The Russian Natural Gas Market and Export from an EUPerspective: Modeling Mediumterm Export Scenario

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• The Russian Natural Gas Market and Export from an
  EU-PerspectiveModeling Medium-term Export
  Scenarios
• Christian von Hirschhausen and Franziska Holz
• German Institute for Economic Research (DIW
  Berlin), and
• Dresden University of Technology,
• Chair of Energy Economics and Public Sector
  Management (EE2)
• Nordic Russian Energy Seminar, 29-30 September,
  2005
• St. Petersburg

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Research Program Globalization of Natural Gas
Markets

• WP-GG-13 Anne Neumann and Christian von
  Hirschhausen Long-Term Contracts for Natural Gas
  - An Empirical Analysis
• WP-GG-12 Karsten Neuhoff and Christian von
  Hirschhausen Long-Term vs. Short-Term Contracts
  A European Perspective on Natural Gas
• WP-GG-11 Anne Neumann and Boriss Siliverstovs
  Convergence of European Spot Market Prices for
  Natural Gas? A Real-Time Analysis of Market
  Integration using the Kalman Filter
• WP-GG-10 Georg Meran and Christian von
  Hirschhausen Corporate Self-Regulation vs.
  Ex-Ante Regulation of Network Access A Model of
  the German Gas Sector
• WP-GG-09 Franziska Holz, Christian von
  Hirschhausen and Claudia Kemfert A Strategic
  Model of European Gas Supply (GASMOD)
• WP-GG-08 Christian von Hirschhausen, Berit
  Meinhart, and Ferdinand Pavel Transporting
  Russian Gas to Western Europe - A Simulation
  Analysis
• WP-GG-07 Anne Neumann and Christian von
  Hirschhausen Less Long-Term Gas to Europe? A
  Quantitative Analysis of European Long-Term Gas
  Supply Contracts
• WP-GG-06 Boriss Siliverstovs, Anne Neumann,
  Guillaume L'Hégaret, and Christian von
  Hirschhausen International Market Integration
  for Natural Gas? A Cointegration Analysis of
  Prices in Europe, North America and Japan
• WP-GG-05 Christian von Hirschhausen and Thorsten
  Beckers Reform der Erdgaswirtschaft in der EU
  Durch Regulierung zum Wettbewerb?
• WP-GG-04 Ferdinand Pavel, Boris Dodonov and Igor
  Poltavets Is the Ukrainian-Russian Gas
  Consortium in the Economic Interest of Ukraine?
  Lessons from a European Gas Model
• WP-GG-03 Christian von Hirschhausen and Anne
  Neumann Liberalisierung der europäischen
  Gaswirtschaft - Neue Regulierungsbehörde soll
  mehr Wettbewerb schaffen
• WP-GG-02 Anne Neumann Security of (Gas) Supply
  Conceptual Issues, Contractual Arrangements, and
  the Current EU Situation
• WP-GG-01 The Globalization of Natural Gas Markets
  - A Research Agenda
• Contact fholz_at_diw.de and anne.neumann2_at_mailbox.tu
  -dresden.de
• http//www.tu-dresden.de/wwbwleeg/projekte/gg/gg.h
  tml

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Agenda

• The Issue How Much Russian Gas to Europe?
• Strategic Options for Natural Gas Corridors
• GASMOD Model Long-Term Russian Gas Exports
• The Baltic Pipeline
• Conclusions

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The Issue Russian Gas Exports and Transit to
Europe

• Western Europe depends increasingly on gas
  imports from Russia
• Ca. 40 of EU-25 gas imports
• 2020 (EU Green Paper) EU-30 consumption 655
  bcm, production 244 bcm imports 411 bcm, of
  which Russia 247 bcm (60 of imports, 38 of
  consumption)
• Russia wants to reduce dependence on Ukraine as a
  (monopolistic) gas transit country
• Ukraine in the past misused its market power,
  also geopolitical diversification sought
• Alternatives to traditional transit through
  Ukraine
• Increase capacity through Ukraine (currently 110
  bcm)
• Increase capacity through Belarus
  (Yamal-Europe, Minsk-Nesvizh-Poland-Germany)
  from 10 bcm to 28 bcm, possibly even to 56 bcm
• By-Pass Russia-Belarus-Slovak Republic
  Kobrin/Kondratki - Velke Kapusany 60 bcm,
  bypassing Ukrainian territory
• Other options Baltic pipeline, Turkey
• We analyze three aspects of the question
• Traditional setting
• Russian exports
• Baltic pipeline

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Russian Gas Export Options
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Agenda

• The Issue How Much Russian Gas to Europe?
• Strategic Options for Traditional Natural Gas
  Corridors
• GASMOD Model Long-Term Russian Gas Exports
• Strategic Character of the North European
  Pipeline
• Conclusions

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2. Russian Policy Options for Natural Gas
Corridors

• A modeling approach of the decision chain
• West European demand for Russian gas (assumption
  independent of other exporters)
• Transit countries (Ukraine, Belarus) set
  profit-maximizing transit fee
• Russia sets profit-maximizing price/quantity
• Symmetric information, no uncertainty
• Assumptions
• Linear demand function for Russian gas in Western
  Europe p ax b
• estimated following Golombek (1995), using
  1988-1999 data
• a - 0.18 USD/tcm, b 58.9 USD
• Russian production costs crus 6.21 USD/tcm
• Variable transport costs (following Golombek.
  1995) cukr 11.73 USD/tcm, cbel 5.9 USD/tcm
• Simplification
• We only consider exports to Western Europe (CEE
  off-take is constant, 40 bcm)
• 1 capacity for Ukraine 115 bcm, 3 capacities for
  Belarus 0 bcm, 28 bcm, 56 bcm
• No strategic adaptation of other gas exporters
  (Norway, Algeria, etc.)

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Traditional Strategic Options for Russian Energy
Exports to Central/Western Europe
II.
Belarus
West European Energy Importers
III.
Russia
Ukraine
I.
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2.1 General Version
2.1 Possible Transit Strategies

• Strategies
• Non-Cooperative Russia and Ukraine determine x
  (or p) and t independently to maximize their
  respective profits (?R and ?U)
• Cooperative Russia and Ukraine determine
  determine x (or p) and t jointly to maximize
  aggregate profits
• Results
• 1) Profits of the cooperative strategy are
  always greater/equal than profits of the
  non-cooperative strategy
• 2) The transit quantity (price) of the
  cooperative strategy is always greater (lower)
  than the transit quantity of the non-cooperative
  strategy

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2.2 Two countries, Non-Cooperative Strategy

• Optimization Problems
• Russia
• max xgt0 ( p cR t ) x incorporating
• p p(x) is the inverse demand function (with
  dp/dx lt 0)
• t t(x) is Ukraines best response function
  (with dt/dx gt 0)
• Ukraine
• max tgt0 ( t cU ) x such that
• Russias Bargaining Power transit volume x
  decreases with higher tariffs (x x(t), dx/dtlt0)
• Solution Concept
• Russia is the Leader, Ukraine the Follower
  (Stackelberg equilibrium)
• Simplifications inverse demand is linear (p
  axb, alt0 and bgt0) and Russias bargaining power
  is constant dx/dt s lt 0
• Results
• Ukraines optimal transit fee t increases with
  transit volume x
• Ukraines optimal transit fee t decreases with
  lower bargaining power s
• Russias optimal transit volume increases with
  lower bargaining power s

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2.3 Two countries, Cooperative Strategy

• Optimization Problem
• Russia and Ukraine maximize their joint profit
  and distribute it among themselves
• Solution Concept
• Nash Bargaining Solution maximizing
• (?R,Coop - ?R,N-Coop)(?U,Coop - ?U,N-Coop)
• Results
• Optimal transit volume x depends only on
  exogenous per-unit costs and parameters of
  inverse demand function, not on the bargaining
  power
• Joint profit is shared equally between Ukraine
  and Russia (alternative according to exogenously
  assumed bargaining power)
• Joint profits from Cooperative Strategy are
  higher than sum of profits from Non-Cooperative
  Strategy (consistent with general result)
• Transit volume from Cooperative Strategy exceeds
  volume from Non-Cooperative Strategy (consistent
  with general result)

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2.5 Empirical Results (Two players)
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2.4 Three countries, Non-Cooperative Strategy

• Extension
• Second transit option through Belarus
• Lower transportation costs (shorter route and
  modern technology)
• Lower capacity (18 to 56 bcm vs. approx. 150 bcm
  through Ukraine)
• Pipeline fully financed and controlled by Russia,
  Belarus is no independent third player
• Optimization Problem
• Russia maximizes profits by fully using
  capacities through Belarus and setting residual
  quantity though Ukraine
• Everything else as in two country,
  non-cooperative case (2.2)
• 2.5 Three countries, Cooperative Strategy
• Joint profit maximization also implies full use
  of capacities through Belarus and setting
  residual quantity though Ukraine
• Everything else as in two country, cooperative
  case (2.3)

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2.6 Empirical Results (Three players)
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2.7 Conclusions Transit Strategies

• By diversifying its export routes, Russia can
  expand both sales to Western Europe and profits
• Ukraine lost from establishing alternative
  transit routes through Belarus while Belarus
  gained
• Will the Cartel of RUS-UKR-BEL merge?
  Theoretically beneficial to all, geopolitically
  sensitive
• European gas importers benefit from increased
  integration with the CIS, since prices fall (end
  of double marginalization)

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Agenda

• The Issue How Much Russian Gas to Europe?
• Strategic Options for Natural Gas Corridors
• GASMOD Model Long-Term Russian Gas Exports
• The North European Pipeline
• Conclusions

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3. The GASMOD model

• Numerical simulation model of the European
  natural gas market based on game-theoretic
  considerations and including infrastructure as a
  limitation to trade flows
• Part of a larger research effort which aims at
  modeling dynamic investment decisions in natural
  gas infrastructure
• Modeling approach to investigate two questions
  for the (future) European natural gas market
• Which countries will be important for natural gas
  supplies to Europe?
• Does infrastructure influence natural gas trade,
  and if so which infrastructure extensions would
  be needed for the new market patterns to evolve?
• For the moment a static model of the natural gas
  supply to Europe and the wholesale trade within
  Europe
• Comparing different scenarios Cournot oligopoly
  and perfect competition on the upstream and/or
  downstream market
• ? Baseline scenario Cournot competition on both
  markets (double marginalization)
• Non-linear profit optimization yielding
  endogenous equilibrium exports, domestic
  production, consumption and the respective prices

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3.1 Literature Partial Equilibrium European Gas
Models

• Mathiesen et al. (1987)
• Market power on the supply side.
• Golombek et al. (1995, 1998)
• Effects on upstream competition of liberalized
  downstream markets in some European countries,
  producer cost function.
• EUGAS model (e.g. Perner, 2002, Perner and
  Seeliger, 2003)
• Linear optimization of European gas supply in a
  long term perspective (implicit assumption of
  competitive markets), many exogenous variables
  demand, prices, indigenous production etc., takes
  into account infrastructure (LNG, terminals).
• GASTALE model (e.g. Boots, Rijkers, Hobbs, 2004)
• Double marginalization approach of two
  successive markets but with simplifying
  assumptions (e.g. symmetry of traders), linear
  demand function and marginal cost curves from
  Golombek et al. (1995), transmission and storage
  sector. Intention to include infrastructure.

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3.2 Model Structure
Wholesale Trader r France
capf,r
exp-capf
Final market m France
capf,r
Upstream Producer f Russia
Intra-EU-capr,m
Final market m Germany
Wholesale Trader r Germany
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GASMOD Scenarios

• Two Baseline Scenarios
• Cournot competition on the upstream and the
  downstream market (todays natural gas market)
• Cournot competition on the upstream market and
  perfect competition on the downstream market (EU
  Commissions objective)
• Assumption that every market participant is a
  Cournot player,
• Might be unrealistic for exporters like Libya,
  Egypt, Iran, Nigeria, Trinidad competitive
  fringe
• Capacity limitation
• Restrict Russian exports to Europe to 150 bcm
  (current export level)
• Restrict Russian exports to Europe to 75 bcm
  (political cooling down between Russia and EU
  and deliberate withholding by Russia)

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GASMOD Results Standard Baseline Scenario

• Cournot competition on the exporter market, and
• Cournot competition on the European downstream
  market
• Perfect competition on the European downstream
  market

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40
18

• Liberalization of the European market increases
  total European imports and most of the
  incremental demand is covered by Russian exports
• But market shares as in reference data are never
  obtained !
• Export capacity limits are never reached !

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GASMOD Results Few Cournot Players

• More realistic market setting
• Small exporters dont behave strategically but
  form a competitive fringe, and
• Cournot competition on the European downstream
  market
• Perfect competition on the European downstream
  market

• Russia benefits from a tighter oligopoly
• Russia benefits from European market
  liberalization
• Export capacity limitations are never reached !

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GASMOD Results Export Capacity Restrictions

• Scenario Russia restricts its exports to Europe,
  e.g. for political reasons
• Market setting Cournot-fringe, and both European
  settings

• Now, capacity limits are reached but they are
  already existing !
• Reduction of market shares on the European
  market, where other exporters can take the place
  of Russia

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GASMOD Results Russian Profits

• Market setting Cournot-fringe, both European
  settings

• Russia would benefit from European market
  liberalization
• Any capacity restriction of exports to Europe
  would be at the disadvantage of Russia!

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Results Capacity bottlenecks- mainly for
intra-European trade, and Norway as the only
exporter
Norway? Europe
UK ? Continent
Between BL, NL, GER and Fr
France ? Spain
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3. Conclusions from Modeling Exercise

• Current Russian export capacity to Europe is
  sufficient
• ? No need for extension or new constructions like
  North European Pipeline !
• Modeling approaches cannot reproduce Russian
  dominance on European market
• Other factors (political, institutional like
  market destination clauses) are also determinants
  for Russian exports
• Russia would benefit from European market
  liberalization

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Agenda

• The Issue How Much Russian Gas to Europe?
• Strategic Options for Natural Gas Corridors
• GASMOD Model Long-Term Russian Gas Exports
• The North European Pipeline
• Conclusions

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4. The North European Pipeline
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4.1 North European Pipeline A Shapley Value
Analysis

• Taken from Franz Hubert and Svetlana Ikonnikova
  (HU Berlin), 2003 Strategic Investments and
  Bargaining Power in Supply Chains (mimeo)
• Cooperative game theory concept The Shapley
  Value
• Attributes a monetary value to strategic options
  of transport routes
• - payoff ?i
• payoff of player i his expected contribution to
  all possible coalitions S,
• with being the value function of
  coalition,
• S function (demand for Russian gas,
  production costs, transport costs),
• i Russia incl. Belarus, Ukraine, Poland,
  Slovakia

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Cost of Transportation via Different Routes
Source Hubert, Ikonnikova (2003), based on
Chollet et al. (2001) and OME (2002)
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Shapley Value Estimates for Different Routes
In million US-/ year and share of total
profits (relative bargaining power)
Source Hubert, Ikonnikova (2003)
Russia has the highest relative bargaining power
for all possible transport routes (Strategic)
gain for Russia from North European Pipeline is
large compared to other options
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4.2 The NEP Profitable from a Business
Economists Point of View?

• Torzhok Vyborg 400 km onshore, Vyborg
  Greifswald 1200 km offshore
• 30 bcm / year

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North European Pipeline Net Present Value

• Net Present Value
• With I0 the initial investment of 4,2 billion
  US-
• i the interest rate of 15 p.a.
• t the life-time of the investment, assumed to be
  30 years
• With Zt, the annual disbursement and payments,
  assumed to be constant over time and equal to
• Where t(l) are variable transport costs
• mc is equal to
• And where Rt is the minimal yearly revenue for
  the project to be profitable

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Agenda

• The Issue How Much Russian Gas to Europe?
• Strategic Options for Natural Gas Corridors
• GASMOD Model Long-Term Russian Gas Exports
• The North European Pipeline
• Conclusions

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Conclusions Russian Natural Gas Export
Perspectives

• Current Russian export capacity is sufficient,
  especially as other players are entering on the
  European market (increasing LNG supply,
  increasing pipeline supply from North Africa)
• Russia has reliable transit countries for its gas
• ? No economic need for North European Pipeline
• For the development of new fields (Shtokman,
  Yamal) significant investment will be needed
• ? Institutional reforms and transparent and
  consistent FDI-policy would make this more likely

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Selected References

• Boots, Maroeska G., Fieke A.M. Rijkers and
  Benjamin F. Hobbs, 2004 Trading in the
  Downstream European Gas Market A Successive
  Oligopoly Approach. Energy Journal, Vol. 25, No.
  3, pp. 73-102.
• BP, 2004 Energy in Focus - BP Statistical Review
  of World Energy June 2004, British Petroleum.
• BP, 2005 Putting Energy in the Spotlight - BP
  Statistical Review of World Energy. London.
• European Commission (2000) Green Paper - Towards
  a European strategy for the security of energy
  supply. Brussels.
• Golombek, Rolf, Eysten Gjesvik, and Knut Einar
  Rosendahl (1995) Effects of Liberalizing the
  Natural Gas Markets in Western Europe. The Energy
  Journal, Vol. 16, No. 1, 85-111.
• Golombek, Rolf, Eystein Gjelsvik and Knut Einar
  Rosendahl, 1998 Increased Competition on the
  Supply Side of the Western European Natural Gas
  Market. Energy Journal, Vol. 19, No. 3, pp. 1-18.
• Grais, Wafik, and Zheng, Kangbin (1996)
  Strategic Interdependence in European East-West
  Gas Trade A Hierarchical Stackelberg Game
  Approach. Energy Journal, Vol. 17, No. 3, 61-84.
• Hirschhausen, Christian von, Claudia Kemfert and
  Franziska Holz (2005) Russian Energy and Climate
  Policy Remains Inconsistent Challenges for the
  EU. DIW Weekly Report 11-2005 . Also published as
  DIW Wochenbericht 10-2005.
• Hubert, Franz, and Svetlana Ikonnikova (2003)
  Strategic Investment and Bargaining Power in
  Supply Chains A Shapley Value Analysis of the
  Eurasian Gas Market. Draft Paper.
• IEA, 2004 Natural Gas Information. Paris,
  OECD/IEA.
• OME, 2001 Assessment of internal and external
  gas supply options for the EU - Evaluation of the
  supply costs of new natural gas supply projects
  to the EU and an investigation of related
  financial requirements and tools, Observatoire
  Méditerranéen de l'Energie.
• Perner, Jens, 2002 Die langfristige
  Erdgasversorung Europas - Analysen und
  Simulationen mit dem Angebotsmodell EUGAS.
  Munich, Oldenbourg Industrieverlag.
• Perner, Jens and Andreas Seeliger, 2004
  Prospects of gas supplies to the European market
  until 2030results from the simulation model
  EUGAS.Utilities Policy, Vol. 12, No. 4, pp.
  291-302.