe Market. We assume Gazprom
maximizes profits on the quantity of natural gas
sales in Europe. This occurs at point E, where
perceived marginal revenue equals marginal
production plus transportation costs. At this
quantity (126 billion cubic meters), the market
clearing price is at point D (106 per thousand
cubic meters). For quantities greater than at
point E, marginal revenue is less than marginal
production plus transportation costs. Thus,
expansion of sales to the point F, where the
price (67) equals marginal production plus
transportation costs, will result in losses on
Russias exports (relative to point D) equal to
the value of the shaded triangle (EFG) (which is
equal to the rectangle DD'E'E). For quantities
greater than point H, additional sales will
reduce the revenues received, and additional
costs are also incurred.
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Figure 1, footnote 2
Russia Market Gazprom faces a controlled price
at 20 per thousand cubic meters, leading to
quantity demanded (and sold) of 375 billion cubic
meters of sales in Russia. The social optimum for
Russia is at point B where long run marginal cost
equals price at 40. An increase in the price in
Russia from 20 to 40 results in an increase in
welfare in Russia equal to the triangle AAB.
Gazprom would maximize profits where marginal
revenue equals marginal costs, leading to point
C. Since the value to Russia exceeds the marginal
costs of production for quantities less than at
Q, there is a triangle of losses equal to BBC
for an increase in the price resulting in a
movement from B to C.