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Energy security in International Relations (IR) theories

Andrei V. Belyi
Higher School of Economics
Cathedra on political issues of international energy

Structure

1. First approach: Realist approach

1.1. General views on security
1.1.1. General definitions of security (A. Belyi, Copenhagen School)
1.1.2. Subsystems and energy security
1.1.3. What is energy security ? (S. Haighighi)
1.2. Oil geopolitics
1.2.1. History of energy supply disruptions (S. Haighighi)
1.2.2. Actors in oil geopolitics (R. Mabro)
1.3. Trends in oil and gas geopolitics in aftermath of the Irak war (G. Luciani)

2. Second Approach: Institutionalist approach

2.1. Theoretical conception of institutionalism (Steimo)
2.2. Overview of Institutions dealing with energy security
2.2.1. IEA and views of IEA on energy security
2.2.2. International public law (conception of T. Waelde on international
arbitration)
2.2.3. International energy law, including the Energy Charter Treaty (Belyi &
Klaus view on institutional and realpolitik approach in using the ECT)
2.2.4. European Union (views of the European Commission and of private
commercial actors on energy security)

3. Third approach: New economics of energy

3.1. International energy interdependency (Ph. Andrews Speed)
3.2. Gas markets, regulation and security (OIES publications)

4. Fourth approach: critical political economy

4.1. Structuralist analysis of energy security (S. Strange)
4.2. Agency-structure analysis (M.Pistor)
4.3. Producers views on liberalization (Gazprom conception of energy security).
Introduction

A consensus seems to exist on the issue of energy security achieving a particular importance since
the energy shocks of the 1970s, when present asymmetries between the geographical distribution
of resources and energy consumers had been consolidated by oil shortages in the petroleum-
dependent countries1. Since then, the energy security has been integrated into the debates of
the IR theories. An overview of the existing IR theories demonstrates four various
approaches. First approach focuses on a rational approach of international political
relations, shapes by structural unbalances between energy producing and consuming
regions. Oil supply became a subject of vulnerabilities, either perceived or real. Since then, much
analysis has been done on the growing rate of energy consumption and on energy import
dependency of many industrialized states. A particular emphasis has been attributed to political
conflicts in connection to natural resources.

Failures of cross-border energy trade cast a sharp light on the efficacy of institutions
governing and regulating this trade. Here, the second approach attempts to analyze the
efficiency of international economic institutions on enhancing security.

Third approach can be defined from a number of recent assessments from the academic
and business world of a “new political economy of energy” 2 characterized by a growing
diversity in energy technology, trends towards a deregulation, foreign investments and
interdependency in the sector. The energy becomes a complex system of trade
transactions, where the price formation becomes the major source of political
vulnerabilities.

Fourth approach is basically the international political economy (IPE) critics towards
rationalist economic theories. This conception stems basically from the points of view of
S. Strange. The interest in taking into consideration the critical IPE consists in an
importance accorded to economic values (nationalism, liberalism), which limit the
rational approach of the international regimes.

In order to analyze those divisions, the reader contains a number of texts, which help to
demonstrates different views on energy security.

1. First approach: Realist approach

1
CHOUCRI, N. (1977), International Politics of Energy Interdependence, Lexington Books, pp. 185-186.
2
The term borrowed from the Editors foreword in the special issue of the Journal of International Affairs,
Spring 1999, 52, no 2
Realist approach includes general definitions of security in international relations, oil
geopolitics and definition of the latest trends emerged in aftermath of the Irak war in
2003.

1.1. Conceptualization of security

If one wants to define the energy security, he or she should address the question: what
does “security” means in general? Is it a response to a concrete threat? Either is a strategy
to avoid a potential threat? Or is a motivation justifying a concrete policy objective?

1.1.1. General definitions of international security: from K. Waltz to

Copenhagen School

Realist approach of IR theories has been traditionally focused on the definition of

international security. In light of a Realist conception presented by K. Waltz 3, states are
acting accordingly to their structural power within international relations. Waltzian
system assumes states to struggle for survival within an international system
characterized by an absence of any “world-wide” authority. The rise for power features
the interstate relations, including those of the access to resources. K. Waltz predicted that
the oil shocks, provoked by the Arab export embargo, would not constitute any change of
power for the West4. However, security of energy supply became a matter of security
motivation for many developed countries in the aftermath of the oil shocks of 1973. K.
Waltz argues that there is a continuity of strategies of the major Western states in energy
geopolitics. Political actors change, the national strategy remains5

Security can be defined as defensive (in relations to a threat) or offensive (optimizing of

profits in relations with other actors6). The Walzian meaning of security is mainly
defensive: security stems from the anarchical structure of society. The energy security is
offensive: as is the only vulnerable point of the Western states, they prefer to use the
offensive strategy.

The concept of security redefined by B. Buzan. In 1990s he joins the Copenhagen School
of security studies. According to this School of thought, “security” is not considered to be
a direct consequence of threat, but is rather defined as the result of the political
interpretation of the threat, a process called securisation. The authors of this School point
out the need to construct a conceptualisation of security that means something much
more specific than just any threat or problem7. Therefore, security is defined as a non-
linear reaction to the threat. Having inherited the Realist perspective towards
3
WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979.
4
WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979, pp. 155-157, 195.
5
WALTZ, K., Theory of International Politics, ed. Random House, New York, 1979, 117.
6
GRAFSTEIN, R., « What Rational Political Actors Can Expect », Journal for Theoretical Politics, Vol. 14,
n°. 2, 2002, pp. 139-165.
international relations, the Copenhagen School considers anarchy as the main feature of
the international structure, which also explains states’ attitudes towards security (security
preoccupations). Furthermore, according to this approach, the term security includes five
separate sectors: the political sector involving the internal and external stability of states,
the military covering their defensive and offensive capabilities, the sector of societal
security meaning the stability of cultural (i.e. national or religious) identity, the economic
security related to the access to resources and markets, and the environmental security
defined as a protection of ecological biosphere8.

However, the Copenhagen School does not distinguish energy security from other
security sectors although it would appear evident to observe its importance among the
above-mentioned sectors. First, political security in international relations involves
security relations with other states because of the international anarchic order: states are
looking for energy self-sufficiency. Second, energy availability also indirectly contributes
to military capabilities. Third, economic security is defined by the difficulty to foresee the
behaviour of economic actors in a decentralised capitalist economy 9. On that basis,
securisation is related to political attitudes towards unpredictability of energy markets.
Fourth, environmental security involves the incompatibility between high-speed
economic development and natural resources protection. In the 1970s, this issue
concerned a preoccupation with the possible expiry of fossil fuels (especially oil) whereas
in the 1990s the ecological security issue is translated to the threat of climate change
caused by growing energy use. Under this context, political and societal attitudes towards
technological development are of strategic importance, i.e. nuclear safety and air
pollution. The Copenhagen School focuses mainly on the political structure of
international anarchy, while neglecting the impact of other structures (production, finance
and technology) on securisation, that constitutes a certain weakness of the theory.

The Copenhagen School describes a multi-level approach to international politics, and

distinguishes four main levels: international (system), regional (sub-system), national
(unit) and internal (sub-unit). The international system is the global level of security
preoccupations. The national or state level is a bridge between traditionally separated
fields of international and national security, therefore called unit level10. Within this unit
level, the internal (sub-state) level involves local policies and logically includes sub-
national security perceptions. However, the key level for security studies is the sub-
system, defined by a group of states who are geographically linked, and whose primary
security concerns link together sufficiently closely that their national securities can not
realistically be considered apart from one another 11. The sub-systems are named the
7
BUZAN, B., WAEVER, O., DE WILDE, J. (1998), Security : a new framework for analysis, London, p.
7.
8
BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the post-cold
war era, Harvester Wheatsheaf, Second Edition, p. 19.
9
BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the post-cold
war era, Harvester Wheatsheaf, Second Edition, p. 235-237.
10
DE WILDE, J. (1995), "Security Levelled Out: the Dominance of the Local and the Regional" in
DUNAY, P., KARDOS, G., WILLIAMS, A. (ed. by), New Forms of Security: views from Central, Eastern
and Western Europe, Dartmouth, p. 88.
11
BUZAN, B. (1991), People, States and Fear: an agenda for international security studies in the post-
cold war era, Harvester Wheatsheaf, Second Edition, p. 190.
regional security complexes, which have evolved throughout history, while retaining their
geopolitical and historical roots: i.e. Middle East, South Asia, Europe, etc.

1.1.2. Security sub-systems and energy security

The Energy Security Complex

1
Energy Security and the Regional Security Complex
Theory
DRAFT, PLEASE DO NOT QUOTE
Mikko Palonkorpi
Researcher
Aleksanteri Institute / University of Helsinki
mikko.palonkorpi@helsinki.fi

The Regional Security Complex Theory (RSCT)

Buzan and Wæver have defined regional security complexes as follows:
“The central idea in RSCT is that, since most threats travel more easily over short
distances than long ones, security interdependence is normally into regionally based
clusters: security complexes. […] Process of securitization and thus the degree of
security interdependence are more intense between actors inside such complexes than
they are between actors inside the complex and outside of it.”
In other words, the regional security complexes can be seen as a group of security
dilemmas concentrated into certain geographical area, where essential threat perceptions
by states (or other actors) are so interlinked and create such strong Energy security
complexes on the other hand could be defined as follows. The regional energy security
complexes are formed by energy related interaction between two or more states in a
limited geographical area, which includes an energy dependency relationship between the
states involved and perception of this dependency as a threat (securitization). The energy
interaction includes transactions such as production (export), purchasing (import) and
transit of energy. Analogous to RSCT definitions by Buzan & Wæver, also the threats
arising from energy dependencies are usually more intense between states (or regions) in
close geographical proximity. On the other hand, thousands of kilometres long oil and gas
export pipelines can link states, located geographically far apart, into a same chain of
energy (inter)dependency. In other instances, this direct geographical link either does not
exist and or is less obvious. A good example is the US and Western European energy
dependency on Persian Gulf hydrocarbon resources, in particular crude oil, which can be
- at least logistically – more easily substituted by energy imports from alternative sources.
In energy security complexes regional distribution of energy resources and regional
energy dependencies could be regarded as parallel to the distribution of military power in
politicalmilitary based security complexes. This highlights an important question: are the
regions and actors the same in the energy security complexes and in the more traditional
political-military security complexes? In order to outline an energy security complex one
needs to evaluate the relative strength of energy dependencies by measuring such factors
as energy trade balance, level of (domestic) energy resources and possibilities for energy
diversification. In the Eurasian context this idea can be roughly conceptualized by
thinking the relative (%) energy dependency of different CIS-states on Russian gas, oil
and electricity imports measured against their ability to diversify energy imports from
alternative sources or increase their own domestic energy production. However, these
percentages or relative dependency figures are aggregate measures of overall energy
(supply) dependency from specific exporting country; therefore these shares have to be
balanced against energy mix of the individual states. For example, at first sight Finland’s
100% dependency on natural gas imports from Russia would indicate strong dependency
pattern resembling circumstances in Georgia and in Armenia. However, the decisive
difference is that natural gas constitutes only around 11% of Finland’s primary energy
consumption. Therefore, there is room for analytical choice, whether one chooses to
construct regional energy security complexes based upon aggregate energy dependencies
or whether it makes more sense to construct these along major energy sources (i.e. natural
gas, oil, coal, electricity, renewables, hydro power ornuclear power). Analyst has to make
the assessment, whether or not this is well-grounded or justified. What speaks heavily
against dividing energy security complexes according to the energy sources is the fact
that in the policy making process the energy security of any given state is treated as an
aggregate whole. However, a powerful counter argument for analyzing the security
implications of the different energy sources separately is the difference in their
transportation capabilities and the structure of their markets. For example, the crude oil
can be easily transported by large tankers from the other side of the world and thereby the
oil market is truly global, where as the natural gas trade rests upon far less mobile gas
pipelines and that is one of the reasons why there is no such thing as the global gas
markets or a global gas price. Although it is technically possible to transport liquefied
natural gas (LNG) over long distances by ships, for the most part the gas producers and
customers alike are still lacking the expensive LNG-infrastructure to create a truly global
market for natural gas. Since the 1960’s and 70’s the dependency and interdependency
concepts have been widely used in the Marxist oriented research on global inequality
structures, north-south and centre-periphery conflicts. More over, in the mainstream IR
theory interdependency has been associated with liberalist emphasis on markets
(dependency) versus realist or neo-realist emphasis on political (dependency). According
to Sullivan for example, the mainstream liberal arguments have advocated separation
between economic and political issues, i.e. that economic activities occur in non-
politicized space, where as realist regard economics subordinate to politics, because for
them nations are the main actors and the power is the main objective. The difference is
illuminated by Benjamin Cohen, who by building upon Richard Rosecrance’s distinctions
has argued that in the two extremes liberalism sees states mainly as trading states seeking
absolute gains and not interested what are the gains of other states, where as realism sees
states mainly as territorial states, seeking gains relative to other states, i.e. gaining (better)
position among the states.

[…]

Based upon these annual energy dependency fluctuations it could be argued that the
structures of the energy security complexes are dynamic, perhaps even more dynamic
than the structures of the militarypolitical security complexes. A separate question is how
much these energy dependency levels have to change before it affects the threat
perceptions of the dependent state? Presented above is only the energy consumer side of
the energy security equation that needs to be balanced against securitization of the market
dependency levels by the energy producers.

Equally important factors that define the energy security complexes are the historical
amity and enmity patterns that have an influence on how the energy dependency is
perceived. Each energy dependency case can be perceived in varying degree either as a
mutually beneficial interdependency (positive dependency) or as an unequal and
threatening dependency (negative dependency). In other words, the amity and enmity
patterns can be seen as factors that partially explain why certain energy dependencies are
politicized and/or securitized when others are not. Based on the different dependency
perception alternatives, the nature of the energy dependency can be placed into an
economic-political-security continuum.For example state with cordial bilateral relations
to another state might not consider 30% energy dependency from neighbouring state as a
serious security threat, where as two states with antagonistic relations might perceive
even 10% dependency as a serious threat to national security. Although, in reality the
economic and political aspects of energy security are often merged together, that doesn’t
reduce the impact of analytical separation of these aspects, which forms the foundation
for the study of energy security complexes. Without analytical separation of these
different aspects, energy security would be interpreted as either completely market driven
quest for equilibrium between energy supply and demand or a completely state driven
geopolitical competition for energy resources, transit routes and so forth. This distinction
is well illustrated in the report “Energised Foreign Policy – Security of Energy Supply as
a New Key Objective” by the Clingendael International Energy Programme (CIEP) in
which two scenarios are constructed based upon global geopolitical developments that
effect energy markets (see figure 1 below). In these scenarios sections D and C would
include China, Russia, India and majority of the producing states which have preferred
the state centric global energy (trade) system. On the contrary the sections A and B would
include the US, Japan and the EU which have opted for global energy market mechanism
instead. In the first scenario movement of energy trade towards dominance of states and
national oil companies in the global energy sector favors the state centric system and
therefore even actors advocating market driven system are forced to adopt more bilateral
practices to secure the energy supply. As a result the role of the governments is increased
at expense of the (international) energy companies as the main actors in energy policy. In
the opposite scenario the global energy sector is dominated by international energy
market mechanisms and it favors the (international) energy companies as the key actors.
Functioning energy markets ensure the balance between energy demand and supply.
Since most of the producer countries and the important future consuming countries
(China and India) prefer the state centric system, the future global energy sector is likely
to gravitate towards the first scenario.
An example of positive energy interdependency the president of the European
Commission José Manuel Barroso described in March 2006 the nature of EU’s energy
relations with Russia as interdependency. “[…] if we need a flow of energy from Russia,
namely gas, I believe that it is also in interests of Russia to have a stable market and a
stable relationship with such an important customer as the European Union”. In Georgia
the tone has been very different. Unlike Western Europe Georgia has been repeatedly
target of natural gas supply cuts or disruptions, which according to President Saakashvili,
have been politically motivated. “[…] Manipulation of energy prices and supplies is a
critical tool of those in Russia who believe that hydrocarbons are the best means of
political influence … [R]ussia’s arbitrary cut-off sent a clear message to the European
Union: There can be no energy security when an undependable neighbour is willing and
able to use its energy resources as a weapon in political influence”. The Georgia’s 100%
dependency on Russian natural gas could be considered as a revealing example of
negative energy dependency. However it is important to emphasize that interdependence
as such is not inheritably a positive phenomenon. Climate change is an illuminating
example since it is mostly caused by consumption in the developed North, but the most
serious consequences of the climate change will be felt in the underdeveloped South.23
Similar negative interdependency analogy could be pointed out between the single crop
economies or “monoculture” producers (for example bananas) in the developing world
and the markets in the developed world. Monoculture comparison is also relevant to
many “one commodity” energy producing countries, but unlike devastating effects of
ruined crops (and/or sharp global price fluctuation) to the entire economy of single crop
producing countries, the energy producing states are better shielded from the annual
fluctuation risks, because ever increasing global energy demand has kept at least oil and
gas prices relatively high. Moreover, count out the Hurricane Katrine type direct hit, the
natural phenomena are usually less of a threat to the energy production.

As a conclusion it is argued that energy dependency is politicized or securitized more

easily if it is linked to other controversies or conflicts (enmity) between states and these
enmity perceptions can be regarded as factors which turn dependency into a negative
energy dependency. Therefore, the energy security complexes are likely to follow the
already existing lines of security interdependence in the region. On the other hand,
positive energy interdependency is likely to develop according to the rules of the energy
market where the main threats are secure supply and stable price of energy as quoted
above. As Howard Chase has pointed out, in itself lack of self-sufficiency in energy is not
a problem, because energy trade is the mechanism that should balance that out. But on the
other hand the concentration of the future oil and gas reserves/production in the hands of
smaller number of states with uncertain prospects for political stability emphasizes
enmity or negative perception aspect.25 By this criteria energy security complex could be
defined as a geographical area where negative energy dependencies are concentrated
and for positive energy interdependencies a more appropriate term would be an energy
security community

1.1.3. What is energy security?

The energy security per se stems from a number of complex factors, related to
international trade, supply and pricing.

The text from S. Haighighi paper “The legal dimension of the EU energy policy”,
Florence, 2006, pp.11-13:

It is imperative to distinguish between the two sources, oil and gas, since they have
different characteristics from the perspective of energy security. Unlike oil, gas is
relatively difficult to store and gas transportation infrastructure is rigid in nature (for the
time being). This means that a physical link between producer and consumer is required
and the number of alternative routes to the consumer is limited. For example, a cargo of
oil destined for the UK can easily be switched and sent to another country in another
continent: this is actually an everyday occurrence, whereas for gas this flexible switching
does not happen. This is because, unlike gas, oil transportation is not costly, and therefore
oil that is destined for a specific place can easily be redirected to another destination.
Moreover, unlike the global oil market, the gas market is regional. A global oil market
implies that a disruption of oil supply in one part of the world may affect the whole world
whereas gas disruption does not necessarily have worldwide repercussions. This is again
due to the fact that firstly, the costs of gas transportation are higher than oil, and delivery
systems are inflexible, and secondly, gas development in one country or region is isolated
(due to a lack of easy switching between routes) from the development of other regions,
which suggests that disruption in one region does not necessarily influence another.
Another difference between oil and gas is that seven cases of oil disruption have been
reported since 1950, occurring for purely political rather than physical reasons, whereas
no gas disruptions have occurred and if they did, were only minor and short-term. This
last difference shows that oil has historically been used as a political weapon while gas
does not have such political characteristics. (The most significant example of politically
motivated gas disruption was the blockage of gas exports from Russia to Ukraine in early
January 2006. This blockage lasted only four days, and the political motives behind it are
controversial and are not widely accepted). In addition, gas security is mostly concerned
with physical shortage rather than price shocks, the latter being an oil security concern
(for example, the energy crisis of 1973 was about the high price of oil and at no time was
the physical availability of oil endangered).
There are debates over what constitutes energy security and these arguments have been
sometimes hindered by a lack of clear understanding concerning the different components
of the energy security problem and their policy implications. The multi-faceted nature of
energy security, which will be elaborated below, makes it very difficult to provide a
definition of energy security that is accepted by all. A commonly accepted practical
definition of this concept is adequacy of energy supply at a reasonable price. This
definition suggests that energy should be physically available and its price should be
reasonable.
There is also a subtle difference between the definition of oil and gas security. Gas
security could be defined as the "guarantee that all the gas volumes demanded by
customers will be available at a reasonable price". Oil security means "reliable and
adequate supply of energy for a reasonable price". The difference between these two
definitions is that gas security necessitates the satisfaction of demand without necessarily
emphasizing the adequacy of gas supplies in all sectors. If one particular sector normally
uses gas, but gas cannot be obtained, then it can be substituted by other fuels, such as coal
or oil. The same does not apply to oil there are sectors in which oil is the dominant source
of energy and no other energy can currently substitute it, such as the domain of transport
in the European Union. Consequently, if there is no oil reaching that sector, the sector
cannot function. In this case, as the oil market is a global market, a major shock
anywhere in the world will be felt throughout the world oil market. The global nature of
the oil market has prompted some to suggest that even if an energy-producing country
could magically and inexpensively raise its domestic output to eliminate total imports, a
shock in the world oil market will affect its domestic price and threaten the stability of its
economy. Therefore, efforts to combat oil insecurity should also be made at the global
level.

1.2. Oil Geopolitics

Oil geopolitics is the centerpiece of the global energy security. The overview of oil
security history is a complex structure, which includes cultural, political and economic
factors.

1.2.1. Events of energy disruption

Events occurred in the Middle East between 1956 and 1973 had a global impact on the
conceptualization of energy security. Somehow, the “securization” of energy trade started
from these events.

S. Haighighi, 2006, pp. 37-47:

On July 26, 1956, Gamel Abd al-Nasser of Egypt froze the assets of international oil
companies, defied the West, and nationalized the Suez Canal. France and the U.K. took
retaliatory measures,
blocked all Egyptian accounts in their countries, and later declared their intention to seize
the Canal. Eventually an Israeli-British-French trio attacked the Canal on October 29,
1956. A ceasefire order by the United Nations was finally accepted by these countries on
November 6th. However, in the meantime the Egyptians had blocked the Canal by sinking
ships and blowing up installations.
This event had grave consequences for Europe’s economy because the Canal was
considered vital to the European energy supply, and that year 69 million tons of oil was
carried through this canal to enter Europe. However, the temporary interruption of the
import of this oil was not in the beginning considered as problematic because of a belief
in the abundance of European coal.

In 1967, the Suez Canal was again blocked by Egypt during the Arab-Israeli six-day war.
Representatives of Abu Dhabi, Algeria, Bahrain, Egypt, Iraq, Kuwait, Libya, Qatar, and
Saudi Arabia, together with representatives of Lebanon and Syria decided to halt the
export of oil to those countries whose policies were supportive of Israel or hostile to the
Arab side in the conflict. After some time the shipments resumed but oil was not sold to
embargoed countries, such as the U.S., Britain and West Germany. 147 Interestingly
enough, the consequences of this embargo were not critical. Some believe that in fact no
real crisis materialized due to some factors: 1) the embargo on the U.S. was mostly
symbolic because the export constituted less than 5 per cent total US oil consumption; 2)
stockpiled supplies existed in Western Europe; 3) swap arrangements undermined the
destination embargoes; 4) Iran and Venezuela, the two main non-Arab producing
countries carried on their shipments and they further increased them after the embargo; 5)
due to the introduction of a new generation of tankers too large to pass through the Suez
Canal, the importance of this Canal for shipments from the Gulf to the West had
decreased.
On October 6 1973, Egypt and Syria declared their aim of recapturing the Arab territories
occupied by Israel since 1967. Following this event, the Arab Oil Exporting Countries
threatened to cut their production of oil by 5% and to continue to reduce that amount
thereafter, until Israel withdrew from the occupied Arab lands. Saudi Arabia pressured the
U.S. to change its policy towards Israel and declared that Aramco's exports (a major
Saudi Arabian oil company) would be halted if no change in their policy took place. The
United States, having the weak repercussions of the 1967 crisis in mind, did not take this
threat seriously and thought of the use of the "oil weapon" by Saudi Arabia as having no
more effect than in 1967.157 Saudi Arabia, on the other hand, sought to ensure that the
non-Arab productive capacity would not undermine the embargo and also supervised the
destination embargo more closely to prevent the swap arrangements, which had been used
during the 1967 crisis to undermine the boycott.
Exporting countries, worried about the negative effects of the embargo on their revenue,
increased the tax on oil, which enabled production to be cut without causing the revenue
to fall below the revenue of the previous month. In order to minimize the detrimental
effects of these gradual cutbacks, a wide variety of measures were introduced, such as
conservation of the oil stocks, restrictions on the sale of gasoline and the use of motor
vehicles, restrictions on non-essential uses of electricity, and limitations on the heating of
buildings.161 There was at no point a shortage of petroleum in European markets, but the
price kept increasing.
Oil import prices quadrupled. The posted price of Arabian light crude increased from $3
per barrel in early October 1973 to $11.65 per barrel in January 1974. Sudden inflation
and economic recession ensued, leading to unemployment, the closing down of schools
and offices and cuts in the production of major factories. This fact caused some to believe
that "a staggering disequilibrium in the global balance of payment will occur that will
place strains on the monetary system far in excess of any that have been experienced
since the war".The German Chancellor Helmut Schmidt explained the situation as an
extraordinarily instable one, which revealed the fragility of the elaborate system of
economic relations among the nations of the world. However, the positive note was that,
whereas the oil crisis could have touched off a chain reaction of destructive forces, it
might in fact have helped to improve international cooperation

The anxiety of an oil shortage led some consumers to approach oil-exporting countries
directly in order to satisfy their crude oil needs, trying to buy as much as possible at
whatever price (panic buying). Major oil companies also failed to take steps to reduce
this consumer anxiety. Unlike some who believe that their failure to act was due to
impotence, others believe the reason to be the fact that "they welcomed the higher prices
and higher profit margins that this panic-buying induced".

1.2.2. Actors in oil geopolitics

R. Mabro, Middle East in World Geopolitics, OIES

1. INTRODUCTION
The Middle East holds a very Iarge proportion of the world's proven oil reserves. More
importantly, the region has been the major potential source of incremental supplies since
the 1940s, and will retain this role in the foreseeable future. Other oil regions that
played this roIe in the past, such as the North Sea and Mexico, have not been able to
sustain it for very long.
Yet, the Middle East is unstabIe politically. Its troubled history has been punctuated
with crises since the end of the Second World War; crises that were associated with
either a threat to or an actual disruption of oil suppIies. The list of these events is long
but familiar: Mosaddeq in 1951, Suez in 1956, Arab-Israeli wars in 1967 and 1973, the
Iranian revolution in 1979, the Iraq-Tran war in 1980-88, and now, in 1990, the new Gulf
crisis induced by Iraq's invasion of Kuwait.
Some of these crises, particularly in 1973 and 1979, involved an interruption of oil
suppIies that caused significant price increases. Others affected oil production and trade
while failing to cause prices to rise. But even these "miId crises induced important
structural changes in the oil industry. The role and behaviour of oil companies changed
after Mosaddeq; the pattern of oil transport changed after Suez with the introduction of
VLCCs and the diversion of tanker traffic around the Cape; and the Iraq-Iran war, which
was not associated with oiI price increases, prepared nevertheless the grounds for the
emergence of a very tight oil situation in the 1990s - a development which would have
occurred in any case, even if Saddam Hussein had not invaded Kuwait.
PoIitical instability in the Middle East has not yet negated the importance of the region
for world oil. To be sure, many industrialized and developing countries made strenuous
efforts in the 1970s and 1980s to reduce their dependence on oil imports from the
Middle East. And for a short period in the 1980s, the view that "the Middle East may
not matter after all" emerged and gained some currency. But oil-import dependence is
on the rise again despite the initial successes of conservation and fuel-substitution
policies. The compIacency which characterized the second half of the 1980s has been
devastated soon after by the new Gulf conflict.
In fact, the world's response to the long sequence of Middle East crises has not robbed
the region of its significance. On the contrary, every new crisis seems to reveal over
again the vulnerability of the world oil system to political developments in the region.
Every crisis brings out in sharp relief all the features of the world's dependence on
Middle Eastern oil.
For these reasons, any serious understanding of major petroleum issues - supply
security?
O.I.E.S. 1
market
market performance, prices, industrial structure, investment patterns, the future
place of oil in the energy demand-mix etc - involves an assessment of Middle
Eastern political problems. OiI, in some fundamental sense, is a commodity
subject to the normal economic laws of supply and demand. But oil, aIso in a
fundamental sense, is apolitical commodity. Politics influences supply and
demand, fiscal regimes, investment decisions, profits and losses. It generates and
alters expectations, these powerful determinants of oil price movements in volatile
and nervous markets. It determines policies. And more importantly, we can now
see once again, as on so many occasions in the past, that oil is a cause and an
instrument of war. In the old days the international oil industry took pride in its
understanding of the politics of oil. Major oil companies devoted resources to
maintain an expertise on the Middle East, following developments and analysing
their implications. They were a source of information and knowledge on these
issues. In recent years, a new philosophy that emphasizes almost exclusively the
economic and commercial aspects of oil has taken over. The old relationship
stemmed from the nature of the relationship between companies and governments
in the pre-1973 era. Oil companies were concessionaires that owned assets on the
ground. In the late 1970s and 1980s the relationship changed, and the companies
became mere buyers of oil from OPEC countries, traders engaged in arm’s length,
short-term commercial deals. They probably thought that this changed relationship
dispensed them from studying the politics of the region. Why should a trader care
about his commercial partner’s politics. Now, the perceptions have become
totally different. The current Gulf crisis has brought back politics to the forefront.
For this reason we decided to incorporate a study of the political dimensions of the
Gulf crisis in our new series of papers on oil issues. Our purpose is to identify and
analyse the main features and causes of political instability in the Middle East.
Although this paper is about politics, and rarely mentions oil explicitly (except in
this Introduction), its main aim is to enhance the understanding of oil, the foremost
political commodity. O.I.E.S. 2

The causes of poIitica1 instability in the Middle East are many. We do not propose
to draw a comprehensive list however, for this would go well beyond the scope of
this essay and cause confusion. The approach followed here is highly selective and
focuses entirely on the few factors which have played the most important part in
destabilizing the region. To begin with we consider three factors which Middle
Eastern countries share with the rest of the third world. The first is economic
underdevelopment. All countries in North Africa, the Levant, the Arabian
Peninsula and the rest of Western Asia are underdeveloped. Oil wealth has not
removed this feature. It may have raised standards of living in parts of the region
and created a small number of very rich families. But even those Gulf states where
per capita incomes are higher than anywhere else in the world are still
underdeveloped. Their manpower resources are limited and poorly endowed
with technical and professional skilIs. Their institutions are bureaucratic and
inefficient. These economies depend entirely on a single commodity, and lack
therefore the diversified productive structures capable of sustained economic
growth. The poorer Middle Eastern countries, which account for a very large share
of the region’s population, suffer from both these and other problems. High rates
of population growth have caused, and continue to cause, greater impoverishment
and social tensions. Internal migration, the inevitable consequence of a galloping
demography in countries where the rural resource base is exceedingly narrow, is a
source of social dislocation and economic frustration. In these countries the
educational system and the health and social services are alI failing to keep pace
with population pressures. And governments are becoming increasingly unable to
manage their economy. They are finding themselves squeezed between the
problems arising from the servicing requirements of their foreign debt and those
posed by their country’s poverty. Continuing underdevelopment is perceived as a
failure by populations which harbour expectations of betterment, expectations
sown in by education, the lure of the town, the money remitted by migrants
working in oil countries, the television image and the allintruding symbols of the
consumers’ society. The frustrations born of a sense of economic failure, which in
the eyes of the frustrated means political and social failure, are one of the many
ingredients of extremism and instability. Underdevelopment is also a fertile ground
for the emergence of dictatorships. The second factor of political instability in the
MiddIe East, as in Africa and in the Indian subcontinent for example, relates
to the drawing of political boundaries by the imperial powers either at the time of
colonization or at the time of independence. In the Levant, the British and the
French divided parts of the Ottoman Empire into countries - Syria, Lebanon, Iraq,
Transjordan, Palestine - in ways which reflected partry local historical realities
and partly compromises between the rival ambitions of the
European powers. In the Arabian Peninsula the British drew peculiar, and almost
everywhere, very imprecise boundaries between the small emirates of the region,
and between the emirates and their big neighbours - Iraq and Saudi Arabia.
O.I.E.S. 3

Once a new country has been created, be it with artificial or very ill-defined
borders, it tends to acquire very quickly all the features and attributes of a nation-
state. Lebanon, Syria, Jordan, Iraq, Kuwait, Qatar, all of these countries are
nation states. The native populations that live within the borders identify
themselves as Lebanese, Syrians etc. even if some ethnic or religious
communities have been artificially divided between two countries. Both Iraq and
Iran recently learned this truth to their chagrin. Iraq thought that the "Arab"
populations of Khuzestan in Iran would rally to them at the beginning of the war.
They did not, and fought the Iraqi invaders instead. The Iranians thought that the
vast Shia population of Iraq would welcome their Shia brothers from Iran. They
did not, and fought the Iranians instead. The people of Khuzestan were Iranian
first, the Shia of Iraq were Iraqi first. And when Iraq invaded Kuwait this year, all
Kuwaitis whether in opposition to their government, or dienated from their
country because of its divisive nationality laws, rallied around the Emir as a
symbol of the unity and integrity of Kuwait. It is always important to remember
that the Middle East now consists of nation states which provide populations
with their first identity. It is not possible to divide these countries up, it is not
possible to merge them into larger entities without much bloodshed and
destruction. This is now visible to aII with the annexation of Kuwait by Iraq which
is in fact a process of wanton devastation. This has been visible for a while to
those who want to see, with the Syrian presence in Lebanon, a presence which
aims at annexation but which has turned out to be for more than ten years a very
degraded form of miIitary occupation. And there is a lesson there reIating to the
long-run prospects of Israel's survival in the region. Although a country, once
established, quickly sets hard and becomes a nation state, the artificial features of
its creation do not usually die away. They constitute, and for a long time, potential
sources of both internal unrest and conflict with neighbours. The problem of ill-
defined borders is dso a dangerous cause of trouble. Border .disputes have plagued
relationships between pairs of neighbouring countries in the Middle East,
particularly in North Africa and the Gulf, since their emergence as independent
states. The problems tend to be more acute when oilfields straddle these imprecise
boundaries. RecaIl the longstanding disputes over Buraimi between Saudi Arabia
and Abu Dhabi, recent military incidents involving Qatar and Bahrain, to give
just two examples out of Iists involving dozens of cases. The Iraq-Kuwait
border dispute which played such an important role in the August 1990 events is
but one instance of a very widespread problem which is at the root of much
regional instability. The third factor of political instability, in this set of causes that
is not specific to the Middle East but extends to most of the third world, relates to
the role of the superpowers in the post Second World War era. The USA was
determined to prevent the spread of communist parties and regimes in the third
world, and favoured therefore military dictatorship or right-wing traditional
governments. The USSR also supported communist dictatorships as well as non-
communist strongmen who happened to be allies. For almost half a century all the
important outside powers (for Britain, France and others have much to answer on
this score) have reinforced, if not positively induced, nondemocratic tendencies
that arise from social and economic underdevelopment, the domestic conflicts that
plague the post-colonial third world state, and a host of other O.I.E.S. 4

internal factors. Democracy does not blossom easily in a third world country. The
first step in the very long process that leads to the establishment of democratic
institutions is the emergence of a national consensus on important political issues
and of rulers or leaders legitimized by public support. It is worth noting that the
great powers have always reacted antagonistically, if not violently, to any leader
who embraced national causes. Any leader who legitimised his rule with his
people by embracing deep national aspirations was confronted at the very time
when he was enjoying legitimacy. The honeymoon between
an emerging dictator and his own people may be a fleeting moment. It is during
this
moment that the great powers usually tried to remove or villfy the leader –
Mosaddeq in 1951, Nasser in 1956, King Feisal in 1973, Khomeini in 1979. But
the dictators who never enjoyed the support of their people were never seriously
challenged. They only incurred the powers’ wrath when they embarked on foreign
adventures without the support of their people - like Qaddafi after twenty years
of unpopular rule when he pushed his luck too far with terrorist attacks, and
Saddam Hussein, cajoled so long as he was fighting Iran, when he turned his
guns onto Kuwait. Of course, the problem is that the legitimacy of a ruler in a
post-colonial state begins with the issues that top the national political agenda.
These issues always relate to the colonid heritage: the ownership of assets such as
oil (Mosaddeq) or the Suez Canal (Nasser), removal of pro-Western or pro-Soviet
regimes (Khomeini, Afghanistan), the conflict with Israel (all Arab states). By
definition these issues involve major confrontation with the West, and in some
cases with the Soviet Union. Thus the moment of internal legitimacy is inherently
and inseparably the moment of confrontation with the outside world. Dictatorships
may achieve, at the cost of coercion and at the expense of basic human rights, a
period of apparent internal stability. But dictatorships are like lids tightly secured
on the top of boiling pans. The pressures are ody contained for a while. When
the lid can no longer hold securely, explosions (like the Iranian revolution) with
considerable side effects occur. Dictators also cause instability because their
power tends in the end to affect their judgement and their wisdom. Power becomes
very quickly absolute power; absolute power becomes arbitrary power. The
exercise of power shuts the dictator’s ears: he does not listen to advice, and even if
he wishes to listen he will rarely find an adviser or a messenger willing to convey
bad news or to contradict the master. The exercise of power by unchallenged
individuals can lead to adventurism and therefore cause considerable instability.
The West and the Soviet Union have encouraged and supported unpopular and
illegitimate regimes in the Middle East. They have been paying and will pay in the
future a very heavy price for this policy. They did it because of the cold war, and
because they have economic and political interests in the region which go against
the national aspirations of the countries and their population. The cold war has
ended but the interests which induce great powers, continuing interference in
Middle Eastern affairs are still there. Their names are Israel, oil and the market for
arms. This leads us to the discussion of two major causes of instability which are
specific to the Middle East.
0. I. E. S. 5

The existence of Israel is a fundamental cause of instability. Israel is a small

foreign body artificially inserted in a large living organism, and kept there with the
application of tremendous force. The organism wants to reject it but has
consistentIy failed to do so for more than forty years. This failure has
traumatized the organism. Hence the deep political frustrations which cause
extremism and terrorism on both sides of the conflict, in the Arab world and in
Israel. Everybody may unite in condemning terrorism and political extremism and
their excesses. Everybody, you and I, could become one day the innocent victims
of an incident. But this should not blind us to the real and deep significance of the
phenomenon: it is an expression, sick as it may be, of despair. More tragically it
is the brutal expression of the fundamental nature of the Arab-Israeli conflict: that
the Arab world cannot destroy Israel but can deny it forever true recognition; and
that Israel can ensure its immediate security with the force of arms and the
exercise of vioIence, but cannot through these means obtain the true and
permanent security that derives from mutual recognition. There is no solution to
this impossible state of affairs. And in their mad ways the terrorists on both sides
are merely telling us that the contradictions inherent to the Arab-Israeli conflict do
not appear to have a rational solution. Madness often involves the revelation of
some unpalatable truth. The existence of Israel has destabilized the region both
through the emergence of extremism and through open wars. It has provided
further excuses for the establishment of dictatorships and coercion (the argument
being that strong regimes are needed to stand up to the outside enemy). It has
frustrated very deepIy every Arab because of the failure of the Arab nation and all
its governments to solve the Palestinian problem and because of repeated military
defeats in the confrontation with IsraeI. This has resulted in alienation on two
important counts. Alienation of the people from their "incompetent" governments,
alienation of the self from the self. The former has made most, if not all,
governments in the region illegitimate in the eyes of their people; the latter has
induced a search for a new basis on which to build self esteem and reconcile
through a solid bridge of values the alienated parts of the self. Hence, the deIving
in the past in a search for roots and values in religion and the culture. Hence the
emergence of fundamentalism which is not the initial cause of instability and
frustrations but its consequence. In its extreme forms (see above) fundamentalism
at the fringes may also become destabilizing in turn. This is how vicious circles
emerge and trap those involved in developments where nobody gains.
The factor that deserves a final mention is oil. Oil has been a'source of both
wealth and corruption. It has induced, after 1973 and 1979, rising expectations for
rapid and significant betterments which the oil economies could not deliver. This
phenomenon has played a partial roIe in the events leading to the Iranian
revolution. To be sure, oil wealth has benefited more people in the Middle East
than generally recognized but it has caused considerable social tensions between
those who obtained a little and those who acquired a lot, be it countries or different
groups in the same country. Because it is a major source of wealth, oil elicits envy
and calls therefore for protection. The arms race in the Middle East, which
recycled very wastefully a large part of the oil income, was not entirely due to
the Arab-Israeli conflict. Many countries also wanted to protect their oil assets
from neighbours. The Iraqi aggression on Kuwait was partly motivated by the oil
factor.
O.I.E.S. 6
Oil also aggravates the separation between governments and their subjects because
it provides governments diredy with all their required revenues. The oil state
has no need to tax citizens or residents; the absence of taxation removes a
possible instrument of accountability. Much worse, the population becomes
dependent on the largesse, direct or indirect, of the state. The citizens become
intermediaries, rentiers or courtiers. Deep down they may despise and resent
those who govern their destiny and on whom they depend for handouts.
In these societies there is dependence but no real allegiance. Oil corrupts, not only
because many deals and most contracts and activities arising from the expenditure
of oil revenues involve bribes and commissions, but because the basic nexus
between work and reward is broken throughout large segments of society in an oil
economy. Finally oil brings in foreign intervention. So long as the Middle East
remains the major source of incrementd oil supplies it will live under the threat of
foreign miIitary incursions. Foreign troops may well be called in by Middle
Eastern states themselves. The fact remains that these calls would not be heeded if
oil, among other things, were not at stake. Compare, for example, the level and
nature of US military intervention in the Lebanon in the early 1980s with the scale
of their response to the arrent Gulf crisis. The destabilizing forces which operate in
the Middle East originate both from within and from outside. There are important
interactions between external and internal factors. There is much that the West can,
but most probably will not, do to unlock the vicious circle. The essential items on
the agenda are the settlement of the Palestinian question,
the encouragement of democracy, a disarmament plan for the whole area,
including Israel, and substantial economic aid. This is a tall order indeed.
Furthermore, this set of actions constitutes the necessary, but by no means
sufficient, conditions of stabilization. Much has to be done at the same time by the
Middle Eastern countries themselves.
O.I.E.S. 7

3. IRAQ AND KUWAIT

The Iraqi invasion of Kuwait cannot be justified. Very few Arabs, if any, really
approve of the forceful annexation of an Arab country by another. Where Arabs
differ is in their assessment of the greater evil: is it Saddam Hussein’s aggression
on Kuwait or the massive return of foreign forces on Arab soil for, as many
think, a future aggression on Arab countries?
Although it is impossible to justify the rape of Kuwait, one still needs to
understand the phenomenon and explain the actions and motivations of all
participants. Moral outrage does not dispense us from the duty to analyse.
Clues to President Saddam Hussein’s objectives and behaviour may be found in
his formative years when he was a young political exile in Cairo in 1959. It is
said that he used to avidly read any book in Arabic he could find on Stalin and his
regime and that he developed an admiration for Nasser’s pan-Arab aspirations.
Readings about Stalin provided many of Saddam’s ideas on how to rule and
controI Iraq. And the ambition of becoming the leader of the Arab nation explains
much of his foreign policy. In 1979 he led the Arab campaign to ostracize Egypt
after Camp David. This was his first bid for the leadership of the Arab nation.
But he had little to offer then. The fact that Egypt’s defection created a vacuum
was not sufficient to consecrate him as the recognized leader of all Arabs.
The Iranian revolution provided him with an important opportunity. He thought
that a quick and victorious war against Iran would establish him as the saviour of
the Arab Gulf countries threatened, as they saw it, by the hegemonic intentions
of the Shia revolution. He was told by exiled Iranian generals, and probably by the
Americans, that the Iranian army was in a very poor state and could be
destroyed in a few weeks. The war lasted eight years and ended with a very
ambiguous Iraqi victory. After the Iraq-Iran war Saddam Hussein, always pursuing
the dream of Arab leadership, probably thought that he needed a wider resource
base to achieve his ambition. Hence the temptation to attack and annex Kuwait.
He may also have been prompted in this direction by a sentiment of defiance
towards the West. Saddam Hussein, as indeed many Iraqis and some Arabs,
began to believe soon after the end of the Gulf war that the West, having
contributed to the defeat of Iran, was going to turn its attention to Iraq and try to
weaken it. In 1988 the West suddenly became outraged about the use of gases
(nobody had mentioned in the past their earlier use against Iranians and Kurds); in
1989, there was much talk about the dangers of Iraq’s military power; in 1990
much fuss was made about a strange device which may or may not have been a
super-gun, an unlucky journalist who may or may not have been a spy, and some
little clocks which were supposed to detonate nuclear bombs that Iraq, by all
accounts, would not be ready to manufacture for many years. More worrying for
Saddam Hussein was the state of Iraq’s economy burdened with a large foreign
debt; the stem refusal of bankers, sovereign creditors, foreign investors to heIp;
and the continuing weakness of the price of oil caused, as then widely alleged, by
over-
O.T.E.S. 8
production in Kuwait and the UAE. There is no doubt that, rightly or wrongly,
Saddam Hussein believed that he was the victim of a plot. It is said that a typical
trait of his character is to confront and kick when he feels threatened or insulted.
The invasion of Kuwait was therefore a complex act involving a gesture of
defiance, an attempt to grab riches for redistribution to other Arabs in a bid for
leadership, and a hope that by shattering the status quo in one part of the Middle
East forces would be set in motion to shake the stalemate on another front, that of
the Arab-Israeli conflict. An analogy may help to understand Kuwait’s situation.
Kuwait is a Switzerland without mountains. Like Switzerland, Kuwait is a small
country completely surrounded by three regionaI powers (Germany, France and
Italy in one instance; Iran, Iraq and Saudi Arabia in the other). Switzerland
succeeded in keeping them at bay partly because of a neutrality pact and largely
because it was able to defend itself by resisting with guerrilla warfare in the
mountains. In the early 1960s Kuwait sought to protect its independence by
emphasizing both neutrality and friendship with all Arab countries. The
enlightened Kuwaiti government of the 1950s and early 1960s understood that
some form of internal democracy and a wide network of good relationships with
other Arab countries were their best protection . . . in the absence of mountains.
Kuwait’s Arab and foreign policy did not maintain this same direction in the late
1970s and in the 1980s. Those in power grew tired of the claims made by
neighbours and many others on their wealth. The dictum that there is no security
for Kuwait outside the framework of Arab security, interdependence and alliances
ceased to be understood. Kuwait was successful both in its financial and oil
policies and grew confident, despite the disaster of the Souq a1 Mannakh. The
new generations in power did not have direct experience of the poverty and
difficulties of the pre-oil era. Oil wealth shielded them from immediate problems
and probably obscured their perceptions about the nature of their situation and its
structural weaknesses. It is possible that even the old wisdom would not have
protected Kuwait from Saddam’s ruthless ambitions and horn aggression. But
now that the tragedy has occurred the question of how best to protect Kuwait’s
independence, how to ensure its survival and prosperity in the long run, is posed in
very stark terms. Kuwait will always be the object of a neighbour’s envy. Today it
just happens to be Iraq, but only recently Iran was perceived as a threat. And on
the other side lies quiet and friendly but powerful Saudi Arabia.
In this tragic affair both Iraq and Kuwait miscalculated. Saddam thought that he
couId get away with a blatant act of aggression. Or perhaps he thought that he
was soon going to be attacked by Israel backed by the USA and decided to kick
first where it was the easiest. Both cases imply huge miscalculations.
Kuwait perhaps believed that it was stronger and better protected than warranted
by its situation. Alternatively, it may have known its weaknesses and decided to
conceal them and bluff its way through by bargaining very hard. It may have felt
that concessions to blackmail would incite further blackmail. The miscalculation
lay in discounting the 0.LE.S. 9
possibility of an all-out invasion.
The purpose of this analysis is not to apportion blame; there are no blames to
be apportioned. Its main aim is to describe the situation in which Iraq and
Kwait found themselves, and their respective perceptions of the situation in
which they found, or had their respective perceptions of the situation in which
they found, or had put, themselves.

1.3. Oil and Gas geopolitical trends in aftermath of the Irak war (2003)
New trends in energy geopolitics constitute a major impacting factor for energy security.
These trends are following: regionalization of oil trade and globalization of gas trade.
Those trends are explained in the background paper of Prof. G. Luciani from European
University Institute (2004).

G. Luciani, Third Annual Conference on the Geopolitics of Energy, 2004:

The fallout of Iraq

Speaking at our second Geopolitics of Energy conference one year ago, Claude Mandil
commented on “The Geopolitics of Oil after the Iraq War”. At that time, the vision of
those that expected the war to mark a turning point in global oil affairs – allowing for the
privatisation of Iraqi oil, the return en masse of international Oil Companies (IOCs) to the
Iraqi upstream, a quick build up of Iraqi production and exports, a period of low prices
and possibly even the marginalisation of Saudi Arabia – had already lost much of their
credibility. Mandil sounded a cautious note:
“The recovery of Iraqi production remains one of the greatest uncertainties currently
affecting the oil market. Iraq’s reserves are the third largest in the world after Saudi
Arabia and Russia. Production potential is enormous. Iraq has proven reserves of 78
billion barrels and an estimated 108 billion barrels of probable reserves. Of 73 discovered
fields, only 15 have been developed.
Despite this vast endowment of resources, Iraq’s performance peaked in 1979 when
production reached 3.5 million barrels per day. Production levels fell, affected by the
political instability resulting from the Iran-Iraq War and the Gulf War. Lack of investment
and poor maintenance in the intervening years further strained the country’s oil
infrastructure; bad management and lack of spare parts may have damaged reservoirs. In
2002, output averaged 2.1 million barrels per day under the UN Oil-For-Food program.
Iraq’s sustained prewar production capacity was estimated at 2.8 million barrels per day.
Yet production was halted during the recent war and is returning slowly. (…) It will take
time before Iraq will surpass 2mbd. Although a limited number of wells were set on fire,
looting has resulted in damage to surface installations and loss of data; and it continues.
The results of poor management and maintenance during the 1990s combined with
insufficient security at oil facilities and questions regarding the state oil company’s
(SOMO) legal status may prolong the recovery beyond the end of this year.”
But notwithstanding this caution, Mandil’s expectation one year ago – in line with that of
most other commentators – was still that Iraq would exert downward pressure on prices,
to the point that possibly OPEC’s target band would turn out to be indefensible:
“In the long term, the world will need Iraqi oil – and Iraq will need oil export revenues to
fund its development. (…) As older fields in the North Sea and elsewhere are retired,
Iraq’s plentiful, relatively low-cost reserves will become increasingly important. (…)
In the shorter term -- barring any unforeseen events -- consumers should be assured that
oil supplies are ample, even if Iraqi production recovers more slowly than initially
anticipated. Assuming that Russian production will increase over the near term, a
resurgence of Iraqi exports will likely pose some challenging decisions for Dr. Silva
Calderon and his colleagues at OPEC. Because oil prices have been held at an artificially
high price by the OPEC price band, higher cost producers and nonconventional oil have
gained a stronger position in the market. The re-entry of Iraqi oil could create downward
pressure on prices, forcing OPEC to act in order to maintain their price band – but such
action comes at a cost. OPEC will lose additional market share or revenues, or both, or
must accept a price below the OPEC band at a level compatible with a stable market.”

OPEC’s dilemmas
OPEC’s understanding of the market was not altogether different. The fear of excess
supplies and soft prices continued for the rest of 2003, although very little softness was in
fact apparent in the markets. OPEC reacted to the perceived danger by deciding to cut
supplies in September 2003 and then again in February 2004. After the February meeting,
Saudi oil minister Ali Naimi, interviewed by Walid Khadduri on MEES, explained:
“In September, we decided to reduce the ceiling from 25.4mn b/d to 24.5mn b/d – a
900,000 b/d reduction. The market, though, behaved otherwise which means that the data
in front of us was either inaccurate or it did not include all the future events. And so
instead of reducing the 900,000 b/d, we actually increased production beyond the
900,000 b/d to keep the market from overheating. This was done in an informal manner,
but by agreement of course. We looked at it in December and we thought it’s OK, let’s
leave the ceiling and the leakage continued. Now at this meeting, OPEC data says there
will be a reduction in demand or surplus of 3mn b/d in 2Q. The IEA data also indicated a
3-4mn b/d reduction in demand or surplus of that amount; so the quandary was: what do
you do, do you wait until you have a huge build-up in inventory and have a precipitous
price fall or do you take a preemptive, proactive course of action?”
The February decision, although in fact never fully implemented (see Table below for
MEES’s estimate of OPEC production levels in recent months), sent prices skyrocketing.
In June OPEC had to formally reverse its decision of four months earlier, and indeed
Saudi Arabia started producing at a level not seen since 1990.
These events are indeed extraordinary in many ways and demonstrate how poor is our
understanding of global oil demand and supply even in the very short run. Weather
forecasts have now become more reliable than oil demand/supply/market predictions.
Paul Horsnell, in the paper which he presented to the International Energy Forum
ministerial meeting in Amsterdam, has presented two very interesting charts showing
how expectations concerning demand and supply for a given period (the fourth quarter of
2003) evolved over time. Demand estimates were progressively increased, from mid
2002 to early 2004, gaining fully 3 million b/d, or about 4 per cent. Non-OPEC supply
estimates were progressively reduced, losing about 1 million b/d. The difference,
needless to say, is quite substantial and much larger than any swing in OPEC quotas.
This points to several important questions.

 Firstly, should we conclude that we have a systematic tendency to underestimate

demand growth and overestimate non-OPEC supply potential?
 Secondly, is it conceivable that OPEC may ever succeed in defending its stated
target band by proactive quota management in the face of such blindness about
the even close future?
 Thirdly, have we entered a new phase in the evolution of the global oil market,
characterized by a higher price equilibrium (i.e. the band must be shifted
upwards)?
The difficulty experienced in anticipating demand growth is very surprising, because
demand estimates use econometric parameters established on the basis of a very large
number of observations. These parameters have a high degree of statistical reliability, and
point to relations that are stable over time. Of course, there is the China factor: the
Chinese economy is one that experiences very rapid structural change, and is therefore
difficult to capture with econometric techniques. We are constantly surprised by China in
many ways, and with respect to Chinese oil import requirements the matter is
complicated by the fact that they are incremental, and grow much faster than demand.
There is little that can meaningfully be added at this stage, except to note that the impact
of Chinese demand on the global oil market over the next five to ten years (not to speak
of further into the future) remains very controversial and clouded in uncertainty.

Prospects for non-OPEC oil

The supply side is more interesting. Here we have two diametrically opposite readings of
the situation.
One would insist on the random and unsystematic concentration of “bad news” that
characterized the last 12 months, and which is unlikely to be extended over time or
repeated in the future. The first piece of bad news was of course Iraq: the political unrest,
the looting and sabotage, the increasing realization that massive investment will be
required to restore or increase Iraqi oil production capacity and political conditions for
that will not be realized for another two years at least (i.e. when a new constitution is
approved and a democratically elected government with full legitimacy is in place – if we
believe the current, and very optimistic, official calendar of things to come). But there
have been more bad news, from Venezuela (where the US and others are hoping that
Chavez might eventually be democratically unseated) to Nigeria and other smaller
producers. These have all one thing in common: they can be categorized as political
interference in industry affairs, i.e. manifestations of irrationality that will eventually be
put right.
In contrast, the second approach points to other, more genuinely oil-related ominous
developments. The one development that caught the eye of the majority of non-expert
observers is the re-categorization of Shell’s reserves, leading to a 20% downward
adjustment. However strictly speaking this shift is not so terribly important, because
those reserves are not lost – simply not considered proved any longer; and we all know
that the concept of proved reserves is quite subjective to say the least. Yet there was
more: reports of declines in mature fields much steeper than expected in numerous areas
– ranging from Oman to the North Sea and the US lower 48. In other areas – e.g. the
Caspian, delays were announced in the bringing on stream of key new fields – notably
Kashagan.
In the Barclays Weekly Oil Data Review of 5 May, Paul Horsnell wrote:
“We have been using very downbeat forecasts for non-OPEC growth this year, with no
net growth forecast outside Russia for the second straight year and for the third year out
of the past four. Our belief is that decline rates in mature areas are higher than has been
anticipated, and that the drag from the mature areas is negating the net growth elsewhere.
However, now that the flow of data for 2004 for mature areas has started, the picture that
is emerging is dramatically weaker than even our prior expectations. Over the past week,
new oil production data has been released by the UK and US, and both sets were far
worse than expected. In February, the combined year-to-year decline in production in the
UK and US alone amounted to an extraordinary 757,000 b/d. The UK reported a
February output level that was 411,000 b/d lower than a year ago, following a 240,000
b/d year-to-year decline in January. The US numbers show a 236,000 b/d year-to-year
decline in March following a 346,000 b/d decline in February.”
And on the 9th of June he added:
“We expect that the oil market will again move above $40/B. The only question is
whether this happens due to some turbulent geopolitics and short-run gasoline market
dislocations at a time of painfully limited spare capacity, or whether it happens further
down the line due to the grinding of some very ferocious fundamentals. The further down
the line you look, the more difficult it is to see how enough production capacity can be
brought on in time.”
So, there was a revival of talk about Hubbert’s curve and the “peak”. At the November
’03 meeting of the Oxford Energy Policy Club a majority of the opinions expressed
seemed to be quite pessimistic about the prospect of continuing growth in non-OPEC
supplies. On the opposite side, Daniel Yergin, writing on the New Your Times on April 4,
predicted that it would be another 50 years before any problem of oil scarcity arises. And
in the paper he presented at the Amsterdam ministerial of the International Energy
Forum, Olivier Appert has written:
“Among the more pessimistic experts, some believe that world production of
conventional oil has already peaked, others that this will happen before 2010. The
optimists - especially those basing their forecasts on data from the U.S. Geological
Survey – say that production should peak in 2020 or later. These divergent opinions rely
on different estimates of the ultimate recoverable reserves of conventional oil. But future
oil resources will not be limited to conventional oil. By mobilizing other resources
(exploiting nonconventional oil resources, improving the recovery of oil in place to add
resources, etc.), the production peak can be postponed.”

The debate on Saudi reserves and production prospects

It is in this context that the controversy over Saudi oil reserves erupted. For years, the
EIA has published estimates of “required” future Saudi production capacity that seemed
quite unrealistic: the latest International Energy Outlook projects Saudi capacity at 14
million b/d in 2015, 18 mb/d in 2020, and 22 mb/d in 2025 (reference case). (See also
EIA’s Saudi Arabia Country Analysis Brief published in June 2004). And that is in a
context in which non-OPEC production capacity is assumed to continue growing until
2025 – no peak in sight. Does Saudi Arabia have the required resources? Do they intend
to increase their production to such an extent?
The controversy about Saudi oil reserves and prospects of future production increases
was sparked by Matthew R. Simmons. At a debate organized by the Center for Strategic
and International Studies (CSIS) in Washington on February 24, 2004, he argued that
Saudi Arabian oil production might soon be peaking, because of expected growing
problems with the country’s key long-producing oilfields. In one of his concluding slides,
he argues:

 The entire world assumes Saudi Arabia can carry everyone’s energy needs on its
back cheaply.
 If this turns out to not work, there is no “Plan B”.
 Global spare oil capacity is now “all Saudi Arabia”.
Representing Saudi Aramco, Mahmoud M. Abdul Baqi and Nansen G. Saleri argued that
Saudi production policy has been very conservative, and the Kingdom could increase its
production easily. The argument was reiterated on April 27 at the same venue by the
Saudi Minister of Petroleum, Ali Naimi, and the CEO of Saudi Aramco, Abdallah S.
Jumah. Jumah had the following to say (and I quote from the speaker’s notes published
on the CSIS web site, which include some interesting detail which is not in the
transcript):

“Saudi Aramco’s current production capacity is 10 million barrels per day, including
some 2 million barrels of surplus production capability. This capacity has been tested and
put into effect as required. Depending on global market demand, we can produce and
sustain the 10 million barrels a day level for more than 50 years, by relying primarily on
our already proven reserves. Further reserve expansion efforts will certainly push the
plateau beyond 50 years.
(Ad Lib: Only minimum use of the probable and possible reserves will be required
to sustain the 50-year plateau.)
[Note: Minimum means only 15% or 15 billion barrels use of probable and possible
reserves.]
[Note: These figures place the probable and possible reserves at about 103 billion
barrels. Considering the 80 billion barrel figure referenced earlier, the 103 billion
barrels include additional recoveries from the existing fields, which are not a part of the
80 billion barrels number, enhanced recovery processes and other reserve expansions
referenced below].
We have developed a range of long-term crude development scenarios that call for raising
production to 12 or 15 million barrels per day, depending on demand growth. We are
confident that we can develop and sustain production at these levels for at least the next
half century by utilizing a higher proportion of Saudi Aramco’s probable and possible
reserves.
(Note: For 12 MMBD and 50 year plateau, 34% or 35 billion barrels use of probable
and possible reserves is required. For 15 MMBD and 50 year plateau, 68% or 70 billion
barrels transfer of probable and possible reserves to proved is required).

Potential also exists for extending the 50 year horizon for these higher production levels
by further expanding reserves. Such expansion will come from a combination of oil-
focused exploration that leverages Saudi Arabia’s rich hydrocarbon potential; the prudent
use of technology; well-conceived reservoir management practices; and incremental oil
recoveries through the application of enhanced recovery processes.”

The point is therefore that sustaining production at 15mb/d over 50 years would require
very substantial draw down of reserves. Higher production levels, as hypothesized by the
EIA, would not be sustainable for such an extended period of time. But would it be wise
and prudent for Saudi Arabia to greatly intensify the rate of exploitation of its reserves,
considering that oil remains the most important asset for the long-term future of the
Kingdom?

Furthermore, the Saudi rebuttal of Simmons’s argument proves that Saudi Arabia can
indeed increase production, but does not negate his last point quoted above, i.e. that Saudi
Arabia possesses almost all available spare capacity in the world, and any talk of
increasing OPEC production means in fact increasing Saudi production. When the
decision was made to increase OPEC quotas in June 04, Saudi Arabia was the only
country with any effective unused capacity left: everybody else was already producing at
capacity.

In this context, the centrality of Saudi Arabia, and of US-Saudi relations, can hardly be
underestimated. Following September 11, US-Saudi relations have entered an
extraordinarily difficult period, which combines a tendency to prejudiced Saudi-bashing
to well-intentioned advice and the perception that Saudi stability can only be guaranteed
in the long run if taboos are overcome and painful reforms are undertaken.
Russian production prospects and political uncertainties

Asserting the centrality of Saudi Arabia does not necessarily mean negating the
increasingly important role that Russia is playing. Indeed, Russian production has
continued to increase steadily, and might have grown even more, had it not been
constrained by logistical bottlenecks. But Russia’s increase simply compensates for
declines elsewhere (in the UK and USA), meaning that incremental demand still needs to
be met by OPEC, i.e. Saudi Arabia.
Furthermore, how far can we expect Russian production to grow? Some observers have
exceedingly optimistic expectations about Russia. Julian Lee of the CGES, for one,
presented the two slides reproduced below at a conference organized by CERI in March
2004. One cannot fail to note that the extrapolation represented by the “second curve”
(the red curve) is quite a bold one.

Towards regionalisation of international oil trade?

These controversies are interesting not just because they indicate that further developing
Russian exports may not be a straightforward affair; but also because they might be
interpreted as pointing to growing regionalisation of the international oil market. While
sufficient arbitrage will always exist to guarantee that petroleum prices are equalized
globally, net of transport costs, most of the oil is in fact likely to move on short haul,
establishing closer ties of interdependence between pairs of regions. Thus, if we consider
the likely evolution of oil exports from North Africa, the Caspian and Russia, we come to
the conclusion that Europe’s reliance on oil from the Gulf is bound to decline. The US
will become ever more of a dominant factor in the Atlantic basin, while Gulf oil will
increasingly be directed to East and South Asia. The exception in the Gulf is likely to be
Saudi Arabia, which might continue to ship significant volumes of oil to the United
States, more out of political than commercial motivations. As mentioned, Russia would
very much like to do the same, but finds the goal considerably more difficult to reach.
If we accept the inevitability of the tendency towards regionalisation – which might be
strengthened by rising transport costs and the preference recently expressed by the
European Union for transporting oil by pipeline rather than ship whenever possible, for
environmental reasons – we should conclude that the EU has good reasons for
concentrating its attention on developing a cooperative relationship with Russia, the
Caspian and North Africa, while devoting much less attention to the GCC. But is this a
sensible approach, in the light of the noted centrality of Saudi Arabia to global supplies?
In the case of the United States, the tendency to regionalisation is manifested especially
in calls to intensify relations with West Africa, primarily in order to reduce dependency
on the Gulf. Because this is not enough, proponents of reducing dependency on the Gulf
point to the need for having access to Russian and Central Asian oil, notwithstanding the
negative logistical implications. So we have the paradox, that while the European Union
speaks of possibly eliminating petroleum carrier traffic from the Mediterranean (see
“Preliminary Discussion on Options Aiming at Diminishing Risks in the Maritime
Transport of Oil and Oil Products”, chapter 5 of Technical Annex 1, “Initiatives on the
Development of Infrastructure Projects of Common Interest”, in Annexes to the Euro-
Mediterranean Ministerial Conference of Rome, December 03), the US presses for
Russian and Caspian oil to be available at deep water ports, for loading on VLCCs bound
for the opposite side of the Atlantic: the potential for conflict there should be
underestimated.
Finally, regionalisation also means rapidly growing ties within Asia. Especially if Russia
deliberately plays down its ties with China, and takes east Siberian oil to the Pacific, the
result will be that Gulf producers will focus on exporting to the major Asian markets even
more than they already do. In the eyes of Gulf producers, the Asian markets offer the
additional advantage that their transformation capacity is much less developed, meaning
that there is scope for exporting refined and/or petrochemical products, to satisfy a
demand that will systematically outpace domestic supplies. The emergence of an “Asian
block”, whose political priorities and values are very much different from those of either
Europe or the United States, may significantly alter the interplay of political and
economic factors in the international oil industry.

Major developments in international gas trading

As the oil market is moving towards regionalisation, the opposite is happening in the gas
market. Historically, the market for gas has been regional rather than global, with three
main trading regions being North America, Europe, and the Far East. There has been little
arbitration between regions (indeed, also within regions, except for North America),
because of the absence of transportation capacity. This has led to widespread price
segmentation and persisting differentials between regions.
However this situation is now rapidly changing, due to the emergence, on the one hand,
of the United States as a major importing country, “pulling” gas from all directions, not
just from within North America; and, on the other hand, of Qatar as the new global
source, based on massive investment in new LNG projects aiming at the US and
European markets, in addition to Far Eastern ones. Thus, although the ability to redirect
gas from one region to another will remain limited some arbitraging will take place
through adjustments in the origin of marginal US imports and the direction of marginal
Qatari exports.

According to BP (a major producer of gas in the US) “US gas production has recently
plateaued despite ample, available domestic gas resources, because they are becoming
increasingly costly to recover”. The decline in domestic production, coupled with limited
import capacity has led to a shift in the average level of prices. Although the spike of
200/1 remained an exception, Henry Hub prices over the last year never fell below $4.50
per MMBTU, a level that makes LNG import projects quite attractive.
Consequently, it is now expected that US LNG imports will increase very rapidly (see the
table from EIA’s Annual Energy Outlook), leading to concerns about security of supply.
Dan Yergin, for example, had this to say (at the same CSIS gathering on April 27
primarily devoted to Saudi Arabia):
“U.S. really is on the threshold of a new era in natural gas, and this has major
implications. In a sense the U.S. is today in natural gas where it was 30 years ago in oil,
about to go from being a minor importer to being a major importer, and a decade from
now the United States could literally overtake Japan as the world's number one importer
of LNG. That will add to the dimensions of energy security that we talk about, a host of
new energy relations, and give a larger dimension to the conversations.”
The importance which is attributed to ensuring abundant LNG supplies to meet the
growing US requirements was manifested by the December 2003 LNG Ministerial
Summit convened by the US DOE. The Summit’s objectives included:

 “Reveal innovative approaches to meeting the challenges facing the growth of US

LNG”
 Provide “a perspective of expected LNG market growth over the next two
decades”;
 Identify “significant US market and investment opportunities”;
 Explore “concerns and issues that producing nations need to discuss to ensure a
successful and fast-growing US LNG market”.

In this same context, we can also point to the Geopolitics of Natural Gas Study, jointly
launched by the Program on Energy and Sustainable Development at Stanford University
and the James A. Baker III Institute for Public Policy of Rice University. The Study
generated a set of papers on several major historical pipeline case studies, plus a paper by
Peter Hartley and Kenneth B. Medlock III entitled “A Global Market for Natural Gas?
Prospects to 2035”. The latter strongly argues in favour of the globalisation of the natural
gas market – dominated by Russia on the supply side and the United States on the
demand side:

“According to the Rice World Gas Trade Model, in a global natural gas market events in
one region of the world will influence all other regions. (…)
The model also suggests that Russia will play a pivotal role in price formation in a more
flexible and integrated global natural gas market. Eastern Siberian gas begins flowing
into Northern China in the middle of next decade. Toward the end of the model time
horizon, specifically 2025-2030, Chinese growth pulls gas from both Western Siberia, via
pipeline through Eastern Siberia to Northern China, and from Kazakhastan through
Western China. Sakhalin production serves LNG markets as well as Japan via pipeline
around 2010. Some Sakhalin gas also moves toward South Korea via pipeline through
Nakhodka. Throughout the model period, Russia is a very large supplier to Europe via
pipeline, exceeding 50% of total European demand post 2020. Strategically positioned to
move large amounts of gas both east and west, the presence of low cost Russian pipeline
gas in both Asia and Europe will serve to link Asian and European gas prices. The model
also suggests that Russia will eventually enter the LNG trade (via Barents Sea), providing
an additional link between gas prices in North America, Europe and Asia. Russia benefits
not only from its location and size of resources but also because it was one of the first
major gas exporters and has access to a sophisticated network of infrastructure already in
place.
Other resource-rich players like Iran and Saudi Arabia must bear the fixed costs of market
entry due to the lack of existing infrastructure. Early entry would drive down prices and
lead to inadequate returns on investment. Therefore, entry must be delayed until world
demand --in excess of alternative sources of supply-- is large enough to accommodate
those incremental supplies. Consequently, Iranian and Saudi Arabian LNG supplies do
not enter the world market until after 2020. Another factor limiting exports from both
countries is domestic demand growth in part to facilitate oil production.
From the point of view of consuming regions, preliminary modelling results suggest that
the United States market will be a premium region pulling in gas supplies from around
the world.”

In the immediate, however, it is Qatar, rather than Russia, which is emerging as the
leading global supplier. After a gestation that has lasted some three decades, Qatar’s
North Field is poised to finally become a major factor in the international gas industry.
The globalisation of international gas trade will therefore be made possible by the
expansion of LNG trade. However, we should keep in mind what has been noted by van
der Linde & Stern (in the paper they presented at the IEF Amsterdam ministerial
meeting), i.e. that in any case LNG growth cannot possibly be sufficient to meet the
expected growth in global demand, meaning that pipeline gas will need to continue
growing - but little progress has been achieved in establishing new pipelines, as political
problems continue to prevent the implementation of various projects.

“In the period to 2020, LNG trade is expected to grow manifold, with the most optimistic
projections assuming a quadruplicating of LNG trade to around 600 bcm/a. This will fall
considerably short of the projected growth in demand of 1700 bcm (IEA). The difference,
consequently, will have to be met by cross-border piped gas. Nevertheless, the current
development of international gas pipelines yields a less dynamic perspective with regard
to the actual commitment to new investments. Many conceptual opportunities are being
discussed and explored. And indeed, these will be very much needed to achieve the
growth projected. But it takes at least 5 and usually up to 10 years for projects to get off
the ground. There are discussions and plans around the development of pipelines from
Russia to Europe via the Baltic Sea, from the Caspian region and Iran to Europe, and
from Russia to China and beyond. So far, none of these have reached the stage of a
commitment to invest. Political issues, regulatory design, as well as the harmonisation of
investments and supply risk, prove to be very difficult to align.”
The difficulty in establishing new pipeline projects therefore remains central in the debate
on security of gas supplies. As I have noted elsewhere (CEPS Policy Brief 51), it is only
through the deliberate creation of redundancy in import facilities – pipelines and LNG
terminals – that we can achieve at the same time a more competitive and secure European
gas market. However, the market is unlikely to bring about redundancy, tending rather to
eliminate bottlenecks only once they become critical. Ensuring competitiveness and
security of supply through diversification is likely to require continuing public attention,
but how this can be done without distorting market conditions is a question that remains
open.
2. Second approach: Institutionalist theories

Institutionalism is one of the most novatrice conceptions of international political and

economic relations. Its core idea consists to demonstrates that institutions (stemming
from norms and regular practices) build a basis for stability and security of economic
relations. The process of legalization of international relations stems from the juridical
ideology: respect of law leads to a better security.

A crucial contribution to institutional analysis has been provided by analyst D. North.

According to his definition, institutions are “the rules of the game in society or, more
formally, are the humanly devised constraints that shape human interaction” (North,
1990: 3). D. North marks how formal and informal constraints have been created by
practices, which then lead to the formal development of institutions. (North, 1990:69). D.
North’s definition opens the idea of institution to a broader sense of the term, but does not
overlap the definition of organization. D. North belongs to the Rational Choice
perspective of institutional analysis. Rational Choice is the objective centered view,
believing that the institutions are created purely out of the goals they are attempting to
reach.

2.1. Theoretical conception of institutionalism

S. Steimo, The new institutionalism, Barry Clark and Joe Foweraker, (eds.)
The Encyclopedia of Democratic Thought, London: Routlege, (July, 2001).

There are two contending research/theoretical approaches within political science which
identify themselves as Institutionalists today: Rational Choice Institutionalists and
Historical Institutionalists. The role institutions play in these two analytic traditions
overlaps in many ways (cf. Hall and Taylor 1996; Rothstein 1996; Thelen 1999). At the
same time the theoretical, indeed epistemological, goals of scholars in these two schools
separates them in some rather fundamental ways. In both schools, institutions are
important for politics because they structure political behavior. Perhaps surprisingly the
core difference is NOT over whether people are Arational or not. Historical
Institutionalists do not argue with the observation that most people act rationally most of
the time. Nor do Rationalists necessarily believe that all action is motivated exclusively
by short-term economic self-interest.

Historical Institutionalists are primarily interested in understanding and explaining

specific real world political outcomes. Building on the earlier work of Peter Katzenstein
and his colleagues in Between Power and Plenty, and then Theda Skocpol and her
colleagues in Bringing the State Back In, a group of younger scholars embarked upon a
variety of studies of specific historical events in widely different places and across large
spans of time. They could not explain these variations without specifically examining the
way in which the political institutions had shaped or structured the political process and
ultimately the political outcomes. In other words, Historical Institutionalists are first
interested in explaining an outcome (say, for example, why France and Britain have
pursued such different styles of industrial Policy or why some welfare states generate
more popular support than others. Because theirs is not a theory in search of evidence,
Historical Institutionalists do not argue that institutions are the only important variables
for understanding political outcomes. Quite the contrary, these scholars generally see
institutions as intervening variables (or structuring variables) through which battles over
interest, ideas and power are fought. Institutions are important both because they are the
focal points of much political activity and because they provide incentives and constraints
for political actors and thus structure that activity. Rather than being neutral boxes in
which political fights take place, institutions actually structure the political struggle itself.
Institutions can thus also be seen as the points of critical juncture in an historical path
analysis (see below) because, political battles are fought inside institutions and over the
design of future institutions. In either case, the Historical Institutionalist is interested in
developing a deep and contextualized understanding of the politics. The goal Rational
Choice Institutionalism is different. For Rationalist scholars, the central goal is to
uncover the Laws of political behavior and action. Scholars in this tradition generally
believe that once these laws are discovered, models can be constructed that will help us
understand and predict political behavior. In their deductive model, Rational choice
scholars look to the real world to see if their model is right [test the model] rather than
look to the real world and then search for plausible explanations for the phenomenon they
observe.1 For these scholars, understanding real outcomes is not the first point – creating,
elaborating, refining a theory of politics is (Weingast 1996). The implications of this
scientific orientation are substantial. Morris Fiorina, a highly regarded RC scholar at
Harvard put the issue in the following way: The most important thing to remember when
reading examples of PTI is that, at heart, most PTI scholars are theorists. This means, first
Athat most PTI scholars are not as interested in a comprehensive understanding of some
real institution or historical phenomenon, so much as in a deeper understanding of some
theoretical principle or logic. Second, Athen [Rationalists] do not demand a complete
understanding of an historical or institutional phenomenon.

2.2. Overview of Institutions dealing with energy security

The density of institutions explains the various angles of energy policy strategies.
Indeed, each institution is shaped by particular principles, norms and rules which
influence different approaches to resolving problematic resource management. On this
basis, five groups of institutions are distinguished:

Institutions/Markets Oil & Gas Gas (downstream) GHG

Upstream & Electricity
International IEA IEA IPCC
Information-based
General rules of WTO, Law of the Emerging Non-existent
International Sea, International Application of WTO
Economic Law Arbitration and International
Arbitration

Sector-specific ECT ECT Kyoto Protocol

institutions
EU internal market None Internal Market Internal Market
legislation
Private Commercial Multinational Firms Emerging Mergers; Emerging
Institutions Industry
Associations

Above are institutions which:

- promote knowledge and information on energy and energy-related issues such as

environment;
- establish general legal binding institutions, which have emerged through general
multilateral conventions and agreements;
- constitute issue-specific agreements which directly involve the international
energy markets;
- form practices of regional economic organizations, with a particular focus to the
practices existing in the EU internal market;
- Cross-border institutions set by private commercial actors.

2.2.1. Information-based Institutions

The analyzed energy markets of oil, gas & electricity as well as GHG are shaped by
information-based institutions. These institutions aim to provide better availability of
data, better transparency of policies, and more awareness of ongoing problems in each
sector. The International Energy Agency (IEA) is one of these agencies. The IEA was set
up for the oil, gas, and electricity sectors in te aftermath of the first energy shock of 1973.
Its’ activities also delve into evaluation of investment needs, and best practices in
different member states. By providing recommendations and data, it has political impact
on national decision-makers. For instance, the IEA’s recommendations have contributed
to the establishment of emergency stocks for oil, a higher consideration of energy
efficiency policies, and investment risk evaluation. In addition, the IEA provides
comprehensive information on energy markets, such as CO2 emissions. The IEA
recommendations contribute to the best-practice transfer of market mechanisms attracting
investments. Cross-country information provides a clear picture of best-practices in
energy policy. However, the IEA does not create any binding regulations. The best-
practice transfer is a purely voluntary procedure which is applied, if not entered into
contradiction with the national interests of particular states. It reflects, in cases such as
France for instance, where state-owned enterprises are keen to avoid the practice transfer
from liberalized energy sectors (such as the UK).
International Energy Agency, security of gas supply in open market, 2004

SECURITY OF GAS SUPPLY IN

OPEN MARKETS: MAJOR ISSUES
In open gas markets, supply and demand can usually be balanced by
the market. The challenge of security of supply is to make sure that
the market can always clear supply and demand. Open markets allow
customer choice. Eligible customers can choose their suppliers and
eventually their own level of reliability of supply, but they are responsible
for that choice. Open markets will not always result in lower prices for
customers, but they will result in an efficient allocation of resources,
capacity and investment. Compared to markets for commodities, the
design of gas markets requires special consideration as gas delivery is
capacity-bound and therefore supply is restricted in the short term, and
because part of gas demand is price-inelastic, especially the household
sector, which is even temperature-dependent. Therefore prices may be
volatile, when capacity limits are close, and there is a risk that supply and
demand do not meet for low-probability events, whatever their cause.
Governments in open gas markets play a different, but important role
to ensure secure and reliable gas deliveries from the
production/import point to the final customer. Instead of managing
the sector, they have to set clear policy objectives all along the gas
chain to manage the geopolitical implications of increasing import
dependence and impacts on the environment, and to ensure the
working of markets to deliver reliable gas supplies. At the time of stateowned
gas companies, or private companies with exclusive concession
rights, governments played an important role in the management of the
sector but delegated responsibility for security of supply to these entities
and made all customers pay for it. These companies were responsible for
security of gas supply across the whole gas market. In open markets,
governments have to define the right framework for the market players so
that markets can deliver reliable gas supplies, and they have to make sure
that market players follow the rules. Governments have the responsibility
of creating a framework for security and for defining the responsibilities
of each player. However, low-probability events (like supply interruptions
19
and extreme temperatures) may not necessarily be valued by the market
itself. Governments therefore should set objectives for reliability of gas
supply, especially to ensure gas deliveries to household customers at
extreme low temperatures. They should also foster demand-side response
as one of the important policies to ensure security of supply. The opening
of the gas (and electricity) market results in the development of hubs and
market centres which prove a useful instrument to optimise the use of the
capacity of the gas system, to bring gas to its highest value use and foster
market transparency.
Governments may be concerned that market outcomes – like volatile
prices, or high prices – may lead some industries to relocate to regions
with lower gas/electricity prices. Governments may take unsatisfactory
market outcomes as an impulse to rethink the framework and implement
its modification to mitigate market outcomes in line with their policy.
However, dealing with the day-to-day operation of the market is hardly
the role of governments. While some of the arguments to ensure security
of gas supply are similar to oil, the arguments for establishing stocks and
a coordinated stock draw do not apply to gas. Strategic gas storage is much
more expensive than oil storage and requires additional substantial
investment into a spare transport infrastructure. Other instruments like
interruptible contracts or fuel switching may be less expensive than
strategic gas storage, if storage is possible at all. As the market is not yet
global and disruptions only have local impact, a global response is not
possible. It is therefore best to leave the design of the response mechanism
to individual countries and their market players, taking into account the
effect of the development of larger regional gas markets.
The global gas supply and demand balance is at a turning point. From
1971 to 2000 worldwide gas consumption more than doubled from
895 mtoe to 2,085 mtoe. World Energy Outlook 2002 (WEO 2002) projects
another doubling to 4,203 mtoe by year 2030. Gas consumption for power
generation was about a quarter of total gas consumption, or 207 mtoe, in
1971; a bit more than a third in 2000, 725 mtoe; and is expected to come
close to half of total gas consumption, or 2,032 mtoe in 2030, so gas
consumption for power generation almost triples every 30 years.
20
For OECD countries the trends in gas consumption look similar: from
1971 to 2000 gas consumption almost doubled from 653 to 1,143 mtoe
and is projected to almost double again to 2,012 mtoe by 2030. Gas
consumption for power generation was 117 mtoe in 1971, or about onesixth
of total gas consumption, increasing to 328 mtoe in 2000, or a bit
more than a quarter of total gas consumption, and is projected to reach
958 mtoe in 2030 – almost half of gas consumption in OECD countries.
So in OECD countries the trend towards increased use of gas in power
generation is even more pronounced, due to increasing saturation in the
residential, commercial and industrial sectors.
The import dependence of OECD countries is projected to increase from
a total of 274 bcm/a or a share of about 20% of total gas consumption in
2000, to a total of 1091 bcm/a, or more than 40% of gas consumption.
The major part of increase in gas imports is explained by the projected
increase in gas used in power plants.
Gas has developed into the fuel of choice for the residential and
commercial sectors, but also for process and small applications in the
industry sector, wherever gas can be economically supplied. While gas can
be replaced for each individual customer mainly by oil products, which
define price limits for individual customers, many IEA countries have no
large-scale alternative to gas on a country-wide scale. The use of gas is not
only linked to a long-lasting investment decision on the customers’ side,
but also to large investment in the gas infrastructure, which would
become obsolete in case of a substantial shortage of gas.
With domestic gas reserves of IEA countries on the decline, imports are
going to cover an increasing part of gas demand in most IEA countries.
This raises the issue of import levels from different non-OECD countries
versus the ability of the market to handle a gas shortfall. It also raises the
issue of the implications of uneven reform in countries along the gas chain.
The increase in gas use for power (and the dominance of gas as a fuel for
new power generation since the beginning of the 1990s in many IEA
countries) is driven by the high technical and economic efficiency of new
gas turbines and CCGTs, as well as by the environmental advantages of
gas compared to other fossil fuels. Projections show that there is likely to
21
be a substantial increase in gas use in power generation in OECD
countries, which, on balance, will have to be imported from non-OECD
countries. The result will be a strong increase in import dependence in
most OECD countries/regions and a strong increase in cross-border trade
of gas by pipeline and as LNG.
For volume and diversification reasons, gas for export from an increasing
number of resource-owning countries will mainly be developed as LNG.
The LNG industry has now entered an era of unprecedented growth. New
large markets are emerging, cost reductions along the LNG chain allow
new projects which were uneconomic 20 years ago, and increased interregional
trading adds flexibility and security to the global gas sector.
Larger regional markets are emerging with the opening of gas markets
(in addition to the already strongly interlinked North American market),
e.g., in the EU. With more flexible LNG trade, more trade develops
between LNG buying countries, like Japan and Korea, and also in the
Atlantic basin between parts of the EU and the US. The creation of larger
markets offers more possibilities for underutilised capacity/volumes to
find their way to other regions, with higher gas value, thereby creating
higher liquid volumes on which to draw in case of shortage or extreme
temperatures. Creating a larger (regional) marketplace may require extra
investment into interconnection infrastructures, which so far have been
built on the basis of national markets. This may require governments to
define common standards (e.g., technical norms, gas quality, LNG
specification and safety norms for LNG tankers), to foster interoperability,
and to arrange for the right framework to remove obstacles to
cross-border investment and trade.
Increased links between open gas and power markets offer the chance
for more efficient use of both systems. However, the reliability of each
system must also be ensured in view of the interlinks between them.
The increased use of gas in power generation combined with the parallel
opening of both sectors creates operational and market links between the
sectors. However, it must be observed that while the link is creating
greater flexibility for the use of gas and for the production of electricity,
both systems are capacity-bound. Experience shows the need to set
22
reliability objectives, which take into account the interdependencies of the
systems. The projected high dependence of power generation on imported
gas might create a domino effect on the power sector in cases of gas supply
shortages, if not anticipated.
The willingness of non-IEA gas-rich countries to develop their gas
resources for export is key to the further development of gas markets in
IEA countries that increasingly depend on such exports. This will
require a stable balance of interests between gas importing and gas
exporting countries. The import volumes of all OECD regions are
increasing substantially and even the UK and US are becoming substantial
net importers of gas. About 10% of world proved gas reserves are in OECD
countries, whereas non-OECD gas reserves are highly concentrated. More
than 50% are in three countries: almost 30% are in Russia, 15% in Iran, 9%
in Qatar. While the investment decisions for exploration and production,
transportation and other gas infrastructure, as well as on the use of gas, is
best left to private investors, the decision on the depletion of natural
resources is in most countries vested in the government of the resourceowning
country. To optimise the use of their resources, they have to decide
on the development path for their reserves, on domestic and export use, as
well as on maximising the remuneration for the export of a finite resource.
While maximising the rent income for a finite resource is a sensible objective
for an exporting country, IEA gas importing countries will try to subject
such rent transfers to competitive forces by promoting diversification of
supply sources, routes and the use of other fuels.
While IEA countries are interested in reliable gas supplies at competitive
prices, governments of resource-owning countries will look for secured
access for their gas to IEA markets and for a reliable income from selling
their resources. Long-term contracts have been a useful instrument to
create a stable balance between gas exporters and importers. With more
open markets new, additional instruments develop, such as selling into a
liquid market, as well as more flexible LNG deals, but long-term contracts
will remain an important instrument, although with increasing flexibility
as markets mature. While having a bankable gas market or a creditworthy
gas buyer is a major precondition for viable investment in gas production
and export infrastructure, a clear framework for foreign investors and
23
a neutral conflict resolution mechanism would help to mobilise financing
for new export capacity at favourable conditions. A suitable way to address
how to create a fair and stable balance between gas producing and
consuming countries is to foster more dialogue between them.
Governments have to ensure that investment for all parts of the gas
chain can be mobilised in a timely way and in competition with other
capital use. The increase in gas demand requires the alignment of timely
investment in all parts of the gas chain, from exploration and production
to transporting the gas to the market, as well as investment into the
distribution and gas consuming infrastructure, especially gas-fired power.
While governments cannot and should not play a role in managing
geological, technical or commercial risks, they should help to reduce
sovereign and regulatory risks. This is particularly important in creating
clear and stable frameworks for investment, especially in cross-border
infrastructure, where there is the risk of abuse of market position. They
should also help with the adoption of clear and streamlined siting rules,
while minimising regulatory risk by creating a stable and predictable
regulatory framework, which would allow investors free commercial
disposal of their property and, where regulated, a risk-adjusted rate of
return competitive with other investment opportunities.
The choice of instruments to hedge long-term risks should be left to
market players. Both the industry from all parts of the gas chain and the
resource-owning countries have an interest in being able to hedge their
decisions dedicating investment or gas resources on a long-term basis. A
variety of instruments linked to the development and maturity of reforms
in each gas market/region has evolved to hedge the risks stemming from
the long-term nature of the gas business:
_ Long-term sales contracts associated with long-term transportation
contracts;
_ Vertical integration along the gas chain;
_ Access to liquid markets (by investing into LNG regasification terminals
and import pipelines) and to financial instruments derived from liquid
gas markets.
24
Governments of IEA countries should leave the choice of instruments to
the market players concerned; they should not favour or disfavour any of
these instruments, as long as they do not negatively impact competition.
In spite of generic and global developments the status of market
opening and the challenges of security of gas supply are specific for
each IEA region and in some cases even for single countries:
North America: open gas markets introduced in the 1980s were able to
mobilise private investment in time for expansion of the infrastructure
and the development of reserves. These markets led to the development of
liquid hubs and gas exchanges and to a more efficient use of the gas
infrastructure. So far gas supply and demand have been balanced by
markets. Upstream, the role of governments was restricted to rule setting
and in the case of Canada, also encompassed rent taking – however, with
some restrictions on E&P in US federal/state owned land, offshore and in
arctic areas. The decline in production due to the depletion of North
American gas reserves combined with the massive increase in gas use in
CCGTs with only limited fuel-switching capacity, resulted recently in
rising gas prices so that some industrial gas users considered moving to
other regions. This situation signalled the need to increase LNG imports
substantially to satisfy the projected use of gas in power generation. After
the requirements were dropped for third-party access (TPA) in LNG
terminals, many new projects emerged. While the chances of obtaining
diversified LNG supplies are good, the expected large share of LNG
supply may raise the question whether interruptions of LNG supplies can
be compensated by the market.
Europe: there is a marked difference between the UK gas market and the
continental gas market. While the UK was a frontrunner in opening the
gas market, the opening in the continental part of the EU happened more
recently with the two EU Gas Directives and their implementation in EU
member states. The opening of the gas market in the UK resulted in the
establishment of the National Balancing Point (NBP), a liquid (notional)
market place where gas is traded on a daily basis. It assisted the massive
use of gas for power generation in the 1990s and, in parallel, a remarkable
increase in gas production from the UK continental shelf (UKCS).
However, lacking large new finds in frontier areas and with the UKCS
25
becoming a mature gas province, within a short time span the UK will
change from being a net gas exporter to a massive net importer. Long-term
contracts are still predominant in the UK, though now they are
increasingly linked with the price at the NBP and in some cases also use
the NBP as the delivery point. The UK is well underway to attract the
additional supplies and the necessary investment to adapt its
infrastructure, although with some specific challenges caused by the
differing quality of the gas to be imported. Another challenge to be
addressed is the link between gas and power, as a large increase in
imported gas will go to gas-fired power plants.
In continental Europe, the implementation of the two EU Gas Directives is
underway with some decisive changes to become binding as of 1 July 2004.
Several of the challenges for reliable gas supplies set before the gas sector by
the Directives still lie ahead, such as finding the right allocation between the
responsibility for reliable gas supplies and the effects of unbundling; finding
the right incentives for the enlargement of the transport, import and storage
infrastructure by allowing for a rate of return which is competitive in a
global context. Creating more regulatory stability by giving the industry the
time to adapt to and to fulfil the requirements stemming from the
Directives currently in force is now of paramount importance.
In view of the increasing import dependence from only a few gas exporting
countries, long-term contracts will remain an important instrument to
ensure gas supplies. In the continental gas market, some hubs are
developing, although they still do not have a deep liquidity. However,
beyond the challenge of creating open gas markets in each EU member
state, the challenge remains to create a single gas market for the EU, which
requires rules, standards and technical regulations as uniform as possible.
The infrastructure, which was built on a national basis driven by large
import projects, must be adapted to allow for more EU-wide gas trade and
liquidity. As in North America, the projected strong increase of gas in
power generation, which will, on balance, be based on imported gas, raises
challenges of increased gas import shares from non-IEA countries and their
impact on the gas and power sector. The pace of supplier and transit gas
sector reform has important implications for the quality and reliability of
security of gas supply to European end-use customers.
26
27
The EU is to a large extent dependent on Algerian and Russian gas
imports, which are projected to increase substantially. Both countries have
a long-standing record as reliable suppliers, fulfilling their contractual
obligations. However, in 1980, Algeria cut off supplies to its US and
European customers to make them accept unilateral changes in contract
terms. While the interruption was only temporary for Europe, it led to the
collapse of Algerian LNG trade with the US. There is some concern about
the long-term future of gas imports from Algeria and Russia: neither of
these countries has yet a clear gas upstream nor transport regulation. In
addition, gas production and export are managed by companies which, in
addition to their commercial role, exercise sovereign rights of the state in
the gas sector. Another concern is that the transit of Russian gas to the EU
is highly concentrated in Ukraine, a country which is struggling to find an
appropriate regulatory framework for its gas sector. Increased
diversification of suppliers and supply routes, and provision of market
flexibility (back-up supply and/or demand management), will remain
crucial issues for the EU.
OECD Pacific: the gas industries of the OECD countries in the Pacific
region differ very much from each other: Japan and South Korea are
almost entirely dependent on LNG supplies, Australia is becoming a large
LNG exporter and New Zealand is so far self-sufficient. While Japan and
South Korea were the driving force of the growth in the LNG trade,
market reforms in both countries has led to more uncertainty about future
gas demand growth. This has led the LNG importing companies to seek
more volumes and pricing flexibility in their LNG contracts. Increased
competition among LNG suppliers, as well as cost reductions in the LNG
chain, allow producers to accept more flexible LNG terms. Security of
supply in the region has always been ensured through diversification of
supplies and infrastructure. The recently increased flexibility of LNG
trade allowed importing companies to swap LNG cargoes, e.g., to
exchange cargoes to meet peak gas demand. It allowed Japanese and
Korean buyers to successfully manage the seven-month shut-down of the
Indonesian liquefaction plant at Arun in 2001.
Policy-makers now have to define the objectives and the framework
for the global role of gas for decades to come. Decisions for major
expansions and replacement of gas and electricity infrastructure have to be
taken soon. These decisions stem largely from a need to enlarge and
replace power generating capacity (built in the aftermath of the 1973/74
and 1979/80 oil price crisis) with a view to minimising environmental
effects and GHG emissions. Due to declining domestic gas reserves in IEA
countries and the increased use of gas for commercial purposes, but also
for GHG mitigation reasons, the overall dependence on imported gas will
increase. That raises the question of a stable balance between the interests
of gas exporting and importing countries, the issue of diversification of gas
supply and the potential of the gas market to cover any interruption of gas
supply, or that of the electricity market to mobilise back-up capacity to
compensate for any shortfall in gas supplies.
28

2.2.2. Legally Binding Institutions

Legally-binding institutional frameworks have been set up in order to create transparent

and predictable rules of game within a market economy. Indeed, the need of “legislative”
legitimacy is inherent in national economic systems. Likewise, the development of law at
international level corresponds to the facilitation of cross-border trade. They
institutionalize practices of market economy: non-discriminatory trade, inter-state dispute
settlement mechanisms in case of frustration of interests by one of states, cross-border
investments with an international protection of investors against discretionary power of
host states, standards of contracts, etc.

Among the binding agreements, the most comprehensive trade arrangement is the
framework created by the World Trade Organization (WTO), which lays down uniform
international norms and practices for the promotion of competition. The WTO principles
can be summarized as follows: transparency of economic policies, interdiction of
quantitative restrictions, and of Most Favored Nation clause which supports non-
discrimination of trade partners. In addition, the WTO norms forbid subsidies that distort
trade. The system provides flexibility: it combines a legalist approach to international
economic law and the pragmatic power logic (Jackson, 1997: 109-111).

The impact on energy trade has not been significant. In fact oil trade has been de facto
exempted from the WTO principles since the oil shocks of the 1970s when consumer
countries proceeded to the diversification policies that aimed to restrict markets.
Moreover, the largest producing countries, such as Saudi Arabia, Iran, and Iraq, have
been outside the WTO for a long time. As for gas and electricity, they are considered
services rather than commodities. The current wave of liberalization in this sector,
consisting of the restructuring of vertically integrated companies, may further increase
the importance of the involvement of the WTO institutions in the sectors.

Dr S. Haighighi view on energy subsidies

§§ 5.4.9. The Agreement on Subsidies and Countervailing Measures
5.4.9.1. Introduction
Because of the strategic importance of energy and its related products, they have been
specifically provided for in some bilateral as well as multilateral agreements. Some of
these special treatments have been acknowledged to carry some trade distorting effects,
and one has been considered as a subsidy. Although the WTO law on subsidies is not
designed to expressly reflect upon subsidies granted in the energy sector, its general
provisions apply to such subsidies.
Subsidies are mostly used by governments as instruments of economic, social and
political policy and serve a variety of purposes, "including benefiting underdeveloped
regions, combating pollution, favouring particular constituents or economic sectors and
developing new technologies and products.” Moreover, the main rationale for regulating
subsidies is that their elimination will reduce energy consumption, raise economic
growth, contribute to the liberalization of energy trade by reducing trade-distorting
effects, which will all ultimately contribute to energy security.
One of the important features of the energy sector is that it has always been strongly
subsidized. Reasons for subsidization include the creation of better energy security
through increased energy production, or permitting a given country to diversify its energy
sources from, for example, coal to gas, through subsidization of gas production, or to
keep up with environmental standards through subsidizing those industries that, for
example, use renewable energy to produce electricity, etc. Moreover, the indirect link
between an energy subsidy and its effect on another economic sector where energy is
strongly used is clear. Subsidies are also strongly linked to the development of the
domestic industry of a given country. These are all reasons why the use of subsidies is
closely supervised in both the WTO and the ECT.
The definition of subsidies is an unsettled issue, and various definitions are provided by
different institutions dealing with energy. One definition adopted by the International
Energy Agency is that: 'an energy subsidy is any government action that concerns
primarily the energy sector and that lowers the cost of energy production, raises the price
received by energy producers or lowers the price paid by energy consumers". 763 This
definition tends to cover a vast array of activities in the energy sector, which can be
considered as interfering in the way prices would otherwise have been attributed to a
given act, such as consumption or production.
Within the WTO, however, a narrow approach to the definition of subsidies is taken. 764 As
defined by Article 1.1 of the "Agreement on Subsidies and Countervailing Measures",
subsidies are 1) financial contributions 2) by a government or any public body within the
territory of a Member State, which 3) confer a benefit. 765 All three requirements
mentioned above should be satisfied for an act to be considered a subsidy. A contribution
may be in the form of a direct or potential transfer of funds, forgone or relinquished
government revenue, provision of goods or services or the purchase of goods by the
government for an entity, and making payments to a funding mechanism.
The other negative effect of subsidies is categorized as their trade distorting effects. An
energy-exporting country can raise its share in the energy market through subsidizing its
energy production where a majority of energy production is dedicated to export. The
subsidy that is contingent upon the use of domestic energy rather than imported energy in
a specific sector could also indirectly affect energy exports. Moreover, if the importing
country takes up production activities, it will be adversely affected through the import of
cheaper subsidized energy products from other energy-producing countries that satisfy
the remainder of its domestic demand. Energy subsidies could also be dedicated to energy
transportation and marketing of energy. They could also indirectly affect other industries
where energy is used. Thus, it is clear that energy subsidies occupy a wide variety of
activities and touch upon many other economic sectors.
Subsidies that boost energy production can be said to be in line with concerns of
consuming nations over security of energy supply. This point, however, should be read
along with the fact that an increased flow of the volume of crude oil or natural gas does
not necessarily guarantee security unless the price of that energy is also reasonable for the
consumer. However, assuming that the price is reasonable, the subsidy, although trade
distorting, could guarantee security by increasing imports up to the limit of their demand.
As one author rightly declares:
[i]f a country is a net exporter of a product, the rest of the world as a whole must be a
net importer of it. Thus an export promoting subsidy for a product of which a
country is a net exporter, must improve the terms of trade of the rest of the world as a
whole. Net importers of the product thus benefit from improved terms of trade
arising from countries' export subsidies.
Based on this example, export subsidies could be considered as benign from the point of
view of international trade. However, the energy-producing countries seek to limit their
production and adjust their level of production to meet demand. Exporting beyond
demand would result in lower prices for energy, which will in turn lower their income
from that export. That is why OPEC countries undertake studies to lower or increase
production based on a supply-demand analysis.
The use of subsidies in energy-related activities has not yet been analyzed within the
context of the WTO. However, these types of subsidies were specifically addressed in the
context of negotiations on the accession of Saudi Arabia and Russia,. The analysis of the
law of subsidies in the WTO, as incorporated into the ECT, is elaborated on below,
followed by an analysis of the circumstances in which the activities in some energy-
exporting countries could be considered as subsidies.
5.4.9.2. A General Overview: The Law on Energy Subsides in the WTO
as incorporated intothe ECT i
Under the Agreement on Subsidies and Countervailing Measures (hereinafter the SCM
Agreement) a subsidy is deemed to exist when a benefit is conferred on an industry as a
result of (Article 1.1):
- A direct transfer of funds from the government (e.g. grants, loans, and equity
infusion), or potential direct transfers of funds or liabilities (e.g. loan guarantees);
- Foregone or uncollected government revenues (e.g. fiscal incentives such as tax
credits);
- Government providing goods or services other than general infrastructure or
purchasing goods;
 - Government making payments to a funding mechanism or to a private body to
carry any of the three functions described above; or,
- Where there is any form of income or price support in the sense of Article XVI of
GATT 1994.
WTO Panels and the Appellate Body have extensively elaborated on these forms of
subsidies in their rulings. However, the cases are very specific and in order to analyze
whether a certain activity is considered as a subsidy or not, the conditions surrounding
each case should be similar to those found in other cases already decided by the Panel or
the Appellate Body. The reason is that the SCM Agreement tends to adopt a rather
ambiguous wording in defining subsidies in order to cover as many subsidies as possible,
and the Panels have tended to restrict its scope by limiting their application. These
restrictions, as found in the rulings of the WTO, should become an important reference
point.
The Agreement on Subsidies distinguishes three types of subsidies: 1) prohibited; 2)
actionable; and 3) non-actionable. Based on Article 3 of the SCM Agreement, prohibited
subsidies are:
(a) Subsidies contingent, in law or in fact, whether solely or as one of several other
conditions, upon export performance, including those illustrated in Annex
I;
(b) Subsidies contingent, whether solely or as one of several other conditions, upon
the use of domestic over imported goods.
Those subsidies that are conditional upon either export performance or the use of
domestic over imported goods are prohibited, and Member States should neither grant
nor maintain such subsidies. A Member State that believes this type of subsidy is granted
or maintained can request consultation, and if no mutually agreed solution is found, the
matter will be referred to the Dispute Settlement Body of the WTO (Article 4).
Actionable subsidies are those subsidies that 1) injure the domestic industry of another
member, or 2) nullify or impair benefits accruing directly or indirectly to another member
or 3) inflict serious prejudice upon the interests of another member (Article 5). 770 If a
subsidy has these effects, the other Contracting Party has the right either to bring its claim
in a dispute settlement body, or to impose countervailing measures on imports of
subsidized products to an amount not in excess of the subsidy (Article 10-23 of the SCM
Agreement). By doing this, the price of imported energy increases and the injury is
alleviated.771 The Dispute Settlement System will decide on the effect of a subsidy and if a
violation is established, the violating Contracting Party can either withdraw or rectify its
adverse trade effects. Non-actionable subsidies are ‘tolerable subsidies’ and are defined
as those activities that provide certain assistance for research activities for disadvantaged
regions, or are those in line with promoting the adaptation of existing facilities to new
environmental requirements (Article 8 of the SCM Agreement).
Only specific subsidies are subject to the rules on prohibited and actionable subsidies as
laid down in Parts II, III and V of the SCM Agreement respectively (Article 1.2). The
argument for this distinction is that "multilateral rules are needed only to regulate
subsidies that distort the allocation of resources within an economy" and not any type of
subsidy.773 A specific subsidy exists "when the granting authority explicitly limits access
to a subsidy to certain enterprises" (Article 2(1)(a)) or when the granting authority
establishes objective criteria or conditions governing the eligibility for, and the amount
of, a subsidy.
In order to better clarify the rules on subsidies and its link to energy, one example will be
provided below, which has been a topic of controversy, especially during the WTO
accession negotiations of Saudi Arabia and Russia. This issue is the pricing of energy in
these countries and its link to the law on subsidies.
5.4.9.3. A Specific Analysis: Dual Pricing and the Question of
Subsidies
5.4.9.3.1. A Brief Remark
One activity directly linked to our energy discussion is 'dual pricing', which is argued to
be a 'hidden subsidy'. Dual pricing is practiced in various economic sectors including
energy. This practice is usually aimed at providing lower prices for products for export
and higher prices if they are for domestic consumption or vice versa, and the rationale is
to boost either exports or domestic production and consumption. This activity has been
subject to scrutiny in the WTO negotiations of Saudi Arabia and Russia, two major
energy-producing countries.
The analysis of dual pricing is important for few reasons: one is directly linked to the
study of the various provisions of the WTO as incorporated into the ECT, and dual
pricing is one good example of the inter-relation between these two frameworks.
Secondly, the dual pricing practice of some important energy-producing countries has
raised some interesting issues in negotiations on the accession of these countries to the
WTO, that not only question the adequacy of the WTO rules to deal with the energy
sector (and the ECT for that matter) but also shows where the interests of consuming and
energy-producing countries really lie. It can be argued that this analysis provides a good
occasion for analyzing the missed opportunity that the Energy Charter Secretariat had in
emerging as an institution, distinct from the WTO, where consuming and producing
countries alike can bring their claims and highlight their interests. These points will be
elaborated on further below.
5.4.9.3.2. Dual Pricing in the Energy Sector of the Energy-Producing
Countries: The Case of Saudi Arabia and Russia
Dual pricing, as practiced in Saudi Arabia, favours natural gas liquids (NGLs)
(hereinafter feedstock) for use in domestic production over those for export. For example,
the NGLs (ethane, propane, butane) are sold more cheaply if used in the petrochemical
industry of that country, and higher, if exported. One example provided by UNCTAD
could clarify this issue.
The United States imports Methyl Tertiary-Butyl Ether (MTBE), a petrochemical product
made from methanol, from Saudi Arabia. Saudi Arabia provides cheaper feedstock to
those producers (either domestic or foreign) that use them in Saudi Arabia’s
petrochemical industry and export the final product abroad. The feedstock is sold higher
to those entities that want to export it abroad without producing the product in Saudi
Arabia. American producers of ethanol (i.e. a product that competes with MTBE), claim
that the 'dual pricing' system, which exists in Saudi Arabia, subsidizes the MTBE through
low-cost provision of the raw material (i.e. natural gas and methanol) to refiners in Saudi
Arabia and therefore, the U.S. ethanol industry suffers as the import of the competing
product from Saudi Arabia increases. 776 This means that, through this practice, the final
goods exported from Saudi Arabia will increase and compete with like products in
importing countries. On the other hand, Saudi Arabia argues that, by providing cheaper
feedstock to domestic producers, more investors are attracted to invest in its
petrochemical industry and, therefore, this country can reap the benefits of the foreign
investment that will then ensue. They believe that this investment cannot be otherwise
encouraged.
The European Union has also raised concerns that this practice is indirectly affecting the
European petrochemical industry. The Association of Petrochemical Producers in Europe
(CEFIC) has been demanding an end to such a practice through lobbying, as they found
themselves at a comparative disadvantage with respect to the cheap import of
petrochemical products from Saudi Arabia. The executive director of this association has
raised his concern by stating that "the dual pricing is an obvious distortion of competition
and free trade. Once it is abandoned we will have more of a level playing field in the
world petrochemicals market".777 For this reason, dual pricing is addressed in the EU-
Saudi Arabia bilateral market access negotiations for the accession of Saudi Arabia to the
WTO. There have been promises on the part of Saudi Arabia to abolish "a number of
obstacles to international trade, such as dual pricing of gas products". 778 The negotiations,
however, failed in August 2005, the EU surprisingly abandoned its efforts, and Saudi
Arabia’s accession agreement was signed.
Before examining the compatibility of this practice with the WTO, a brief reference to the
subject of dual pricing in Russia is also useful for the sake of comparing the issues at
stake in the two countries. Russia's dual pricing is concerned with natural gas itself. Dual
pricing takes place because Russia charges lower prices for natural gas destined for
domestic consumption than for export. As one writer analyzes, differentiated wholesale
prices are set by the Russian Federal Agency Commission, and this differentiation is
controlled on the basis of numerous legislative and administrative acts. 779 There is also a
special export tax on gas exports. Moreover, the market of the Common Wealth of
Independent States is charged less than other markets, such as Europe.
Russia was not willing to fully abandon this practice, as a result of which their accession
negotiations in the WTO had faced obstacles. They have raised many arguments to
suggest that dual pricing does not fall within any category of subsidy as defined in the
WTO Agreements. Moreover, a World Bank study enumerated the merits of dual pricing
of Russian natural gas by explaining that if Russia eliminates this practice and unifies the
price of natural gas - thereby charging the same price for exports of its natural gas as it
charges in its home market- it would lose between 5 to 7 billion dollars per year, an
amount that cannot be overlooked in any given economy. Russia believes that domestic
prices of natural gas should be raised, but find no rationale for unified pricing between
gas that is sold domestically and exported gas.781
Interestingly, the European Union intervened in this debate through the framework of the
EU-Russia bilateral trade talks, and reached an agreement with Russia. Europe previously
argued, similar to what was mentioned above, that domestic energy prices in Russia are
much lower than the world prices, which led to unfair competition. It therefore proposed
their elimination during the WTO accession agreement. The reason was said to be that as
the Russian government has a monopoly over the energy industries, it imposes very high
export taxes to support a domestic price of gas at a level below the market price, which
was found to be inconsistent with WTO principles. On the other hand, Russia argued that
firstly, this practice is not undertaken to support domestic markets and secondly, it is
impossible for Russia to move to world energy prices in a single day. Finally, Europe
managed to convince Russia to increase the price of natural gas for industrial users from
the current 27-28$ to 37-42$ by 2006 and 49-57$ by 2010. 782 While this increase was
previously established in Russia’s energy strategy and domestic plan, Europe sought to
expedite the process.783 The rationale behind this increase is not readily available, or can
only be explained through complex economic terms, but this achievement was claimed to
bring Russia ‘a step closer to the WTO membership’. It was also claimed that the other
advantage of this outcome is that the increase in domestic energy prices encourages a
It is argued that dual pricing has some effects similar to a subsidy. The price of feedstock
is determined by the government at a level that could not be maintained if it was
otherwise exposed to market forces. Through this activity, the feedstock will be used for
domestic production, because it is cheaper than the feedstock destined for export.786
Granting the status of a subsidy to dual pricing as practiced in Saudi Arabia is
complicated, and the indirect complaints by the WTO or the EU are not forthright. There
is no express provision in the WTO that prohibits this activity. Although dual pricing is
referred to in the Agreement on Subsidies, it is defined differently from what occurs in
the pricing of feedstock in Saudi Arabia.
As mentioned above, a subsidy that is prohibited is either conditional upon export
performance or the use of domestic over imported goods. Moreover, Annex I of the SCM
Agreement provides a list of prohibited subsidies. As the provision of cheaper feedstock
is not conditional upon the two issues mentioned, we should look at Annex I to determine
its compatibility with its rules. Paragraph (d) of this Annex elaborates on one type of
prohibited subsidy as:
The provision by governments or their agencies either directly or indirectly through
government-mandated schemes, of imported or domestic products or services for use
in the production of exported goods, on terms or conditions more favourable than for
provision of like or directly competitive products or services for use in the
production of goods for domestic consumption, if (in the case of products) such
terms or conditions are more favourable than those commercially available 787 on
world markets to their exporters.
This provision can be named as one example of dual pricing. As mentioned in this
Article, in order for this activity to constitute a prohibited subsidy, several conditions
should be met. In simple terms these conditions are: 1) the government or its agencies
address domestic or imported products for use in the production of exported goods in
more favourable terms; 2) preference is given to these types of products only, and not to
those like products or directly competitive ones that are used for domestic consumption;
3) in order to determine whether this discrimination exists, the terms and conditions
based on which preference is given to goods for export should be more favourable than
those 'commercially available' on world markets to their exporters.
The last condition means that there should be unrestricted access to both domestic and
imported products, and the only way to prefer one product over another is based on
commercial consideration. One commercial consideration can be named as the price of
the product.788 For example, an exporter is attracted to export domestic products to a given
country because that product is cheaper compared to similar products on world markets
due to a preference given to that product. Here, the cheap price of the product makes it
commercially available to the exporter. Hence, dual pricing has taken place because the
government treats products for export more favourably than those destined for domestic
consumption through cheaper prices. It should be highlighted here that this provision
expressly deals with the favourable treatment of products that are destined for export and
not those that are destined for domestic consumption. The Saudi activity, for example,
could fall within the ambit of this provision (Annex I(d)) if the feedstock that is used in
the production of petrochemicals for export is cheaper than the feedstock that is used for
the production of petrochemicals for domestic consumption. As explained earlier, in the
sale of feedstock in Saudi Arabia there is a difference in price between the feedstock
itself, which is higher, and the feedstock that is domestically used in the Saudi
petrochemical industry, which is lower. Surely, only a very broad interpretation of this
article could encompass the Saudi practice. It is curious to see the extent to which the
existing provisions of the SCM Agreement could be interpreted to prove these activities
as against the basic provisions of the WTO. If this violation is found to exist, it should
still be determined what exemptions are available to these countries to maintain this
activity as an incentive to attract foreign investment. The latter issue is discussed later in
this section.
On the other hand, for the activity to fall within the ambit of this Annex, the condition of
‘specificity’ should be satisfied, which necessitates the grant of a subsidy to certain
enterprises only. In relation to the sale of NGLs (feedstock) in Saudi Arabia, specificity
would exist if feedstock is only sold more cheaply to particular enterprises. Therefore,
some kind of discrimination should exist between various enterprises in receiving this
benefit. This discrimination does not exist in the method of dual pricing in Saudi Arabia.
The raw material is available at a cheaper price for any enterprise established in Saudi
Arabia no matter if they are linked to the petrochemical industry or fertilizer industry or
any other industry that uses the feedstock.
The second condition established by Article 2(b) is also not satisfied. Article 2(b)
provides that when a granting authority establishes objective criteria or conditions
governing eligibility for a subsidy, 'specificity' does not exist if eligibility is automatic.
Automatic eligibility means that the criteria and conditions governing eligibility are
neutral and do not favour certain enterprises over others (e.g. based on nationality or
when locating a new petrochemical plant close to available sources of feedstock of a
given country is restricted to some enterprises). This discrimination does not exist in
Saudi Arabia.789 Cheaper feedstock is available to both domestic and foreign producers on
equal terms.
The third condition is more challenging. Article 2(c) provides that there are cases where,
although an activity may not fall within the first two parts of Article 2 on specificity,
there are reasons to believe that the subsidy is in fact specific. The factors to determine
specificity are:
1. Use of a subsidy programme by a limited number of certain enterprises,
2. Predominant use by certain enterprises,
3. The granting of disproportionately large amounts of subsidy to certain enterprises,
4. The manner in which discretion has been exercised by the granting authority in the
decision to grant a subsidy.
In applying this subparagraph, account shall be taken of the extent of diversification
of economic activities within the jurisdiction of the granting authority, as well as of
the length of time during which the subsidy programme has been in operation.
The first paragraph is ambiguous. It is not clear what exactly amounts to 'certain
enterprise'.790 Whatever the interpretation, it should be different from Article 2(1)(a)
where specificity exists where there is an 'express limitation' on the use of subsidy for
some enterprises. Therefore, it can be submitted that there should be an indirect limitation
on certain enterprises and an indirect specificity should thus exist. In this respect, the only
possibility that comes to mind is that the subsidy could only be used by some enterprises
due to the ‘nature’ of that enterprise. For example, the subsidy can only be provided for
those enterprises that use feedstock due to the nature of those enterprises, as opposed to
other enterprises engaged in activities for which no feedstock is needed. However, one
should also link this result to the second sub-paragraph of Article 2(c), which talks of the
"predominant use by certain enterprises". This could mean that since a subsidy can only
be used by some enterprises, an indirect specificity is established.
Through this last interpretation, however, as many subsidies as possible could be
included since the probability of any activity falling under this category is relatively high.
Although it may have been the will of negotiators to include a priori as many subsidies as
possible under the term 'specific',791 it seems dubious that the WTO Panel accepts such a
broad interpretation. This is more so the case when we look at the last sentence of this
paragraph, where 'the extent of diversification of economic activities of the jurisdiction of
the granting authority' should be taken into account in addressing the 'specificity' issue.
The Agreement suggests that, in calling a subsidy specific, some factors should be taken
into account, as mentioned above, and in applying them, the extent of economic
diversification should be taken into consideration. This sentence would mean that the
more the economy is diversified, the more enterprises exist in that economy, and,
therefore, it is easier to verify those enterprises that take advantage as opposed to others.
On the other hand, if the economic activities of a given country are not diversified, it
would be impossible to favour one enterprise over another, since there will be only one or
two major sectors in the country on which the economy is dependent. This consideration
could be directly linked to the situation of energy-producing countries, where their efforts
to diversify their economies from energy is common knowledge. Those countries, where
dependence on energy profits is high, have great difficulties in departing from the old
patterns of their economy and have little possibilities to promote new ones. Therefore, it
is doubtful that the subsidy is called specific in that situation. If one accepts the
arguments above, none of the conditions in the definition of a subsidy applies to the
practice of dual pricing of this country, and therefore, the practice can be maintained.
As mentioned above, on the other hand, the rules on actionable subsidies (i.e. only when
the requirements of specificity are satisfied) should also be analyzed to verify their
applicability to the practice of dual pricing. However, even if an activity falls under the
provisions of the WTO on actionable subsidies, the so-called ‘injured member state’ can
counter that practice through the adoption of countervailing measures, which are also
subject to various conditions as prescribed in the WTO. For example, the European
Union and the WTO argue that the pricing system of feedstock in Saudi Arabia creates a
preferential treatment for those that buy the cheaper feedstock, which indirectly damages
the petrochemical industry of other countries that do not have access to such cheap
feedstock. However, this ‘preferential treatment’ should be evaluated in detail, and a
totality of factors is necessary to establish the existence of such a benefit provided for the
recipients of cheap feedstock in Saudi Arabia to allow other members to impose
countervailing measures. One issue that could be looked at is the difference between the
prices of feedstock, because the main argument with respect to dual pricing is the
question of Saudi Arabia’s differential pricing system. 792 For example, imports should be
looked at to verify whether they are entered at ‘prices’ that will have a significant
depressing or suppressing effect on domestic prices and would be likely to increase
demand for these cheaper products. These issues could then be analyzed to determine
whether, for instance, the European petrochemical industry is seriously injured as a result
of this practice. Therefore, one issue to be analyzed here is whether the price charged to
the feedstock sold to producers, which was less than the one sold for export, really enjoys
a preferential rate.
The SCM Agreement does not provide adequate information on how and against what
benchmark the difference in prices should be compared. One could argue that the mere
fact that the government, or the state-trading enterprise, is selling feedstock at a lower
price to selected companies is adequate to determine preferential treatment. However, for
an actionable subsidy to be established, an ‘injury’ should exist. Therefore, charging less
should amount to ‘charging less than adequate’, which in turn results in an injury.
In the past, the Saudi Arabian government issued a decree that dedicated a 30% discount
(based on the lowest export price) to the feedstock used for domestic production. Later, in
2003, they abandoned this practice and substituted it with a mechanism which ties the
prices of products, such as LPG and other natural gas liquids, to the price in the Far
Eastern LPG markets. How would this pricing mechanism be analyzed for the purposes
of our study on subsidies? One could argue that an international price could be used, in
order to have a yardstick against which the prices of feedstock can be compared.
However, this is particularly problematic because there is no international price of LPG,
and prices still vary depending on their location and trading conditions. There is,
therefore, a high price volatility, which has made the price of butane (one type of LPG),
for example, to be 185$/t in the Gulf in 2002 compared to 175$/t in North West Europe. 793
This example shows that a ‘generalized’ approach to the issue of dual pricing is not valid.
Imposing lower prices on feedstock for domestic production rather than for export in
Saudi Arabia does not necessarily mean that prices in Europe are higher. Hence, in order
to determine the discrimination, they should be compared either with each other or with
other competitive feedstock such as ethane, naphtha and gasoline and at a given point in
time. In this case, if the price of the Saudi LPG is based on a link to naphtha prices in
Japan, the possibility remains that this price is higher than the price of LPG in North West
Europe. Therefore, the dual pricing practice does not necessarily create a competitive
disadvantage for Europe’s petrochemical industry because they have access to cheaper
feedstock compared to that sold in Saudi Arabia.
The complexities of the issue of dual pricing in Saudi Arabia demonstrates that this
practice can neither be considered as a prohibited subsidy nor necessarily as creating an
injury to the European or the American petrochemical industries. The issue has to be
decided on a case-by -case basis. An outright ban of this practice is therefore not justified
and it is surprising that this issue has come up as a ‘legal issue’ in the negotiations on
Saudi Arabia’s accession to the WTO. The issue can be considered as a rather political
issue within the context of a political bargain between various members of the WTO and
Saudi Arabia.
Two other issues related to dual pricing should be highlighted. One is a reminder of the
fact that the WTO and the ECT only regulate the activities of states and not private
bodies.

In addition, the practice of the international arbitration (both inter-state and state-
investor) forms a complex chain stemming from different Conventions including: GATT
1947 (further integrated within the WTO system), the New York Convention of 1958, and
the Stockholm Chamber of Commerce with the arbitration tribunal of 1965. International
arbitration is a necessary tool for the private commercial companies in order to secure
their relations with host countries during investment projects. International arbitration
procedures contribute to the centralization of practices by promoting investor-state
dispute settlement procedures, which have strongly increased in numbers during the last
decade (Allen & Overy, 2004). International arbitration procedures are mostly used by
private commercial companies, which have the necessary resources to defend their own
rights against a particular state, which is very costly.

Another international legally binding institution is the Law of the Sea. Adopted within
the framework of the United Nations, the Law of the Sea is a set of norms which involves
the delimitation of the Territorial Waters of the Continental Shelf and of Exclusive
Economic Zones. The freedom of transit in water areas has facilitated energy trade,
allowing the free construction of pipelines under the sea, whereas onshore cross-border
pipelines are subject to various national licensing procedures. In this regard, the Law of
the Sea represents one of the most consensual international practices among legally-based
mechanisms. The Law of the Sea contributes to the facilitation of maritime energy trade.
Therefore, the transport by offshore pipeline as well as by tanker represents a lower
transaction cost as they do not require any licensing procedures.
 2.2.3. Issue-Specific Regimes

More particular agreements, which directly involve the sector of energy trade is the
Energy Charter Treaty (ECT). The ECT is the first institution of energy trade. It was
signed in 1994 by 52 countries representing major energy producers on the Eurasian
continent (Azerbaijan, Kazakhstan, Norway and Russia), as well as EU member states,
Japan, and Australia. The Treaty covers all cross-border energy markets though it’s main
focus is to cover the oil, gas, and electricity sectors. For its trade provisions, the ECT
integrates the values established within the WTO framework. The ECT presents an
additional set of practices for international arbitration. It favors conciliation between
states and provides clear conciliation procedures. In the field of energy investments,
investors prefer to use the Energy Charter Treaty framework when claiming their rights
from the host states.

The ECT contains a particular focus, it attempts to constitute a legal framework for the
freedom of the transit of energy. The Treaty outlines two major aspects of the freedom of
transit, stipulated in article 7:

1) Non-discrimination in access to the transit onshore pipeline network

2) Non-discrimination when according rights to construct new onshore transit
capacities

The institutional framework presented by the Energy Charter Treaty is an evolving set of
initiatives related to the facilitation of energy trade. In addition to the text of the Treaty
itself, contracting parties are in the process of negotiating a transit protocol. The protocol
aims to reinforce and clarify aspects related to the allocation of available capacity in
networks, and non-discrimination in tariffs. The Transit Protocol has provoked a number
of controversial reactions. For instance, Russia’s major gas producer Gazprom is
unwilling to give up its trade practices with transit states in favor of non-discrimination.
Gazprom considers the Transit Protocol contrary to their commercial interests and
reserves the right to the totality of it’s transport capacity through it’s bilateral agreements.
However, the ECT’s Freedom of Transit still ensures Gazprom’s free transit to the
European markets.

Though perhaps not evident by Gazprom’s actions, the feedback concerning the Transit
Protocol is very clear: states and private commercial actors are willing to establish a clear
framework of practices. Already the Transit Protocol is mentioned in the host-government
agreement for the one of the longest cross-border pipelines (Baku-Tbilissi-Ceyhan) from
private consortium oil companies and transit states Azerbaijan, Georgia, and Turkey. The
reference to the ECT norms and arbitration practices enhances the viability of the host-
government agreements.

Energy Charter Treaty: short overview

The Energy Charter is an international organisation established by the Energy
Charter Treaty (ECT). The Treaty has 52 signatories 30. It contains legally
binding obligations to be upheld by its contracting parties regarding protection
of foreign direct investment in the energy chain, international trade in energy,
international trade in equipment related to the production of energy, transit
of energy, and intergovernmental cooperation in the field of energy efficiency.
Political concern about the security of European natural gas supply was an explicit
and major driver for the agreement on the European Energy Charter of 1991,
a political declaration which started the Energy Charter process.
The ECT itself has no explicit references to security of supply, but its rules and
the Energy Charter process are directed at maintaining and improving energy
security. The Treaty and its Protocols combine rules for securing investment,
transit, trade, and energy efficiency enhancing supply security in general, and
the security of natural gas supply in particular, by promoting favourable
business conditions in the various elements in the natural gas chain, natural
gas production, transmission, transit, distribution and supply. Rules for the
protection of foreign direct investment reduce investors’ risks in ECT member
states in general and in economies in transition in particular. ECT’s transit rules
protect natural gas in transit, whereas the trade rules secure non-discrimination
and respect of the World Trade Organisation (WTO) rules also in ECT
countries not yet members of the WTO. ECT countries are committed to
promote energy efficiency, which not only contributes to an improvement in
energy security by reducing the energy use, but also reduces the environmental
impacts of the energy cycle.
In addition, the policy dialogue and international cooperative efforts in the
Energy Charter process are focussed on improving the functioning of the
energy markets by removing distortions and barriers to competition (the latter
is considered as a major instrument of improving efficiency in the energy
30 Albania, Armenia, Australia, Austria, Azerbaijan, Belgium, Belarus, Bosnia and Herzegovina, Bulgaria,
Croatia, Cyprus, the Czech Republic, Denmark, Estonia, the European Communities, Finland, France, Georgia,
Germany, the Hellenic Republic, Hungary, Iceland, Ireland, Italy, Japan, Kazakhstan, Kyrgyzstan, Latvia,
Liechtenstein, Lithuania, Luxembourg, the Former Yugoslav Republic of Macedonia, Malta, Moldova, Mongolia,
the Netherlands, Norway, Poland, Portugal, Romania, the Russian Federation, the Slovak Republic, the Republic
of Slovenia, Spain, Sweden, Switzerland, Tajikistan, Turkey, Turkmenistan, Ukraine, the United Kingdom of
Great Britain and Northern Ireland, and Uzbekistan.
226
supply chain, adding to multiplicity of supplies as a way to adequately respond
to the growing energy demand), and by promoting market reforms and
restructuring of the energy sector. The Charter process is an important part of
the international efforts directed at creating an open and competitive Eurasian
natural gas market as stipulated in Article 3 of the ECT.
The key dimensions of the ECT activities related to the security of natural gas
supply are outlined below in more detail.
Foreign direct investment
The expected increase in demand for natural gas on the Eurasian continent of
more than 40% over the next twenty years, as well as the need to replace
production from existing fields in decline on the continent, will require
significantly increased investments in natural gas production, transportation
and distribution across the Eurasian continent.
The fundamental objective of the ECT is to ensure the creation of a “level
playing field” for such energy investments throughout the Charter’s constituency.
The ECT ensures protection of energy investments based on the principle of
non-discrimination. By accepting the Treaty, a state takes on the obligation to
extend national treatment, or most favoured nation treatment – whatever is
the most favourable – to nationals and companies of other member states
who have invested in the energy sector. This protection is applicable for existing
investments. As a complement to the legal obligations and rights there is in the
Energy Charter process a constant focus on general investment climate issues
by providing regular assessment, through survey activities and peer reviews, of
investment practices in the participating states. The aim is to improve the
general investment climate in the energy sectors of the member states.
Transit rules
Transit of gas is of increasing importance for the supply to the Eurasian
market and improving the access to transit will result in an improved security
of supply. The ECT’s transit rules oblige the participating states to facilitate
the transit of energy, and therefore also of gas, on a non-discriminatory basis
consistent with the principle of freedom of transit. These rules are currently
being enhanced through the elaboration of a legally binding Transit Protocol,
which will develop a regime of commonly accepted principles and “minimum
standards” for transit flows. The aim of the Protocol is to establish, inter alia,
negotiated access to available capacity and it sets the principles for transit tariffs.
227 227
31 They are Azerbaijan, Belarus, Bosnia & Herzegovina, Kazakhstan, Russian Federation, Tajikistan, Turkmenistan,
Ukraine and Uzbekistan (situation as of November 2003).
Trade rules
The ECT’s trade regime applies by reference WTO rules and practices, which
are founded on the fundamental principles of non-discrimination, transparency
and commitment to the progressive liberalisation of international trade. The
Treaty’s trade regime represents an important stepping-stone for the nine
member states that have not yet acceded to the WTO 31. The commitment to
non-discrimination and trade liberalisation is also an important element in
securing gas supplies by creating a stable international framework for gas trade
from multiple supply sources.
Dispute settlement
The ECT’s provisions for dispute settlement are crucial elements in securing
the application and respect of the Treaty’s fundamental rules. In the area of
investment, the ECT establishes dispute settlement procedures concerning
the application or interpretation of the ECT. There are rules for dispute
settlement between a private investor and member state of the ECT and there
are also rules for settling state-to-state investment disputes. In addition, there
are specific mechanisms under the Treaty for trade-related disputes between
member states of the ECT.
Policy dialogue
Policy dialogue supported by analysis of key energy market and policy issues
is increasingly becoming an integral part of the Energy Charter process. At
present, a major part of the Energy Charter activities is focussed on issues
related to the Eurasian gas and electricity markets and has directly or indirectly
a bearing on policies related to the security of natural gas supply.
Some examples of the ongoing work in gas-related areas are:
Gas pricing: a structural issue affecting the competitiveness and the security
of supply of the Eurasian natural gas market is the lack of cost-reflective
natural gas prices in about 50% of the Eurasian market, predominately in
Central and Eastern Europe and in the CIS countries. In order to support
the policy dialogue on this important issue, the Energy Charter Secretariat
has undertaken in-depth analysis of the economic and gas market effects
228
of the needed gas price reforms, taking into particular consideration possible
social effects of price increases to cost-reflective levels;
Alternative sources of gas – liquefied natural gas (LNG): LNG has the
potential to both reduce short-term security of supply uncertainties as well
as long-term security of supply issues related to over-dependence on one
source of supply of natural gas in Eurasia. Lower costs and the emergence
of a more competitive global LNG market could increase this role.

Article Belyi & Klaus, “Transit Dispute Resolution Mechanisms in the ECT and
Russia Missed opportunities for Gazprom or false hopes in Europe?”, Journal for
Energy and Natural resource Law, August 2007

1. Role of Dispute Settlement Mechanisms in the Political Approaches: Realpolitik

vs Institutionalism

In modern International Relation theory, much of analysis is attributed to the use of

institutions by states for their foreign policy purposes. Addressing the issue of state
influence at the level of international institutions, various models are proposed. In this
context, D. Dessler (1987) suggests taking into account two ontologically different
models of states’ “action” and “interaction”. First, Dessler distinguishes a positional
model containing three phases: (1) unit action => (2) interaction => (3) its result (i.e.
arrangement between units). Second, he conceptualizes a transformational model, which
involves (1) existing set of rules => (2) action using the rules => (3) transformation of the
structures of rules. The first model largely corresponds to the bilateral interstate relations.
The second rather reflects the international norms as an impacting factor on the
international system.

Both models are interdependent: an arrangement resulting in the positional model can
involve a creation of international norms; a transformation of norms of the transformative
model does not exclude inter-state power relations. The two models reflect the way a
state can use its power within in relation with other states and the way to take into
account a normative interdependency. The present article schematizes the two models in
the following way: on one hand, the positional model reflects the Realpolitik approach,
where states resolve disputes by direct arrangement with another state involved in the
conflict; on the other hand, transformative model outlines an institutionalist approach,
where an international actor prefers to use norms of the international arbitration to
resolve a dispute. The agency-structure perspective of the two approaches suggests that
international actors have a power to decide whether to use one or another approach.

Realpolitik approach

The Realpolitik approach is generally defined by states pursuing their national interests
within international structures. In light of a realist conception presented by K. Waltz
(1979), states are acting accordingly to their structural power within international
relations. Waltzian system assumes states to struggle for survival within an international
system characterized by an absence of any “world-wide” authority. States define their
national interests in relation to their security within this structure. This security approach
is not proportional to the power of the state within international structures. Therefore,
Realist approach does not define security to be a direct consequence of threat, but is,
rather, defined as the result of the political interpretation of that threat, a process called
“securization”. Hence, a definition of national security, according to the more modern
approaches of Realpolitik, means “something much more specific than just any threat or
problem.” (Buzan, 1996)

This approach considers the international law as a state-handled devise in order to defend
their interests. In turn, the international law is neglected when a state does not find it
appropriate for its security reasons. The security factor remains the most important and
the international law is serving to defend national security.

Institutionalist approach

The institutionalist approach stems from the current development of international norms
and regimes. A crucial contribution to institutional analysis has been provided by analyst
D. North. According to his definition, institutions are “the rules of the game in society or,
more formally, are the humanly devised constraints that shape human interaction”
(North, 1990: 3). D. North marks how formal and informal constraints have been created
by practices, which then lead to the formal development of institutions. (North, 1990:
69). D. North’s definition opens the idea of institution to a broader sense of the term, but
does not overlap the definition of organization. D. North conception of institution is
based on is the objective centered view, believing that the institutions are created purely
out of the goals they are attempting to reach. The constraints on international economic
interactions, or international practices, demonstrate the growing number of knowledge-
based, legal and contractual institutions. In international relations theory the influence of
an institution on international structures is defined by international regimes: implicit or
explicit principles, norms, rules and decision making procedures around which actors’
expectations converge (Krasner, 1982).

Institutionalist theories often use the term “legalization”, which is defined as a need for
states to find a legal legitimacy for political actions. The rule of law becomes a necessary
part in improving investment climate. Here, this approach contrasts with Realpolitik:
national security is not the priority of the international relations, instead, the priority is
the economic development with the cross-border trade (Gilpin, 2001).

Political approaches and DSM

In this context, the dispute settlement mechanism (DSM) is reviewed within the two
proposed models. Within the realist perspective, states are the only legal personalities in
the international relations structures. They create international norms and can choose not
to be bound by them. Herein, states are the only official 'subjects' or 'persons' of
international law because they have the capacity to enter into legal relations and to have
legal rights and duties. According to realists, the DSM stems from the legal positivism,
which views an instrumental dimension of the law in resolving disputes. From this
perspective, the DSM is rather related to the pressure that one state can exert on the other
via the use of international law.

From the institutionalist perspective, the international law is related to the consideration,
which identify the principles and rules as necessary to live in a predictable international
society. In particular, the institutionalist approach points out the importance of the
transparent and non-discriminative legal regime for the investors: Likewise to the
institutional economics, it helps “to explain the function of the rule of law with respect to
both objectives of international investment treaties, the promotion of foreign investment
and economic growth and development” (p. 32). Hence, none of the models opposes the
DSM per se, but the international arbitration norms find a positive context for their
development within institutionalist approach.

The present article outlines a possibility for international actors to choose between the
two approaches in their international strategy. The choice of the approach also influences
the value of the DSM in interstate relation. The article roughly relates the Realpolitik
approach to the preference of the state to use directly the bilateral interstate arrangements.
In turn, the instituionalist approach involves more the use of the international norms
(including DSM) in defending international actor’s interests.

2. Political Approaches Towards Eurasian Gas Markets

The present article attempts to schematize both approachs, Realpolitik and institutionalist,
in the Eurasian gas trade. The schematization aims to define the strategy of the main
political actors towards the dispute prevention. In accordance with the afore-mentioned
theoretical scheme, four different approachs can be defined: institutionalist approach of
the EU, moderate institionalist approach of its Member States, moderate Realpolitik
approach of Ukraine and the Realpolitik approach of Russia.
Institutionalist approach of the EU and its Member States

The most institutionalist actor is the European Union (EU). The EU is a combination
between an international organization and an international actor. The external energy
security as well as the energy market regulation remains dominated by intergovernmental
logic of an international organization, whereas the discourse of the EU officials attempt
to represent the economic union as a very coherent entity. The EU legal system is based
on the jurisprudence, where the European Court of Justice served a role of promoting
transparency and non-discrimination. The EU system has a legal institutionalist approach,
therefore the EU accords an important place to the legal dimension of its external
relations. Therefore, the EU considers relevant to establish clear and predictable
institutional relation with energy producing countries, such the Energy Charter. On these
grounds, the EU strongly supports Russian ratification of the ECT, which is mainly
blocked by Gazprom’s lobbying at Russian Parliament.

The EU external energy policy is also characterized by an exporting the EU model of the
internal market. In particular, this policy is translated into the Energy Community Treaty
with South East Europe and requires the adoption of the acquis communautaires of the
energy regulation (such as the third party access, unbundling and coordination between
regulatory authorities) to the Contracting Parties. Although the Treaty is supposed to
further enlarge to Ukraine, Kiev remains outside the application of the acquis
communautaires. As far as Moscow is concerned, it remains reluctant to any EU-driven
law making inside Russia.

The political approach of the EU Member States is not especially same as of the Union,
although the countries are on the source of the European integration. Mainly, the
institutionalist approach of the EU is moderated by the security concerns regarding the
energy security. The best example has emerged in the UK, while British authorities
blocked the penetration of Gazprom into Centrica. Basically, the security argument is
reinforced by the events of January 2006: if Gazprom does not prove to be a reliable
supplier, the image which has been partly damaged during the crisis, it should be
prevented from the distribution networks and retail markets in the EU Member States.

Realpolitik approach of Russia and Ukraine

By contrast, countries emerged from the former Soviet Union (FSU) are less experienced
in the international arbitration and in the application of the international norms. The gas
trade between Russia and Ukraine is governed by bilateral agreements:

 Russia-Ukraine agreement on supply of Russian gas to Ukraine and on transit systems

of gas through the territory of Ukraine (18.02.1994) ;
 Russia-Ukraine Agreement on Mutual Assistance in Trunk Pipeline Exploitation
(26.07.1995);
 Agreement between Russian Government and Ukrainian Council of Ministers
(01.10.2001), complemented by a Protocol (02.07.2004);
 Agreement between Russian Government and Ukrainian Council of Ministers on
strategic cooperation in gas sector (7.10.2002) complemented by agreement between
Russian Government and Ukrainian Council of Ministers on the implementing the on
strategic cooperation in gas sector (18.08.2004)

The agreement of the 2001, in its Article 9, provides only a narrow definition of the
DSM: of “disagreements to be settled amicably between the parties to the dispute”. The
political agreements are implemented by specific private commercial arrangements
between the respective monopolies Naftogas and Gazprom. Gazprom has the right to take
part in capacity expansion in Ukraine, of which the new capacity then becomes
« common property ». Gazprom is able to reserve the right to use of the entire transit
capacity of Ukrainian networks. In 2001, the agreement between the Russian
Government and the Ukrainian Council of Ministers established rules for supply and
transit. Gazprom may pay a pre-established transit fee in natural gas in exchange for
transit services.

During the crisis of January 2006, Ukraine demonstrated a willingness to use the DSM.
The Ukraine’s willingness to use the idea of international arbitration was motivated by its
political pro-western orientation, which is reflected in the diplomatic semantics of
Ukrainian officials since the “Orange revolution”. Nevertheless, the parties continue to
prefer conflict resolutions by bilateral political agreements. This situation underlines that
using arbitration is more complex in practice than in discourse. Reasons for Ukrainian
gas monopoly Naftogas to avoid the ECT dispute settlement mainly consists in the non-
transparency about the gas underground storages and about the available capacity in the
networks. In particular, the ECT article 7 provisions could be used against Ukraine for
violating transit obligations, but Ukraine can hardly use the ECT against Russia for
reducing supplies. Moreover, the bilateral agreement of 2001 states that in the case of a
violation of the established transit agreement, Russia may reduce either payment for
transit or volumes for Ukrainian domestic supplies. Instead, Ukraine can use its transit
position as a factor of pressure on Gazprom in its bilateral relations with Russia.

As far as Russia is concerned, its state owned monopoly clearly rejected any idea of an
international arbitration during the crisis of January 2006. Russia preferred to exert
pressure on Ukraine in order to achieve better economic (tariffs increase) and political
(political regime change) in Ukraine. As far as the attitude towards the ECT is concerned,
Gazprom opposes the ECT for the three following reasons, which are continuously put
forth by Gazprom officials and experts12:

First, the ECT in its provisions is facilitating energy transit, allows for private pipelines
and pushes for a non-discriminatory approach therein. Moreover, Gazprom officials are
convinced that the freedom of transit also involves third party access for Central Asian
producers to Ukraine and Western Europe. The latter argument has been proved to be the
effect of a misunderstanding, as the transit provisions do not involve the third party
access. Nevertheless, Gazprom fears that the ECT framework can be used against its
12
O.Butchnev, M. Nedzveckyi, “Vlianie Processov glovalizacii na rossijskuu gazovuu promyshlennost”,
Gazovyj Biznes, May-June 2006, pp. 40-42.
domination within the FSU area. In particular, Gazprom opposes any possibility of
granting licenses for non-state own pipelines.

Second, the ECT does not integrate pre-investment phase in its investment provisions.
For that reason, the United States did not sign the ECT because it does not include the
necessary clauses for a pre-investment climate and treats purely post-investment
situations. For Gazprom, a non-discrimination clause for a pre-investment situation is
necessary for its strategy to get distribution markets in the EU.

Third, Gazprom considers that the dispute settlement mechanism foreseen by the article
7(7) for transit issues is imperfect. It attributes too much power and responsibility to the
conciliator, who can decide on tariffs and supplies for a period up to 12 months. These
arguments demonstrate that Gazprom prefers to deal with conflicts on bilateral basis and
to avoid a multilateral involvement.

The general opposition of Gazprom to the ECT is based on the general perception of it as
a consumer-based mechanism. Instead of the traditional formula of “investment vs.
supply”, Gazprom prefers “supply vs. market”, where it can keep a dominant position. It
goes in line with the newly established strategy of Gazprom, which intends to become an
“energy superpower.”

An analysis of the international actors’ attitudes towards the two approachs of the
international behavior demonstrates contradiction between the EU institutionalist
approach and Gazprom views on Eurasian gas markets. It involves a clear misperception
of Gazprom’s interests: according to the European approach, the use of the DSM would
provide a better set of opportunities than the existing Realpolitik approach. The EU is
expecting Gazprom to move towards a new logic, regardless political practices within the
FSU. On these grounds, it is necessary to understand (1) if and in how far the ECT
institutional framework could be used by Gazprom in its strategy.

3. Gazprom and the institution “ECT”

The current position of Gazprom concerning Russia’s ratification of the ECT is clearly
negative and an intense lobbying of its position in the Russian Duma, which has stated in
2001 the conclusion of the Transit Protocol as a condition for the ECT ratification. At the
same time, three concerns within the Transit Protocol remain the major obstacle for the
ECT ratification: the calculation of transit tariffs, the Regional Economic Integration
Organization Clause and the so called “Right of First Refusal”13.

a. Gazprom and the fallout of the Realpolitik-approach in January 2006

But despite all these arguments against ratification, the Russian-Ukrainian Gas crisis in
2006 created a momentum in which some of the possible benefits of the ECT for Russia
and Gazprom became visible. Next to the benefits propagated widely, like the attraction

13
Shtilkind, Energy Charter Treaty – A critical Russian perspective, TDM, Vol. 2, Issue 3 June 2005.
of investments, energy security etc., Russia could have used the transit provisions of the
ECT to improve its legal and political stance in this conflict. The gas crisis displayed the
classical conflict between a supplier and a transit country aimed at in Art. 7 ECT.

Looking back in recent history, one may discover that this conflict actually is a constant
pattern between Russia and the Ukraine which has developed out of a mixture of Soviet
heritage and a lack of will and abilities on both sides to integrate a market approach in the
energy trade. From time to time this conflict erupts, but never got as much attention as in
January 2006.14

As already mentioned before, bilateral relations were usually favored the Russian side
being much more power- and resourceful than the energy dependent (and energy
inefficient) Ukraine. The bargaining power of the Ukrainian side in these negotiations
generally spoken is reduced to the transit tariff hikes or interruption of flows.

Under the Realpolitik-approach, Russia and Gazprom by far had a better bargaining
position than the Ukrainian side. Furthermore, by raising the gas prices, Gazprom had
economic arguments on its side, too, in trying to obtain higher, market-orientated prices
for its gas. And finally, despite all the interdependencies and bonds knitted in Soviet
times, there exists no obligation from the Russian side to subsidize the energy inefficient
economy of the Ukraine.

Political pressure in order to influence the new western-orientated Ukrainian government

and the voters are sure to have played a role in the time-setting, rhetoric and staging of
the dispute. The culmination, shutting of the pipeline valves on new year’s day 2006
broadcasted live on television, showed that far more than purely economic needs and
dissensions were at work here. While the economic questions under discussion have
brought the conflict as such on the agenda, political motives have definitely influenced
the setting of the crisis on the Russian side.

The spill-over of political Realpolitik-pressure beyond the economically justified claims

has in the end backfired on Russia. Timing and psychology must not be underestimated in
the political fall-out that followed. The staging of the crisis was clearly aimed at the
Ukrainian (and Russian) audience, whereas the possible reactions in the West were
completely ignored. Moreover, we have observed a willingness to make this crisis public
and mass-media oriented. Somehow, Gazprom attempted to make a demonstrative action
against Ukraine.

In order to estimate the fall-out of Russia’s Realpolitik-actions, one must sketch a short
slightly exaggerated personality program of the western audience. Europeans felt that
Gazprom could use this power against them as well.

In this psychological environment the (overreacting) outcry from western society, press
and politicians struck Russia unprepared and the echo could be heard all through 2006.
Of course Russian policy strategies first and foremost have to serve Russian interests and
14
Liesen, Transit under the 1994 Energy Charter Treaty, JERL Vol. 17, No. 1 1999, p. 58.
to please the Western audience as such is not on Russia’s agenda. But taking a second
look choosing power politics over institutional behavior may have harmed Russian
interests more than it seemed.

In a political sense, Russia gets away with ignoring Western energy sensibilities as long
as there is enough undiversified European demand for Russian gas and no Russian
companies want to get involved substantially in the European downstream consumer
market. But exactly these conditions are bound to change.

While European supply diversification seems to be a rather slow process, it is clearly a

part of Gazprom’s strategy to expand into the European consumer markets. Economically
it is very interesting for Gazprom to control the whole gas chain from the extraction to
the end consumer’s markets.

But even if the Realpolitik-approach towards the Ukraine may have been a rational
choice to gain maximum political and economic profit in the bilateral relations, it
significantly harmed Gazprom’s chances with regards to other vital interests of Gazprom
and Russia, namely to enter the European consumer’s markets. Liberalization in the
European gas markets while having difficulties is advancing and poses a unique chance
for Gazprom to diversify its own demand structure by taking over the supply of end
consumers directly. But apart from the fact that foreign investment in infrastructural
industries, especially in the energy sector, is always looked at skeptically, the Russian
Realpolitik-approach in the mid-term perspective did harm Gazprom strategy in getting
distribution markets.

Although, western European energy markets are relatively open to third country investors
the overall mood concerning especially investments from state-backed Russian gas
monopolist Gazprom could change substantially. Next to the already installed common
safeguards to ensure economic competition, national and European competition law,
Gazprom could face much more resistance when political actors in Europe as well as
their public opinion call for a limitation of foreign investment in certain strategic
industries.

Therefore, the Realpolitik-approach of Russia towards the Ukraine indirectly limits its
abilities to engage with further players in the EU area, which basically cling to the
international institutions to sort out their conflicts.

b. Crisis solution under Art. 7 ECT

The question is, if a more moderate and institutionalist approach during the gas disputes
with the Ukraine could have brought Russia and Gazprom an overall gain. The first
question of course is, if Russia actually could have used the instruments transit dispute
settlement mechanisms implemented in Art. 7 (7) ECT during its dispute with the
Ukraine.
According to Art. 45 ECT Russia applies the ECT provisionally. The treaty applies as
long as national Russian laws and regulations do not prohibit a provisional application of
the treaty or certain clauses. As far as one can say so far provisional application of Art 7
(7) ECT seems possible under Russian law.

The DSM of Art. 7 (7) apply and may be invoked by one of the Contracting Parties if “in
the event of a dispute over any matter arising from that Transit” (Art. 7 (7) and (6) ECT)
occurs with regard to another Contracting Party.

The conflict, as mentioned above, arose around a mixture of disputed problems

comprising questions of transit and supply tariffs and conditions which were inevitably
interconnected due to the barter nature of the gas agreement between Russian and the
Ukraine15.

Art. 7(6) and (7) ECT do only apply to conflicts arising over transit not conflicts over
supply. There is also no other provision in the ECT that applies to the fact, the conditions
or the tariff of energy supply. The ECT signatories wanted to leave this directly to the
players involved.

As a result to this limitation to transit a possible dispute resolution according to Art. 7

ECT would have included only the transit tariff dispute between Russia and the Ukraine.
The price hike for gas supplies to the Ukraine would not have been object to the dispute
settlement process. Even if transit and supply maybe economically and politically
interdependent, the DSM under Art. 7 ECT does only extend to the transit. This
restriction is underlined by the fact, that according to Art. 7 (7) c ECT the conciliator can
only decide on the “interim tariffs and other terms and conditions to be observed for
Transit from a date which he shall specify until the dispute is resolved.”

For the Russian-Ukrainian dispute this restriction to transit would have meant that after
the “exhaustion of all relevant contractual or other dispute resolution remedies previously
agreed between the Contracting Parties” (Art. 7 (7) ECT) either of the parties could have
started DSM procedures under Art. 7 ECT. According to Art. 7 (6) ECT the Ukraine in
this case would have been prohibited to interrupt or reduce the gas flow to Europe prior
to the conclusion of the dispute resolution procedures.

This situation would have put Russia in a rather comfortable situation. While the
Ukrainian bargaining power with regards to transit reductions and interruptions would
have been bound by an international treaty, the own obligation to supply the Ukraine with
gas would legally and economically only have been relevant within the bilateral relations.

Using the ECT as an international institution in this specific situation Russia could have
gained more, than it gained using power politics. The Ukraine would have been partly
neutralized by the DSM proceedings concerning transit. During the conciliation period of
90 days (Art. 7 (7) c ECT) Russia could have started a communicative offensive in order
to explain its economically driven price hikes to a western audience, which in a cool
15
Stern, The Russian-Ukrainian gas crisis of January 2006, p. 1.
atmosphere could hardly have rejected the argumentation with market prices. By using
the dispute settlement procedures of the ECT Russia could have shown that it is willing to
use international institutions. This would certainly have raised the image of Russia in
Europe and diminished any tendencies towards sealing Europe off from Russian
investments in the European energy sector.

On the other hand any disruptions in the transit of gas to Europe during the formalized
conciliation and with regards to the provisions in the ECT could have more easily been
blamed on the Ukraine. This would have forced Europe to take a more critical stance
towards the Ukraine that it happened during and after the heated crisis in January. Russia
could have used one of the very advantages of international institutions, which is, to
create a cooled down playing field and equilibrium.

Russia has already realized that it has to distinguish its approach towards the FSU
countries (more of a Realpolitik-approach) and Europe (more of an institutionalized
approach). But so far and especially in the January gas crisis Russia has failed to realize
that a too harsh or an ill communicated power politics approach towards its FSU
neighbors may also threaten its stance in Europe.

Nevertheless, a weak point of the article 7 of the ECT is the opposition of Russia towards
the DSM itself. The Western countries seem inflexible to modify any norms related to the
art. 7 (7). In turn, this inflexibility complicates the willingness of Gazprom to allocate a
right to a third party to decide on tariffs during the mediation within the framework of the
Energy Charter. Likewise, the Energy Charter DSM is hardly applicable in the context,
where Russian political mood is skeptical towards norms agreed during the period of
1990s, when Russia negotiated them in the position of weakness. Now, Russian political
class sees an opportunity to avoid those practices and to avoid the international DSM to
achieve best political results. Moreover, the acceptance of the ECT norms could have
brought a prejudice in the Russian position towards Yukos affair and the subsequent
Kremlin’s sobjective to gain back the control on the oil and gas sectors.

4. Conclusion

Contrasting realist and institutionalist perspectives allow us to understand differences in

the political attitude of various countries towards the DSM itself. A co-existence of the
strong security dimension of inter-state relations with market-oriented institutional norms
limits the use of international DSM, which is however reinforced within the
institutionalist perspective.

The use of the DSM does not mean that a state loses its sovereignty. Instead, a state can
use it for its own advantage. In this context, Gazprom had an opportunity of the “best
move” advantage using the ECT against Ukraine in January 2007. However, a “loss
aversion” seems to prevail the company’s strategy: Gazprom is unwilling to lose its
control inside FSU and Russia, which remains the priority strategy to the distribution
markets in Europe.

A conclusion which can be drawn is: although such a submission under the rule of an
independent court or conciliator may be highly unpopular in the current Russian mood of
new political strength and economic power, a strategy based on a more institutionalized
approach could bring benefits for Russia. A substantial economic expansion will not be
gained through money and power politics alone. What it also needs is image and
psychology. And a player submitting to rules will always be more trustworthy than a pure
power politics player.

In turn, in order to support a political attitude move from Russia, Europe should
recognize a positive legacy of Russia gaining back the control over natural resources. It
would certainly diminish the wrong political perception of the ECT being only a pro-
consumer legal mechanism.

2.2.4. EU Regime

The EU constitutes an important cross-border set of practices, which has an impact on

worldwide development of trade practices. By being the most integrated economic bloc,
the EU integration is influencing other regional economic agreements. The EU is
characterized by principles of the freedom of movement of capital, commodities, and
people. Likewise, the EU practice, reflected at its supranational institutions, integrates the
principles of transparency and allocates an important place to the prevention of uneven
competition.

The EU legislation has not established any specific regime for the oil sector. The internal
market directives cover gas and electricity. The EU role emerged in mid-1990s, with the
Licensing Directive (94/22/EC) of 1994, which regulates the licensing procedures for
exploration, taking into account safety and environmental issues. Among the largest oil
producers, the UK adopted the Petroleum Act of 1998 in order to implement the afore-
mentioned directive. Since that time, the UK government has preferred to attract small
private investors for exploration activities, which demonstrates their decentralized way of
governance of resource allocation.

Oil transport in Western Europe has never been subjected to vertically integrated
companies. Oil transportation has been diversified between tankers and pipelines.
Sufficient market fragmentation avoided the dominance of one or a group of companies
in oil transport. Oil companies have been able to develop transportation networks
consisting of oil terminals in Western Europe, where the oil can be imported by tankers.
The maritime transport has not been a subject of the EU regime since is covered by the
Law of the Sea. Onshore pipelines have been built and owned by refinery companies in
order to supply their own petroleum products. Consequently, the oil markets evolved
independently from the EU trade regime and prior to its development.
By contrast, the EU has stimulated the gas and electricity in their internal market. Gas
and electricity have longtime been exempt from competition rules as well as from the
allocation of policy at European level. These sectors were initially subject to vertically
integrated monopolies. However, since the mid-1980s, the process of liberalization of
electricity markets emerged with the successful liberalization of the UK wholesale and
retail markets. The UK experience opened a debate over electricity liberalization and over
the extent to which the gas and power markets should be opened to competition (D. Bohi,
K. Palmer, 1996: 12). Furthermore, Scandinavian countries have established a common
electricity market, called Nord Pool. Nord Pool consists of institutions allowing
coordination between regulatory authorities as well as common standards of market, i.e.
contracts which can be transferable from one country to another of the pool. Nord Pool
became the first cross-border electricity regime.

In 1996, after seven years of intergovernmental negotiation, the EU established the

96/92/CE Directive on electricity sector liberalization. Two years later, the similar
98/30/CE Gas Directive was adopted. Both Directives introduced a competitive retail
model within their respective sectors. The model requires the unbundling of transmission
and distribution channels which remain exempt from the competitive model, and from
generation and distribution, which are subject to competition. The unbundling is coupled
with the rules of non-discriminatory and transparent access to shippers which are not the
pipeline holders, called third party access. In 2003, two renewed Directives (2003/54/CE
for electricity and 2003/55/CE for gas) were adopted with a more precise time schedule
for the opening of these markets. EU targets reflect the state-of-the-situation within the
liberalization process already existing among its member states. Indeed, energy industries
proceeded to unbundling and third party access rules, independent of the European
normative targets. The internal energy market establishes its own regime for cross-border
trade within the EU.

Directive of the European Parliament and Council on the security of gas supply

concerning measures to safeguard security of natural gas supply

(Text with EEA relevance)
THE COUNCIL OF THE EUROPEAN UNION,
Having regard to the Treaty establishing the European Community,
and in particular Article 100 thereof,
Having regard to the proposal from the Commission (1),
Having regard to the opinion of the European Economic and
Social Committee (2),
After consulting the Committee of the Regions,
Having regard to the opinion of the European Parliament (3),
Whereas:
(1) Natural gas (gas) is becoming an increasingly important
component in Community energy supply, and, as indicated
in the Green Paper ‘Towards a European strategy
for the security of energy supply’, the European Union is
expected in the longer term to become increasingly
dependent on gas imported from non-EU sources of
supply.
(2) Following Directive 98/30/EC of the European Parliament
and of the Council of 22 June 1998 concerning
common rules for the internal market in natural gas (4)
and Directive 2003/55/EC of the European Parliament
and of the Council of 26 June 2003 concerning
common rules for the internal market in natural gas and
repealing Directive 98/30/EC (5), the Community gas
market is being liberalised. Consequently, regarding
security of supply, any difficulty having the effect of
reducing gas supply could cause serious disturbances in
the economic activity of the Community; for this reason,
there is a growing need to ensure security of gas supply.
(3) The completion of the internal gas market necessitates a
minimum common approach to security of supply, in
particular through transparent and non-discriminatory
security of supply policies compatible with the requirements
of such a market, in order to avoid market distortions.
Definition of clear roles and responsibilities of all
market players is therefore crucial in safeguarding
security of gas supply and the well-functioning of the
internal market.
(4) Security of supply obligations imposed on companies
should not impede the well functioning of the internal
market and should not impose unreasonable and disproportionate
burden on gas market players, including new
market entrants and small market players.
(5) In view of the growing gas market in the Community, it
is important that the security of gas supply is maintained,
in particular as regards household customers.
(6) A large choice of instruments are available for the
industry and, if appropriate, for Member States, to
comply with the security of supply obligations. Bilateral
agreements between Member States could be one of the
means to contribute to the achievement of the minimum
security of supply standards, having due regard to the
Treaty and secondary legislation, in particular Article
3(2) of Directive 2003/55/EC.
(7) Indicative minimum targets for gas storage could be set
either at national level or by the industry. It is understood
that this should not create any additional investment
obligations.
(8) Considering the importance of securing gas supply, i.e.
on the basis of long-term contracts, the Commission
should monitor the developments on the gas market on
the basis of reports from Member States.
(9) In order to meet growing demand for gas and diversify
gas supplies as a condition for a competitive internal gas
market, the Community will need to mobilise significant
additional volumes of gas over the coming decades
much of which will have to come from distant sources
and transported over long distances.
(10) The Community has a strong common interest with gas
supplying and transit countries in ensuring continued
investments in gas supply infrastructure.
(11) Long-term contracts have played a very important role
in securing gas supplies for Europe and will continue to
do so. The current level of long term contracts is
adequate on the Community level, and it is believed that
such contracts will continue to make a significant contribution
to overall gas supplies as companies continue to
include such contracts in their overall supply portfolio.
L 127/92 EN Official Journal of the European Union 29.4.2004
(1) OJ C 331 E, 31.12.2002, p. 262.
(2) OJ C 133, 6.6.2003, p. 16.
(3) Opinion not yet published in the Official Journal.
(4) OJ L 204, 21.7.1998, p. 1.
(5) OJ L 176, 15.7.2003, p. 57.
(12) Considerable progress has been made in developing
liquid trading platforms and through gas release
programmes at national level. This trend is expected to
continue.
(13) The establishment of genuine solidarity between
Member States in major emergency supply situations is
essential, even more so as Member States become
increasingly interdependent regarding security of supply.
(14) The sovereign rights of Member States over their own
natural resources are not affected by this Directive.
(15) A Gas Coordination Group should be established, which
should facilitate coordination of security of supply
measures at Community level in the event of a major
supply disruption, and may also assist member States in
coordinating measures taken at a national level. In addition,
it should exchange information on security of gas
supply on a regular basis, and should consider aspects
relevant in the context of a major supply disruption.
(16) Member States should adopt and publish national emergency
provisions.
(17) This Directive should provide rules applicable in the
event of a major supply disruption; the foreseeable
length of such a supply disruption should cover a significant
period of time of at least eight weeks.
(18) Regarding the handling of a major supply disruption,
this Directive should provide for a mechanism based on
a three step approach. The first step would involve the
reactions of the industry to the supply disruption; if this
were not sufficient, Member States should take measures
to solve the supply disruption. Only if the measures
taken at stage one and two have failed should appropriate
measures be taken at Community level.
(19) Since the objective of this Directive, namely ensuring an
adequate level for the security of gas supply, in particular
in the event of a major supply disruption, whilst contributing
to the proper functioning of the internal gas
market, cannot, in all circumstances, be sufficiently
achieved by the Member States, particularly in light of
the increasing interdependency of the Member States
regarding security of gas supply, and can therefore, by
reason of the scale and effects of the action, be better
achieved at Community level, the Community may
adopt measures, in accordance with the principle of
subsidiarity as set out in Article 5 of the Treaty. In
accordance with the principle of proportionality, as set
out in that Article, this Directive does not go beyond
what is necessary in order to achieve that objective,
HAS ADOPTED THIS DIRECTIVE:
Article 1
Objective
This Directive establishes measures to safeguard an adequate
level for the security of gas supply. These measures also contribute
to the proper functioning of the internal gas market. It
establishes a common framework within which Member States
shall define general, transparent and non-discriminatory
security of supply policies compatible with the requirements of
a competitive internal gas market; clarify the general roles and
responsibilities of the different market players and implement
specific non-discriminatory procedures to safeguard security of
gas supply.
Article 2
Definitions
For the purpose of this Directive:
1. ‘long-term gas supply contract’ means a gas supply contract
with a duration of more than 10 years;
2. ‘major supply disruption’ shall mean a situation where the
Community would risk to lose more than 20 % of its gas
supply from third countries and the situation at Community
level is not likely to be adequately managed with national
measures.
Article 3
Policies for securing gas supply
1. In establishing their general policies with respect to
ensuring adequate levels of security of gas supply, Member
States shall define the roles and responsibilities of the different
gas market players in achieving these policies, and specify
adequate minimum security of supply standards that must be
complied with by the players on the gas market of the Member
State in question. The standards shall be implemented in a nondiscriminatory
and transparent way and shall be published.
2. Member States shall take the appropriate steps to ensure
that the measures referred to in this Directive do not place an
unreasonable and disproportionate burden on gas market
players and are compatible with the requirements of a competitive
internal gas market.
3. A non-exhaustive list of instruments for the security of
gas supply is given in the Annex.
29.4.2004 EN Official Journal of the European Union L 127/93
Article 4
Security of supply for specific customers
1. Member States shall ensure that supplies for household
customers inside their territory are protected to an appropriate
extent at least in the event of:
(a) a partial disruption of national gas supplies during a period
to be determined by Member States taking into account
national circumstances;
(b) extremely cold temperatures during a nationally determined
peak period;
(c) periods of exceptionally high gas demand during the
coldest weather periods statistically occurring every 20
years,
These criteria are referred to in this Directive as ‘security of
supply standards’.
2. Member States may extend the scope of paragraph 1 in
particular to small and medium-sized enterprises and other
customers that cannot switch their gas consumption to other
energy sources, including measures for the security of their
national electricity system if it depends on gas supplies.
3. A non-exhaustive list in the Annex sets out examples of
instruments which may be used in order to achieve the security
of supply standards.
4. Member States, having due regard to the geological conditions
of their territory and the economic and technical feasibility,
may also take the necessary measures to ensure that gas
storage facilities located within their territory contribute to an
appropriate degree to achieving the security of supply standards.
5. If an adequate level of interconnection is available,
Member States may take the appropriate measures in cooperation
with another Member State, including bilateral agreements,
to achieve the security of supply standards using gas storage
facilities located within that other Member State. These
measures, in particular bilateral agreements, shall not impede
the proper functioning of the internal gas market.
6. Member States may set or require the industry to set indicative
minimum targets for a possible future contribution of
storage, either located within or outside the Member State, to
security of supply. These targets shall be published.
Article 5
Reporting
1. In the report published by Member States pursuant to
Article 5 of Directive 2003/55/EC, Member States shall also
cover the following:
(a) the competitive impact of the measures taken pursuant to
Articles 3 and 4 on all gas market players;
(b) the levels of storage capacity;
(c) the extent of long-term gas supply contracts concluded by
companies established and registered on their territory, and
in particular their remaining duration, based on information
provided by the companies concerned, but excluding
commercially sensitive information, and the degree of
liquidity of the gas market;
(d) the regulatory frameworks to provide adequate incentives
for new investment in exploration and production, storage,
LNG and transport of gas, taking into account Article 22 of
Directive 2003/55/EC as far as implemented by the
Member State.
2. This information shall be considered by the Commission
in the reports that it issues pursuant to Article 31 of Directive
2003/55/EC in the light of the consequences of that Directive
for the Community as a whole and the overall efficient and
secure operation of the internal gas market.
Article 6
Monitoring
1. The Commission shall monitor, on the basis of the
reports referred to in Article 5(1):
(a) the degree of new long-term gas supply import contracts
from third countries;
(b) the existence of adequate liquidity of gas supplies;
(c) the level of working gas and of the withdrawal capacity of
gas storage;
(d) the level of interconnection of the national gas systems of
Member States;
(e) the foreseeable gas supply situation in function of demand,
supply autonomy and available supply sources at Community
level concerning specific geographic areas in the
Community.
2. Where the Commission concludes that gas supplies in the
Community will be insufficient to meet foreseeable gas demand
in the long term, it may submit proposals in accordance with
the Treaty.
3. By 19 May 2008 the Commission shall submit a review
report to the European Parliament and the Council on the
experience gained from the application of this Article.
L 127/94 EN Official Journal of the European Union 29.4.2004
Article 7
Gas Coordination Group
1. A Gas Coordination Group is hereby established in order
to facilitate the coordination of security of supply measure (the
Group).
2. The Group shall be composed of the representatives of
Member States and representative bodies of the industry
concerned and of relevant consumers, under the chairmanship
of the Commission.
3. The Group shall adopt its Rules of Procedure.
Article 8
National emergency measures
1. Member States shall prepare in advance and, if appropriate,
update national emergency measures and shall communicate
these to the Commission. Member States shall publish
their national emergency measures.
2. Member States' emergency measures shall ensure, where
appropriate, that market players are given sufficient opportunity
to provide an initial response to the emergency situation.
3. Subject to Article 4(1), Member States may indicate to the
Chair of the Group events which they consider, because of
their magnitude and exceptional character, cannot be
adequately managed with national measures.
Article 9
Community mechanism
1. If an event occurs that is likely to develop into a major
supply disruption for a significant period of time, or in the case
of an event indicated by a Member State according to Article
8(3), the Commission shall convene the Group as soon as
possible, at the request of a Member State or on its own initiative.
2. The Group shall examine, and, where appropriate, assist
the Member States in coordinating the measures taken at
national level to deal with the major supply disruption.
3. In carrying out its work, the Group shall take full account
of:
(a) the measures taken by the gas industry as a first response
to the major supply disruption;
(b) the measures taken by Member States, such as those taken
pursuant to Article 4, including relevant bilateral agreements.
4. Where the measures taken at national level referred to in
paragraph 3 are inadequate to deal with the effects of an event
referred to in paragraph 1, the Commission may, in consultation
with the Group, provide guidance to Member States
regarding further measures to assist those Member States particularly
affected by the major supply disruption.
5. Where the measures taken at national level pursuant to
paragraph 4 are inadequate to deal with the effects of an event
referred to in paragraph 1, the Commission may submit a
proposal to the Council regarding further necessary measures.
6. Any measures at Community level referred to in this
Article shall contain provisions aimed at ensuring fair and equitable
compensation of the undertakings concerned by the
measures to be taken.
Article 10
Monitoring of implementation
1. By 19 May 2008, the Commission shall, in the light of
the manner in which Member States have implemented this
Directive, report on the effectiveness of the instruments used
with regard to Article 3 and 4 and their effect on the internal
gas market and on the evolution of competition on the internal
gas market.
2. In the light of the results of this monitoring, where
appropriate, the Commission may issue recommendations or
present proposals regarding further measures to enhance
security of supply.
Article 11
Transposition
Member States shall bring into force the laws, regulations and
administrative provisions necessary to comply with this Directive
by 19 May 2006. They shall forthwith communicate to the
Commission the text of those provisions and a correlation table
between those provisions and this Directive.
When Member States adopt these measures, they shall contain
a reference to this Directive or be accompanied by such a reference
on the occasion of their official publication. The methods
of making such reference shall be laid down by Member States.
Article 12
Entry into force
This Directive shall enter into force on the 20th day following
that of its publication in the Official Journal of the European
Union.
Article 13
This Directive is addressed to the Member States.
Done at Luxembourg, 26 April 2004.
For the Council
The President
J. WALSH
29.4.2004 EN Official Journal of the European Union L 127/95
ANNEX
Non-exhaustive list of instruments to enhance the security of gas supply referred to
in Article 3(3) and
Article 4(3)
— working gas in storage capacity,
— withdrawal capacity in gas storage,
— provision of pipeline capacity enabling diversion of gas supplies to affected areas,
— liquid tradable gas markets,
— system flexibility,
— development of interruptible demand,
— use of alternative back-up fuels in industrial and power generation plants,
— cross-border capacities,
— cooperation between transmission system operators of neighbouring Member States
for coordinated dispatching,
— coordinated dispatching activities between distribution and transmission system
operators,
— domestic production of gas,
— production flexibility,
— import flexibility,
— diversification of sources of gas supply,
— long term contracts,
— investments in infrastructure for gas import via regasification terminals and pipelines.
L 127/96 EN Official Journal of the European Union 29.4.2004

The European Union of Gas Supply Industry (Eurogas) views on the Directive
2004/67/EC
Eurogas has considered the proposed Directive on security of gas supply.
Eurogas agrees that security of gas supply, so vital for Europe’s economic
interests and the welfare of its citizens, needs to be discussed with a view to its
most efficient delivery, and any necessary enhancement in the expanding
market. Eurogas, however, does not accept the premise that, because of structural
changes, additional internal market legislation is necessary on top of the
revision of Directive 98/30/EC now before the European Parliament for a
second reading and to be implemented by 1 July 2004. The Commission’s
analysis underestimates the dynamics of the market and the positive effects on
security of supply. Implementation of the Directive’s proposals could weaken
the ability of the market participants to meet security of supply objectives.
Introduction
Eurogas agrees on the importance of examining the implications of these
changes in the gas market for security of gas supply, and is considering how
resulting challenges are to be met18. Eurogas identifies a number of points, which
should underpin the dynamics of gas security.
Security of supply is best delivered through properly functioning energy
markets, sending clear price signals to all market participants. Security of
supply has to be a shared responsibility, taking into account that there are
several actors in the market, with different objectives.
Gas production, supply, and transport companies will continue to play the main
role in delivering security of supply because they have a fundamental economic
interest in competing successfully with other energy sources, and developing
the gas business. The commitment of these companies will ensure the challenge
of meeting security of supply requirements is shared along the gas chain. It should
primarily be the supplier’s decision how to do business in a competitive market,
where to seek consumer market expansion, and when to deliver gas in
competition with other fuel and other gas supplies.
18 In June 2002, Eurogas issued a Position Paper Security of Gas Supplies Markets,
Principles, and Actors. This
paper acknowledged that because of structural changes in the market the approach to
security of supply issues would
also evolve, and explored how market participants should respond to new challenges in
line with commercial and
entrepreneurial objectives.
Spot markets and the introduction of more flexible contract formulas will
enhance choice improving the liquidity of the market, alongside long-term
contracts, which will play a very important role. This combination will ensure
that suppliers can offer security of supply as a competitive element. Levels of
risk and commercial uncertainties, however, may be higher. As far as possible,
market participants should be confident that their investments can yield
long-term returns in a stable market, with a rate of return commensurate
with the risk.
A distinction, however, is necessary in the supply security approach to
domestic/smaller customers and large customers. Large customers should be
free to choose their own level of supply security based on their knowledge of
the commercial and technical options available to them. Households and
smaller customers may need some protection beyond what is normally provided
for consumer protection.
In a regulated system, the regime must provide adequate returns to permit
transmission system operators (TSO) and distribution systen operators (DSO)
to maintain an efficient and safe infrastructure in a competitive market. The
regime should also clarify the role, which regulated networks have in contributing
towards security of supply.
In any system, security of supply must be based on entrepreneurial responsibility.
Reliable long-term supply and demand forecasts for the EU will become even
more crucial in supporting management decisions on investment.
Setting the legislative framework for security of supply remains a matter of
national policy. Member states’ Governments should take adequate measures
to assure that their energy policy is carried out in the general interest.
Eurogas accepts that the EU should have a non-regulatory monitoring role
in security of supply issues, and should ensure that different approaches to
security of supply do not introduce market distortions. The EU can facilitate
market development by fostering stable political relations with gas-producing
regions outside the Community, and promoting a sound investment climate.
Eurogas’s global views on the proposed Directive
In the light of these key principles, Eurogas has concerns about the approach
of the proposed Directive. The issues raised in the proposal have to be analysed
in greater depth in dialogue with the stakeholders. Furthermore, although the
134
proposal says it aims to ensure continuing security of supply alongside the
development of the internal market, the regulatory approach outlined could
be counter-productive to market solutions.
Eurogas also refers to the reported debate on the legal basis for this Directive.
Eurogas has major doubts about the choice of Article 95 of the Treaty as a legal
basis for the Directive and the establishment of the Commission’s competence
on security of supply matters.
Eurogas affirms that:
_ Reserves that could supply the market are robust. There is no fundamental
problem connected with increased dependence on natural gas. Gas
importation is not a difficulty in principle and should not be viewed as a
strategic danger. Therefore the reasoning in this respect and the consequent
provisions are open to criticism;
_ Open markets, effective liberalisation, in which the responsibilities of the
different market participants are clear, and a sound infrastructure will deliver
greater security and efficiency of gas supplies. The market framework should
incentivise investment, encouraging new production and infrastructure
development. The proposal does not contribute to these objectives. On the
contrary, the Commission’s proposed new competence allowing it to intervene
in the market is likely to distort incentives for market participants and
would therefore diminish the effectiveness of the market in providing security
of supply;
_ All security of supply measures will have costs attached. The proposed
Directive does not provide for this aspect.
Comments on the different elements of the proposal
Measures and security of supply standards (Arts. 3 & 4)
Eurogas can agree that member states should be encouraged to develop, in
consultation with gas companies, output-related objectives on security of
supply. The requirements, however, mentioned in Article 4(1-3) are impractical
and inappropriate for several member states.
Also, the proposal specifies that they are to be set with reference to the whole
customer base except those with fuel switching capabilities. In a competitive
market, any special protection should only cover small customers, since the
position of large users is quite different. Large users will be assumed to have
more knowledge on security of supply aspects, including the commercial and
135
technical options the market offers. They should not require the same level of
protection as small consumers.
Furthermore, the wording of Article 3.4 referring to “supply standards for gas
supplies for power generation” is unclear. While member states should monitor
the security of power supplies, it would be inappropriate for the EU to
encourage interference with the commercial decisions of power plant operations
to build dual-firing plant or to negotiate interruptible contracts. These
decisions must be left to market participants, otherwise there will be uncertainty
and market distortions.
Any general guidance at EU level should be in accordance with the principle
of subsidiarity. An attempt to harmonise or standardise requirements, as well
as instruments, could lead to non-optimal solutions.
Exemptions for small companies and new entrants
(Arts. 2.3 & 4, 3.6, 6.2)
Security of supply policies must be compatible with the internal market and
not constitute barriers to market entry. Policies and measures have to be
nondiscriminatory.
The proposed exemptions for new entrants and small companies
would lead to discrimination between incumbents and newcomers, as well as
between differently sized companies.
Reporting and monitoring procedures (Arts. 4.5, 5)
Monitoring and transparent reporting are important, but these should be
focussed on the achievement of agreed goals and any difficulties in meeting these.
They should not undermine or negate the responsibilities appropriate to
member states, nor impact the management of companies. The framework for
the reporting procedure has already been established in the Directive amending
the current gas and electricity Directives.
Long-term contracts (Art. 6)
Eurogas welcomes that the proposal recognises the importance of long-term
contracts in Europe’s energy supply, but:
_ Setting the definition of “more than one year” will not meet the objective,
since that would not be “long-term”. It should be left to the market to
decide on the duration of contracts. Long-term contracts in practice are
usually from ten to twenty years. The definition should reflect this;
136
_ The approach appears to overlook the equal importance of long-term
transport contracts and long-term transport provision.
Also, the thinking behind Article 6.1 needs to be explored. Promotion and
monitoring of market liquidity is important, but the possible supposition that
there could be an insufficient degree of long-term contracts (especially if longterm
is more than a year) is not well understood. Contracting future supplies
is a decision of market participants.
Non-discriminatory authorisation procedures (Art. 7)
Eurogas agrees that facilitating authorisation procedures to build new storage
or LNG facilities would benefit security of supply objectives. The same would
be true regarding new pipelines, especially interconnectors and new supply lines.
Action in case of an “extraordinary gas supply situation” (Art. 8)
It should be clarified what is envisaged by an “extraordinary gas supply situation”
(Art. 8.1). Eurogas is concerned that the Commission could apparently act on
its own initiative, without member states’ agreement (Art. 8.3), and considers
that the measures planned to respond to extreme and unlikely situations would
turn out to be legally, technically, and commercially unworkable.
Envisaged redistribution of gas throughout the EU, in the event of an
“extraordinary gas supply situation”, presupposes that gas (releases from storage)
and capacity (provision of pipeline capacity) are available. If so, markets
following price mechanisms and international companies can respond more
quickly and efficiently than any public authority. Intervention by the
Commission would discourage investors.
A better approach to the issue would be to ensure that companies that already
deliver a very high level of supply security and member states have agreed on
the procedures with each other in the event of a crisis. Cooperation at this level
would obviate the need for the Committee provided for in Article 9.
Proposed european observation system (Art. 10)
Apart from the emergency procedures in Art. 10.3c, other points in Article 10
are covered by the other monitoring and reporting procedures. In addition, the
Commission already has a role in monitoring implementation of the internal
market (Art. 10.1), and there is the Madrid Forum and the Energy Transport
Forum. Eurogas is not convinced of the need for this new body.
137
138
Monitoring of access to storage and possible further proposals
(Art. 11)
This issue is covered by the Amendments to the Gas Directive 98/30.
Conclusion
Security of supply is best provided through efficient and properly functioning
energy markets sending clear signals to consumers, investors, and national
authorities. The proposal underestimates the dynamic potential and driving
forces in the market, and some elements in the proposal could have the effect
of unnecessarily distorting the competitive market, EU policy states it is
putting in place.
More information on Eurogas can be found on the following website:
www.eurogas.org.
 Centre for European Policy Studies views

Box 1. Definitions of security of supply

European Commission: “Energy supply security must be geared to ensuring…the proper

functioning of the economy, the uninterrupted physical availability…at a price which is
affordable…while respecting environmental concerns…Security of supply does not seek
to maximise energy self-sufficiency or to minimize dependence, but aims to reduce the
risks linked to such dependence” (European Commission, 2000, p. 2).

International Energy Agency: “Technological developments will affect the choice and
cost of future energy systems but the pace and direction of change is highly uncertain.
Governments will…have an important role to play in reducing the risk of supply
disruptions. Regulatory and market reforms…will also affect supply. Increased
competition between different fuels and between different suppliers of the same fuel will
tend to narrow the gap between production cost and market prices, reducing monopoly
rents, encouraging greater efficiency and lowering the cost of supply” (International
Energy Agency, 2001).

European Parliament: “Being dependent on imports is neither necessarily a bad thing nor
economically inefficient provided the sources are diverse, no one supplier is dominant
and we can produce sufficient goods and services to pay for them…We cannot alter the
fact of where the oil comes from, but we can do a number of things on the demand side,
in particular in the transport sector” (European Parliament, 2001).

CEPS, in the context of a task force has used the following definition: Security of supply
consists of a variety of approaches aimed at insuring against supply risks. Security of
supply becomes a cost- effective risk-management strategy of governments, firms and
consumers (Egenhofer & Legge, 2001).

Source: CEPS, based on Egenhofer & Legge (2001; revised).

Eight steps towards the discovery and estimation of risks and costs
Step 1: Identification of risks (‘what is the risk?’)
A first phase identifies the concrete risks (i.e. definition). This necessitates that generic
risks such as ‘import dependence’ or ‘dependence on unstable countries’ are broken down
into subtopics, which are associated with risk. Generic categories of such risks are too
broad to identify a targeted response. For example, in the case of natural gas, the risks
stemming from import dependence can be associated with source dependence, transit
dependence or facility dependence. In all three cases the response is different. This issue
is dealt with in all INDES Policy Briefs. A detailed application is provided by Luciani in
Policy Brief No.51.
Step 2: Insurability (‘can risks be insured?’) Insurance only makes sense if there are tools
(with reasonable effort) to hedge risk. Note that some risks could deliberately go
uninsured because they are ‘uninsurable’ at least in the short term (e.g. terrorist attacks;
failure of all major gas suppliers to deliver).
Step 3: Assessment of risk (‘how likely is the risk?’)
The next step concerns the likelihood. Some risks may be extremely unlikely (e.g. a
meteorite falling on a major installation). The conclusion on the likelihood needs to be
closely related to potential consequences. This will guide policymakers to decide whether
the risk is big enough to consider insurance against. It may be rational and reasonable not
to ensure against a highly unlikely limited risk. This is where the issue of cost assessment
comes into play for the first time.
Step 4: Market functioning/failure (‘can the market ensure the risk?’)
Companies, or more generally, the market may be prepared to accommodate risk if the
market allows for price differentiation to make it commercially attractive. Examples
include the price differential between long-term supply contracts and spot markets both in
oil and power. Another example is ‘interruptible contracts’. The fundamental question is
how to optimize pricing tools and market instruments (term markets, short-term markets,
hedging tools, long-term contracts, involvement of the financial sector, etc.) to achieve a
maximum degree of security.
Step 5: If the market fails, identification of the affected groups (‘who should be
insured?’)
A particular risk may not have the same consequences for all members of the society.
While a major gas supply interruption for a company with dual fuel capacity may not
constitute a fundamental problem, it may be very serious for a domestic customer during
winter in Finland. Therefore, there is a need for a clear distinction on how different
sectors are affected. Luciani develops this analysis in Policy Brief No. 51, by
distinguishing between different customers groups, notably priority and interruptible
customers.
Step 6: Identification of an appropriate insurance tool (in conjunction with step 2)
Mitigating policies can have a long-term ‘strategic’ character (e.g. investing in
technological innovation and alternative fuels, democratisation and political stability of
fuel-exporting states) and a short-term component (e.g. holding of emergency stockpiles
for oil, and perhaps natural gas, use of fuel taxation to reduce private car utilisation, while
providing incentives for public transport usage). The two approaches are mutually
reinforcing. It is thus necessary to decide according to the issue at stake what tool should
be given preference, but only in combination with step 7.
Step 7: Cost assessment of the measures (‘how much will the measure cost?’)
If policymakers and regulators have identified a risk that needs to be insured against and
also a target group, there is a need to assess the cost of the measure. Estimation of costs
pervades the entirety of the project, with the focus mainly on the methodology of cost
assessment.
Step 8: Allocation of costs (‘who should pay the costs?’)
Once the measure is implemented, there is still the question of who pays. This does not
always need to be the customers. For example, it is low income groups that often are
most affected by supply disruptions. At the same time, these groups may not be able to
pay for expensive measures. Certain costs may as well be allocated at the member state
level (and thus burden citizens within one country only), or concern the entirety of the
EU (through taxation). They can also be shared among all customers in the Union
through the imposition of a levy, or by other means.
Answers to questions in Steps 1–8 will differ in relation to the different sectors (i.e. oil,
gas, coal, power) as well as to different countries, reflecting for example differences in
fuel mixes or vulnerabilities. Nevertheless, there appear to be a number of sensible EU
responses while respecting the principle of subsidiarity. The policy synthesis in the
framework of INDES does not make the case for a ‘one fits all’ security of supply policy.
Rather it provides policymakers and regulators with a framework to shape decisions on
what risks to be insured.

3. Third Approach: new energy economy approach

3.1. International energy interdependency

The analysis of the international structures explains indeed patterns of capability among different
states. In this respect, a British author, P. Andrew-Speed, proposes a schematisation of
international oil interdependency16:

1. Countries exporting finance and technology, but importing energy, such as the USA,
Japan and the majority of the EU countries (Germany, France, Italy, Belgium, Spain) ;
2. Countries exporting oil and gas, but also finance and technology, among which are the
UK, Norway, Denmark, and the Netherlands ;
3. Oil & gas exporting countries which import technology and finance, such the majority of
the hydrocarbons producers; including the OPEC countries, Russia and the Caspian
region (Kazakhstan, Azerbaijan, Turkmenistan and Uzbekistan) ;
4. Countries importing both technology , finance, and energy products: the majority of the
EU applicant states as well as developing countries of South-East and East Asia.

Structural differences lead to a variety of trends in energy security.

3.2. Investment risks

The economic sector of security in general is defined by the vulnerabilities within a market
economy. Energy is the key input for an economic system and is widely used in industry,
residential and transport sectors. Therefore, low energy prices are the basic condition for the
overall competitiveness of an economic system.

Trends in the security of gas markets are rather related to the ongoing liberalization
process, which is ongoing in many consuming states.

16
ANDREW-SPEED, P., "The Energy Charter Treaty and International Petroleum Politics", CEPMLP,
University of DUNDEE, http://www.dundee.ac.uk/cepmlp/journal/html/article3-6.htm.
J. Stern & C. Van der Linde, The Future of Gas: Will reality meet expectations? 9th
International Energy Forum 2004 22-24 May, Amsterdam
Executive Summary and Questions
Natural gas is the most dynamically growing fossil fuel in the international energy
market. The reasons for this growth are obvious: it has been competitively priced and is
highly convenient in both industrial and domestic use, as well as in power generation.
Furthermore, it is the most environmental friendly fossil fuel. Given the premise of
ongoing competitiveness of gas prices, it is not surprising that most energy forecasts,
among them the IEA World Energy Outlook 2002, suggest a continuing, substantial
growth in demand for gas. New supplies, that are needed to meet growing demand, will
have to come from sources much more remote from today’s markets by means of
expensive, long distance transport through pipelines or in the form of Liquefied Natural
Gas (LNG). For the next 25 years the International Energy Agency expects a 300 %
increase in international trade between the major supply and demand areas around the
world. Indeed, the notion of a global market for LNG is gaining ground. However, the
growth in LNG trade will fall considerably short of the projected growth in demand of
1700 bcm (IEA). The difference, consequently, will have to be met by cross-border piped
gas. Many conceptual opportunities for new pipeline projects are looked at but few have
reached the actual investment stage. The IEA demand-side growth projections, however,
will only be realised when the IEA demand-side growth projections, however, will only
be realised when the required additional volumes of gas will be made available in a
timely and coordinated way. This cannot be taken for granted. The development of new
natural gas supplies faces a variety of obstacles. Even when successful, it takes on
average 5-10 years to put a pipeline project in place because political issues, regulatory
design, as well as the harmonisation of investments and supply risk, prove to be very
difficult to align. Natural gas projects will only materialise if the risks inherent to
investment in these projects can be properly mitigated. Characteristic is the great
magnitude of risk involved, stemming from the combination of very high investment
costs and the lack of flexibility in the supply chain, and the long horizon over which these
risks have to be managed. Huge, specific investments have to be made into facilities that
produce and transport gas from a specific gas province, or field, to a specific area of
consumption over a longer period of time. Long term contracts with competitive pricing
clauses have formed an important basis to ameliorate and manage the risks. Security of
supply to consumers is as important as security of demand is to producers and
transporters of gas. The development of gas demand, in part, depends on government
policies, such as security of supply and environmental policies, restricting the use of
fossil fuels. Security of supply policies can either be aimed at a reduction of the
dependence on imported fuels or at an increased diversification of suppliers. Yet, other
aspects may also be determined by government policy. Transparency, consistency and
predictability of government policies form the backbone of successful gas development.
But in addition, positive action and supportive participation in the orchestration of a new
gas supply chain is essential. In some gas markets, notably the United States and EU, the
governments have embarked on a process of liberalization. Experience learned that
economies need an adequate institutional framework to reduce uncertainties among
market participants, to correct un-avoidable failures in the operation of the market, or the
sheer lack of a market, for certain categories of goods and services and to safeguard
public interests. Deregulation became re-regulation, and privatization was to be
undertaken as a strategic process. Moreover, it was accepted that structural change should
pay due attention to public interest issues and to the objectives of competition policy.
Unlike the traditional perspective that denied the feasibility of competition in the whole
of the gas industry, the proponents of structural change start from the hypothesis that the
introduction of competition is possible in particular segments, and that this would
improve the performance of the whole of the value chain. Furthermore, regulatory
experience in gas markets has shown that competition in the gas market can be achieved
in several ways, each requiring a specific regulatory approach, depending on the stage of
development of these markets and the geopolitical and economic characteristics of supply
and demand patterns. The size and the complexity of gas projects require a high degree of
confidence and assurance. Generally, the economic risk, particularly for large scale
international supply systems, is mediated by sellers and buyers, through appropriate
arrangements embedded in long term contracts and only to a lesser extent through spot-
markets and hedging facilities. Nevertheless, the need to co-ordinate investments in
projects throughout the supply chain and the objective to minimise the lead times will
require full cooperation between all stakeholders. Agreements between these parties, as a
precondition for investments in large-scale gas projects are complex and may require
government support. This important role for government applies both to the active
involvement prior to the investments, facilitating the process of putting the necessary
conditions in place, as well as to provide the comfort for a prolonged business climate,
positive to these large investments. With regard to the long term period of repayment of
investments in gas supply chains, sellers and buyers, together with equity investors and
financial institutions, also consider risks which are fully in the domain of governments,
like:
- The political stability of producing countries and the risk that gas supply, or transit,
will be refused for political or economic purposes. - The political and regulatory stability
of consuming countries and the risk that market circumstances may change unexpectedly
for reasons of economic, environmental or other policies. Thus, despite the ability of the
private sector to manage many of the risks involved in complex gas projects, the
government plays a crucial role in creating such a climate that these risks remain
manageable over time. International gas markets as well as public interests are not static
but dynamic. The task of the government is to facilitate an investment climate that
evolves in line with the various stages of market. Assuming that producing and
consuming governments wish to realise the full economic benefits of the projected future
production and demand for gas in global energy balances, this will require a more pro-
active role of governments than would be the case for other fossil fuels. The enabling
factors that they should consider include the following:
_ Developing clear energy and regulatory policies which facilitate both the production
and use of gas and the development of infrastructure;
_ Developing policies on environment and emissions where the priority for gas
production and gas use - in comparison to other fossil fuels and renewable/nuclear
energy sources - is clearly stated, especially in terms of taxation;
_ Developing clear policies on security of supply and demand in terms of dependence
on:
_ imports of gas from a single source of supply or company
_ exports of gas to a single market or group of markets
_ a specific supply route for gas
_ Ensuring that plans for future liberalisation and the development of competition in
all phases of the gas chain are articulated well in advance, and that such plans:
_ do not compromise existing long term contractual arrangements;
_ take account of the requirements to ensure long term security of supply
_ recognise the need for long term contractual arrangements (and possibly
aggregation thereof) to secure new supplies for most markets
_ recognise the need for capacity contracts, back-to-back to the conditions of new
supply contracts
_ are discussed between producing and consuming governments either bilaterally
or in multi-lateral governmental fora;
_ Providing active assistance in stitching together international gas chains in terms of
treaties, and international/multi-lateral relations between states;
_ Providing a policy framework for the power generation industry allowing for timely
decisions to commit to investments in new gas-fired generation capacity,
recognising the anchor role of power generation for attracting new gas supplies
_ Providing financial guarantees (via government credit agencies) and limited
financial support, particularly for very large multi-billion dollar gas investments;
_ Ensuring that taxes and other fiscal measures upstream and downstream do not
discourage market players from moving ahead with gas projects in a timely fashion.
The International Energy Forum could play a significant role in developing and
achieving these enabling factors for producer and consumer governments.

Question to Ministers of Consuming Countries:

How do the ministers think they can best organise the balance between
liberalization of the gas market and security of supply?
Question to Ministers of Producing Countries:
How do the Ministers think to they can best organise a balance between risk and
rent that facilitates a sustainable exploitation of their gas resources in the future?
Question to all Ministers:
How do the ministers think they can solve the information gap, that follows from
market liberalisation, in order to continue to achieve a timely match between
future demand and supply?

Risk, investment climate and the role of the government Natural gas projects will only
materialise if the risks inherent to investment in these projects can be properly mitigated.
Security of supply to consumers is as important as security of demand is to producers and
transporters of gas. As is shown above, investments in gas supply chains involve a
considered view that an adequate level of sales over a long period can be achieved at
market reflective prices. The development of gas demand, in part, depends on
government policies, such as security of supply and environmental policies, restricting
the use of fossil fuels. Security of supply policies can either be aimed at a reduction of the
dependence on imported fuels or at an increased diversification of suppliers. Yet, other
aspects may also be determined by government policy. Transparency, consistency and
predictability of government policies form the backbone of successful gas development.
But in addition, positive action and supportive participation in the orchestration of a new
gas supply chain is essential.

Market Structure
The gas markets around the world differ substantially in their stage of development.
Some markets have already matured, such as the United States, Japan and South Korea,
while other markets are still in a first expansionary phase (such as India and China).
Europe covers the full spectrum from emerging to mature markets. But even mature
markets will require considerable new investments in infrastructure to meet projected
growth. The United States is in a process of changing from a predominantly domestic gas
resource base to a mixed resource base with increasing LNG imports entering an already
liquid market. In Europe there are mature markets, mostly based on domestic supplies
and/or long term supply contracts from external resources; and new markets (mostly
around the periphery) based entirely on imports from outside the region. Based on its
conomic competitiveness, it is predicted that gas will contribute substantially to the fuel
in the power sector. The Asian market remains a mosaic of national gas markets which
largely depend on LNG imports and which have different regulatory structures. There are
very few mature markets and a relatively high proportion of countries where gas is either
a new fuel, or accounts for a relatively small proportion of energy demand.
In an expansionary power market, gas will predominantly be used to fuel new power
capacity, while in a more mature market additional gas demand must also come from the
replacement of other fuels in the power sector. The size of both new and replacement gas
demand will depend on the economics of gas in the power sector and the portfolio
management of large power suppliers. In many markets, both developing and mature, the
power industry has an “anchor” role in developing new gas supply lines as a consequence
of its capacity to absorb significant additional volumes of natural gas. However, if newly
planned power stations at the end of the supply line are not built in line with the
development of the rest of the infrastructure, less gas will flow and financial risks are
incurred of an unacceptable scale. The firmness of contractual obligations and the
assurance that contracts can be efficiently enforced is crucial in this respect. Yet, given
the key role of the power sector, regulatory certainty in this sector is a precondition for a
smooth development of the gas sector. In liberalised electricity markets, the commitments
for gas purchases have to be made by the power industry proper. In countries where the
power sector is a public utility market, the authorities will have to commit. In either case,
keeping options open is not going to bring new gas to the market. It will be hard enough
to reconcile the volumes and flexibility that the prospective power generator is looking
for with the “security of demand” needed to line up the supply chain. Uncertainty about
government policies and regulation in a liberalising business environment will not help in
making these commitments.

Pricing
The immense investments require a certain level of prices for natural gas. Tensions may
arise with regard to the understandable objective of consuming governments to keep
prices low, especially for small consumers. Regulated low prices, however, discourage
natural gas developments in many markets with growth potential, which in turn could
frustrate the growth of the national economy. In other markets governments have been
promoting the introduction of competition and consequently introduced market prices
into natural gas markets. Changing markets bring changes in prices and pricing
principles. Increasingly, even long term contracts develop different indexations. In the
future short term price volatility, like in other fossil fuel markets, will be a fact of life.
However, the greater risk, affecting gas prices over the longer term could well be the lack
of timely investments in new supplies: shortages of gas supplies drive up gas prices in the
markets, leading to economic pain for consumers and in the second instance to a loss of
confidence in the competitiveness of gas among the investors in the power sector. It is
argued that the governments have the responsibility to foster investments climate
conducive to these timely investments and thus prevent unnecessary and prolonged price
fluctuations.

Transportation
Shipping oil is much cheaper than transporting pipeline gas. LNG can only compete with
pipeline gas beyond a few thousand kilometres from the market. Especially for pipelines,
inadequate or non-existing legal and regulatory regimes add extra hurdles to bringing the
needed regular supplies to the market at viable economic costs. For transit pipeline
projects – that is projects which cross third countries between exporter and importer-
unstable bilateral political, economical and regulatory conditions can prevent gas from
reaching the markets. The gas chain is as strong as its weakest link.

4. Regulation of gas markets

Where the new rules for a liberalised market environment are still in the process of
evolution, natural gas projects, given their long repayment periods, are suffering from
a lack of certainty about the future regulatory framework. Liberalisation may, in addition,
lead to fragmentation of markets and create noise in the information flow, which in turn
could delay the signals that invoke new investments. In response to the characteristics of
the gas industry discussed above, a variety of hierarchical relationships have been
established over time amongst gas producers, transporters and consumers. In case of
contracts, the volume and the price risk were reduced, by agreeing to price structures and
by establishing specific terms of trade for a longer time period, so that the producers’ as
well as the consumers’ investments would not be jeopardized. Often this involved a role
for public bodies, taking ownership and management over (parts of) these systems. As a
consequence, gas markets have developed on a regional scale, each with its own market
structure, its characteristic institutional framework and specific roles for governments and
local authorities and, eventually, its particular outcome, in terms of the economics of
supply and demand. Towards the end of the last century a new perspective on regulation
developed, driven by, on the one hand, international economic integration of national
markets for goods, labour, capital and services, and on the other, by the general aim to
reduce the role of the state in the coordination and ownership of economic activities, in
favour of the market and private initiatives. This new approach was slowly accepted in
the latter part of the last century. Initially, a simple withdrawal of the state from the
economy was advocated, through the privatisation of state owned enterprises and the
deregulation of public utilities, which would be sufficient to bring about the advantages
of unconstrained markets and the associated gains in welfare and economic growth. Over
time, however, empirical evidence has shown that economies need an adequate
institutional framework to reduce uncertainties among market participants, to correct un-
avoidable failures in the operation of the market, or the sheer lack of a market, for certain
categories of goods and services and to safeguard public interests. This new vision
demanded a much more subtle approach. As part of the process, the specific form of
economic restructuring in the distinctive industries and sectors and the accompanying
sets of rules and regulations appeared on the agendas of policy makers, industry
associations and researchers. Deregulation became re-regulation, and privatization was to
be undertaken more as a strategic process. Moreover, it was accepted that structural
change should pay due attention to public interest issues and to the objectives of
competition policy. Of course, this refinement of the recipe for restructuring induced an
expansion of the regulatory framework and the toolbox of regulatory instruments and,
associated therewith, the responsibilities of the regulatory agencies. The latter, initially,
were meant to operate as lean and mean executive organizations, but being forced to
develop and apply new insights in regulatory practice, they rapidly grew in scale and
scope. A number of general issues of importance can be derived from recent experiences
in the economic regulation of sectors, although there is a large difference in the regulation
aimed at the identification and correcting of abuse of dominant positions and the
structuring of the industry and its processes so as to maximise the objective of creating a
competitive environment: The latter, in the absence of adequate experience, contains
experimental aspects with their inherent risk of failure and uncertainties about future
change. To operate effectively regulators should have a clear, politically determined,
legislative mandate, establishing in unambiguous terms, their objectives, their tasks and
the degree of freedom in developing guidelines and rules. To operate independently on
behalf of their general public responsibilities, regulatory systems and regulators should
seek to secure and carefully balance the interests of both the several segments of the gas
industry and the (large and small) consumers. To achieve an appropriate level of
legitimization, regulators should be held accountable both in respect of the reasons they
give for their decisions and by making the regulatory process fair, open and accessible to
the firms and stakeholders alike. To gain trust in the industry and among consumers,
regulators should have a more than adequate level of expertise, which is as independent
as possible from industrial, consumer, or political interests. Finally, a regulatory system
should be efficient, in the sense that the benefits of its involvement to society should
outweigh the direct and indirect costs of its interventions.

Approaches to gas market regulation

In this section we discuss policy options in the regulation of the gas sector. Perhaps more
so than in other fields of regulation, it is clear that the policy towards the functioning of
markets and the safeguarding of public interest is an extremely urgent concern. In
complex, specific, networks, such as the electricity, the natural gas, the telecom and the
water systems and in transport infrastructures, essential facilities are involved, through
which the controlling party is able to obstruct any serious competition by other (potential)
suppliers, while exploiting its monopolistic position vis-à-vis the consumers. This
effectively ruled out an integral liberalization of these systems and required the
establishment of adequate regulatory regimes. To be sure this debate is ongoing. For
example, recent experiences, such as the blackouts in Europe and California, railway
accidents and the emerging problems with the supply of natural gas, provide confirming
evidence of the need to create fine textured regulatory approaches. Unfortunately, there is
a serious question whether there is a uniformly applicable approach for all stages of
development of the gas market. Quite apart from the fact that a regulatory structure is
very much a system and context dependent phenomenon, we are doubtful that such a
approach would provide an optimal route as the advocates suppose. We argue that four
main facets stand out in respect of the regulation of these systems.
The manner in which the value chain of the industry is re-structured ex-ante is related to
the question as to what vertical segments of the supply system should be characterized as
an essential facility, requiring regulation, and which segments could be potentially
competition driven, if an adequate horizontal structure could be arrived at. The
determination of the ownership of the essential facilities in the value chain is a strategic
issue, involving aspects like the attractiveness to private investors, the degree to which
their information can and should be checked by regulators, the possibility to create
mutual commitment by establishing public private partnerships, etc. The marching orders
of the regulatory agency on how to structure the industry and its processes so as to
maximise the objective of creating a competitive environment, vis-à-vis the government,
the industry and other agencies involved, like competition authorities and other countries’
regulatory approaches.
Unlike the traditional perspective that denied the feasibility of competition in the whole
of the gas industry, the proponents of structural change start from the hypothesis that
the introduction of competition is possible in particular segments, and that this would
improve the performance of the whole of the value chain. Typically gas supply systems
involve four segments. The exploration and production segment includes a variety of
firms involved in exploration, drilling, production, and the collection of gas from the
fields’ wellheads, to move it to the transmission pipelines. Gas production is a potentially
competitive segment of the industry. Producers sell natural gas to a gas utility, or to
traders, which sell it to the end users. Main elements of the regulation involve a depletion
and taxation regime, plus (ex- post) competition policy, to restrict the market power of
the gas producers, relative to each other, to the utilities and to large consumers. Gas
transmission involves the long distance, high-pressure pipeline transport of gas from the
producers to the consumer markets, or LNG systems including, gasification, ocean-going
tanker transport and re-gasification terminals. Natural gas distribution consists of the
local operations necessary to deliver natural gas to the end users, including low-pressure
pipeline transportation, metering, and supply activities vis-à-vis the several types of
customers. The distribution segment of the industry is seen as a natural monopoly,
because of the economies of scale and scope, the fixed costs of pipeline construction and
the relatively low variable costs of their operation, plus their essential facility character.
Depending on the maturity of local systems, their specific lay-out and the particular
function of these connections, this segment should be more or less actively regulated,
with a focus on access conditions, the fees charged, the cost recovery of the systems and
their timely expansion. What is crucial here is the balance between the longer-term
interest of the investor and owner of the system and the short-term users’ interest of low
cost, flexible transport contracts. As gas supply is becoming increasingly dependent on
long-distance cross border pipelines, international treaties safeguarding transit will be
required. The WTO agreements may not be sufficient to minimize the risk of
international transport. Multilateral treaties like the Energy Charter and its Transit
Protocol have been established to fill this void. The Energy Charter, as an example, may
be an important support to investments in production and transit capacity. So far, 46
countries and the European Communities signed and ratified the Charter, but some
important states have not yet ratified. In other situations, specific bilateral transit treaties
may be more appropriate. A discussion exists in respect of the regulation of storage,
blending and other facilities, to secure open access and avoid an abuse of a dominant
market position in the provision of these services. If, because of the scarcity of such
facilities, competition policy fails to provide the required openness, other forms of access
regulation – similar to that for pipelines - should be taken into consideration. Trading
refers to the resale of natural gas in the wholesale market and retail market. Unbundling
of the vertical column of the gas industry creates a large number of supply companies,
which aggregate demand and supply for a number of smaller market participants by
purchasing natural gas and transportation services on their behalf. New flexible short-
term trading and contractual arrangements will be provided to balance supply and
demand and give market participants the flexibility they need. Yet, end-users may have to
be protected from the market power of gas traders, while ex- ante merger control or ex-
post competition policy may be necessary to reduce anticompetitive behavior in this
segment.
A general view on the way in which economic restructuring in these different segments of
the value chain may take place should recognize that liberalization, regulation and
unbundling, and merger control , are means to achieve an end. The aim is to establish
efficient and effective systems that supply energy, including natural gas, to end
consumers in a manner that is commercially sound and that supports the overall welfare,
from an economic, a social and an environmental perspective. This implies that, given
these objectives, a deliberate choice will have to be made with respect to the precise
means to achieve these goals. Arguably, it is in the combination of context, objectives and
instruments that the appropriate outcome emerges in different countries and regions.

Fourth approach: critical (non-liberal) approach towards the energy security

As has been pointed out by a political economist S. Strange, this economic sector can not be
analysed in purely quantitative terms. The oil shocks were partially provoked by Israeli-Arab
conflict of 1973, which can not be incorporated into economic modelling 17. On these grounds, she
stigmatises the existing theoretical barriers existing between three major social sciences, i.e.
economics, political science and international relations and stresses the need to analyse energy
security from both economic and political angles. Her conception represents a particular view of a
structural approach to the international political economy: the structures which shape global

17
STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 191.
political and economic behaviour for states, firms, and other social and economic actors 18. She
argues that four primary structures, namely security, finance, production and knowledge,
constitute a source for structural power of international actors 19. Energy, in turn, plays a vital role
for production (especially industry, residential and transport sectors), finance (in terms of benefits
provided especially by oil trade), knowledge (related to technological development, including
energy and environental sectors), as well as security (setting up international institutions dealing
with energy supply or direct intervention in oil-producing regions) 20.

Electricity and gas liberalisation constitutes a basis for new energy security scares. Firstly,
opponents of the electricity liberalisation refer to the Californian crisis of 2001, caused by the
inability or unwillingness of the private sector of this American state to provide long-term power
supplies for its electricity generation (“Californian syndrome”). Secondly, as far as gas security is
concerned, full liberalisation might lead companies to refuse to establish legally required gas
storage because of tougher competition with other gas distributing companies 21. In this respect,
liberalisation gives new grounds for political debate over the role of the private sector in ensuring
energy security.

Gazprom considerations of security of supply in the liberalizing markets

OAO GAZPROM
(RUSSIAN FEDERATION)
General framework
Open Joint Stock Company (OAO) Gazprom is responsible for gas production
in Russia. The state, represented by the Russian Government, holds 38% of
the company’s shares. Gazprom is responsible for gas supply security as well
as for the development of the United Gas Supply System (UGSS) of Russia.
Gazprom owns and operates a gas pipeline network, which is an integral part
of the UGSS. Besides, Gazprom bears sole responsibility for gas export outside
the former USSR territory through Gazexport, Ltd., fully owned by Gazprom.
Gazprom is also involved in financing, engineering, construction and ownership
of gas transmission facilities in a number of European countries.
Oil companies and other gas operators also produce natural gas; they each
produce about 6% of the total Russian gas production. Gazprom holds interests
in the share capital of the majority of the said gas producing companies, while
fully independent companies produce somewhat over 1% of the total gas
production in Russia. Independent gas producers sell their gas mainly in the
Russian internal gas market; nevertheless, in 2001 they provided a quarter of
the total Russian gas deliveries to the Commonwealth of Independent States
(CIS) and Baltic states. Gas production of other companies and their share in
the total Russian gas production is expected to significantly grow in the

18
STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 25.
19
STRANGE, S. (1980), States and Markets, Pinter Publishers, London, p. 27-29.
20
STRANGE, S. (1980), States and Markets, Pinter Publishers, London, pp 186-206.
21
BUCHAN, D. (2002), “The Threat Within: Deregulation and Energy Security” in Survival, vol. 44, no 3,
Autumn 2002, p. 109.
future – up to 20%.
The projects for the extension of the gas infrastructure are financed in
Russia by attracting private capital (corporate financing) through bank
(non-Governmental) credit facilities.
Definition/concept of security of gas supply
While security of natural gas supply is supposed to be a multifaceted concept
and not easy to define, there are three dimensions of particular relevance:
Resource and infrastructure availability (physical existence of sufficient
resource, existence of adequate infrastructure to bring the resource to market);
Economic availability (affordability of supplies, contractual arrangements
in place (including transit);
158
Supply continuity (accidental short-term disruption (natural/technical
causes), deliberate supply disruptions).
The physical existence of gas resources will be no limiting factor in the further
development of the gas market. To mobilise these resources for Europe, the
required field developments and infrastructure construction have to take place
in a timely fashion. The import dependence is not seen as a problem, given that
political and economic stability exist to allow for a long-term supply planning
and fostering the required infrastructure investment.
The costs of gas production (including gas transmission/transportation) are
very likely to increase because of the following: remote production areas;
difficult climate conditions and physical circumstances; and stricter
environmental constraints.
Changes in the European gas market, mainly triggered by the liberalisation
process, will lead to new structures and redistribution of responsibilities. As
transmission and distribution activities have to be legally separated from other
activities in the gas chain, responsibility for security of supply will be a shared
responsibility of all market players.
One of the gas industry key policy elements for the security of natural gas supply
is diversification (new pipelines from new and “traditional” suppliers, new LNG
projects either from existing or new players, etc.). At the same time, it is
necessary to pay due attention to the reliability of the new gas suppliers.
All relevant market players should be involved in deciding the required
levels of security of supply and how those levels should be implemented.
The end-consumers have their demand and pay for it. The gas industry
is responsible for supplying what is contracted. It will be a challenge for the
total gas industry to maintain the efficiency and reliability, which the
end-consumers are used to.
The company’s instruments used to secure supplies
All forecasts predict significant growth in gas demand in the EU countries, on
the one side, and reduction of indigenous gas resources in the EU, on the
other side. The world’s biggest Russian gas reserves are one of the main sources
that can be used to meet increasingly growing gas demand. Gazprom, with its
undisputed reputation as the world’s biggest and highly reliable gas exporter,
has accumulated vast experience (over 30 years) in the gas business and managed
to build a long-term portfolio (up to 25 years) of gas export contracts, which
159
enables it to meet a major part of expected gas demand growth. Under the
framework of the liberalised gas market in Europe, this objective cannot be
reached without signing long-term take-or-pay agreements. In the company’s
view, these contracts should lay the basis for further development of the gas
market and they should embrace no less than 75-80% of gas market volume.
Growth in gas exploration, production and transmission costs in Russia due
to natural depletion of major gas producing fields in the northern Russia
(beyond the Urals ridge), commercialisation of the far north fields and
development of deep-seated gas-bearing structures actually increase gas costs.
To implement large projects related to the field development and gas transmission
infrastructure construction, tens of millions of dollars are required in investments.
It is only long-term contracts that assure the payback of investments
incurred – a vital condition for project financing. Since the late 1960s, Gazprom
has heavily invested in developing the UGSS, which today plays a key role in
securing Russian gas deliveries to Europe. Under present conditions, when huge
investments are required to maintain and develop the UGSS in order to build
up gas export, Russia cannot successfully implement capital-intensive projects
without access to western capital.
Financing of capital-intensive gas projects is a key factor which will shape
future natural gas deliveries to Europe. Although huge investments are required,
the following key issues have to be resolved:
Equal rights for Russian companies in getting access to the European capital
market (for the time being, loans offered to Gazprom are 2-3 times as
expensive as those offered to big western corporations);
Financial participation of European consumers in the development of
Russia’s export-oriented mineral base and respective gas transmission
infrastructure;
Investment risk sharing among producers, gas transmission companies and
gas consumers, which can be realised through the conclusion of long-term
take-or-pay agreements on gas supply, transmission and transit.
If a full-scale legal unbundling is to take place in the EU countries, it may
cause serious problems and also additional administrative and technical expenses
in case of overregulation. This may have a negative impact on the efficiency of
the whole gas industry and consequently lead to unnecessary increase in tariffs
and end-consumer gas prices. The main problem would be the obvious
discrepancy between decision making regarding the infrastructure and decision
160
making regarding market development/supply. Lower investments in the
infrastructure and discrepancies between transportation/service contracts and
supply/trade contracts could seriously affect the security of supply.
In order to maintain the current level of security of natural gas supply, it is
important to avoid unnecessary costs or taxes on natural gas.
At the moment, there is no significant threat that the gas industries might not
be able to maintain their extremely high level of security of supply as has been
displayed by them so far. Unfortunately, some new regulations could threaten
this favourable future, even in the short run. A clear example is the impossibility
in some countries to match long-term supply contracts with long-term
transit/transportation contracts. Such anomalies should be removed as soon as
possible. They cause unnecessary additional costs and supply risks in the market.
The EU policy pertaining to Russian gas purchase is dual. On the one hand,
the EU Gas Directive notably worsens Russian gas sales conditions in the EU
gas market. On the other hand, the EU leaders expressed their intention to
double gas import from Russia.
The EU Gas Directive primarily protects the consumer interests, ignoring the
needs and interests of producers. At the same time, short-term and spot market
deals are considered as an alternative to long-term contracts. In our opinion,
the significance of the former is obviously overestimated. A growing number
of short-term and spot market deals naturally disturbs gas trade effected under
long-term contracts and, in fact, undermines Europe’s gas supply security.
At present, the EU Commission is investigating long-term agreements on
Russian natural gas purchase in order to find out whether certain articles of
these agreements, banning the re-export of Russian gas delivered (the so-called
territorial restriction clauses), comply with the EU legislation. The ban was
introduced into agreements from the very beginning in order to prevent unfair
competition in the gas market due to natural gas price differences caused by
different terms and conditions proposed to various buyers in various European
countries. Therefore, some western companies could actually obtain unfair
profit through Russian gas re-export.
For the time being, Gazprom is in negotiations with the EU Commission on
this matter. During these negotiations, the EU Commission representatives
had to recognise that the issue of “destination clause” was extremely important
for Gazprom, and it is necessary to find an alternative economic approach to
resolving the re-export issue. Yet, the problem still needs some time to be solved.
161
162
Since major gas resources are located far away from Europe’s main gas-consuming
regions and natural gas has to be transported through many countries to reach
end-users, it is obvious that the issue of unrestricted natural gas transit through
all the EU countries, whose borders divide gas producers and gas consumers,
plays a key role in securing gas deliveries to Europe. In this respect, the following
issues should be focussed upon and solutions found:
Fair, non-discriminatory gas transit tariffs in all countries involved, based
on investments and operating costs and a reasonable rate of return, which,
therefore, should reflect the interests of gas suppliers and owners of gas
transit facilities;
Right of first refusal (priority right in getting access to gas transit pipelines)
when producer/trading companies have to fulfil long-term obligations and
their transit contract is expiring.
The intention of the EU Commission to consider gas transit within the EU
as an internal gas transportation activity, carried out under the EU regulation,
seems to be unacceptable for Russia. This stance appears to be a refusal to respect
gas transit obligations taken when signing gas purchase contracts with Russia,
and the aspiration to obtain exclusive jurisdiction in respect of gas transit
issues within the EU.
Belyi & Kuzemko, Conflicting values in gas markets: a view on the UK-Russia relations,
2007 (forthcoming)

Introduction

The beginning of the twenty-first century has been characterized by the increased role of
Russia in energy supplies to North West Europe. Since 2001, Russian gas has been traded
in the UK and in 2005 Gazprom engaged in a gigantesque project when it started
construction of an underwater pipeline, the Nord Stream, from Russia to the UK through
the Baltic Sea and Germany. In turn, the UK is entering a transition period from its recent
status of oil and gas exporter to one of import dependency in both products. Hence, the
UK and Russia have entered into a position of interdependent interests in the gas trade.
Notwithstanding this objective interest between the two States, their relations have, in the
past few years, become quite difficult in political terms. Such difficulties are caused by
their opposing political approaches, particularly in the case of energy. As any economic
policy is based on the preference of certain values over others (S. Strange, 1998), energy
relations are based on the political values of both countries. Indeed, their respective
recent historical backgrounds demonstrate rather opposite political trends: on the one
hand, the UK has since the mid 1980’s been at the forefront of gas market liberalization;
and on the other hand, Russia is attempting to reinforce national control over energy
flows, including gas. This has led to a number of concrete political issues, namely:
- The waiver of Gazprom’s participation in the UK distribution market due to the
lack of reciprocity regarding market liberalization in Russia;
- The insecurity of long term investments in the Nord Stream pipeline undertaken
by Russia.

In addition, the UK-Russia gas trade relations cannot be separated from the general
European context, marked by ever-increasing cross border trading. The UK has been a
frontrunner in the liberalization process in Europe, however, it remains unclear what the
future prospects of this process are both in the UK and the continental Europe.

Considering this context of the gas markets, the analysis of UK-Russia energy relations
consists in demonstrating the historical background of these two political approaches
particularly in the gas sector, which, in turn, are having an impact on current energy
relations between London and Moscow. For instance, Russian re-nationalization of
Gazprom and re-negotiation of existing contracts with Shell and BP have provoked a
reluctant, sometimes even virulent, response in London. In turn, capacity auctions and
spot markets in the UK are feared as a factor of long term gas market demand instability
in Moscow. The purpose of this chapter is to demonstrate those misunderstandings
between Russia and the UK which stem from the historical development of the differing
political approaches in the gas sector.

In order to proceed with this study, the present article suggests the following structure:
first, we outline the historical development of gas market liberalization in the UK and
consequences for current policy; second, we point out the logic of the current trend in
Russian gas export policy which is quite opposite to the UK liberalization trend; third, we
analyze the resultant influences on UK-Russian relations in gas sector.

1. UK Historical background: gas market liberalization and multilateralism

The period of Labour government immediately after the Second World War saw a
prolonged attempt by the British government to bring energy supplies under the control
of government, not entirely unlike what is happening in Russia today. The 1948 Gas Act
allowed for the nationalization of the system which proved a radical departure from the
previous system which had consisted of over 1,000 separate municipally and privately
owned gas companies. The process of nationalization caused these companies to be
consolidated into the 12 gas boards each of which had a good degree of independence
with their own executive boards and chairmen. The Gas Act of 1972 further centralized
control of the industry with the creation of the British Gas Corporation, the relatively
autonomous gas boards became regions of geographic control under British Gas central
administration.

However, during the 1970’s, there were two major changes in the UK which radically
effected gas policy thereafter. The first was the discovery of gas by British Petroleum
(BP) in the West Sole field off the coast of East Anglia in 1965. This find, despite early
set-backs, encouraged further investment in exploration. The harsh economic conditions
of the 1970’s, combined with the first ‘oil crisis’ kept the emphasis on further exploration
and development in the UK North Sea with the goal of becoming self-sufficient in oil and
gas. This was ultimately achieved in both commodities when the UK became a net
exporter of oil in the early 1980’s and of gas in 1997. This self-sufficiency provided the
economic and geopolitical backdrop to the next round of reform of the gas sector, but this
time in reversal to what had gone before. The second major change was the ascendancy
of the Conservative Party which provided a deeply ideological context to future reform.
The ultimate liberalization of the UK gas market which took place between 1992 and
1998 found its roots in the 1982 Oil and Gas Enterprise Act under the Conservative
government of Margaret Thatcher. This Act not only opened up UK pipelines to third
party competition but also gave the government the power to sell off British Gas assets
and was part of a general programme of liberalization and privatization across Great
Britain. The opening up of UK pipelines is held as being responsible for the ensuing
‘boom’ in the UK oil and gas industry and associated oil self-sufficiency 22. By the mid
1980’s there were over 100 oil and gas installations in production in the North Sea.

22
Hanson, North Sea Oil and Gas website
Further ramifications of the domination of neoliberal ideology over UK domestic policy
was the freeing up of trading commissions in the financial centre of London, the ‘city’.
The ‘Big Bang’ had led to a proliferation of financial organizations and a boom in trading
exchanges, including oil and gas. Today London is the global centre for oil and gas
trading through the International Petroleum Exchange (re-named the Intercontinental
Exchange in 2005) and since 1995 there has been a UK Gas Forwards Market in
operation. During the 1980’s the Thatcher government ‘downgraded’ the Department of
Energy to an adjunct of the Department of Trade and Industry (DTI) on the premise that
‘the title smacked of economic planning … whereas our (UK) energy needs should be
supplied by the market’23. This was the start of the overt depolitisization of UK energy.
In 1986 the British Gas Corporation was privatized and the regulator ‘Ofgas’ was created.
Liberalization was complete by 1998. In 1992 competition was opened up in the
commercial gas market and alternative suppliers to British Gas started to enter the
market. This was followed in 1996 by partial, and then in1998, full lifting of restrictions
on competition in the retail market. These quite substantial reversals away from state
control resulted in a system which was consciously designed so that there would be little
or no government involvement in the provision of energy in the UK. This put the UK at
the forefront of gas market liberalization. Despite a great deal of European Union
discourse about gas market liberalization in most of Europe, including Germany, France
and Italy, the encumbant gas company still controls over 80% of the market. In the UK
British Gas controls only 25%.

The context behind current energy policy is very different although the tendency for
government to remain apart from involvement in energy supplies is largely the same 24.
With the peak and decline of North Sea oil and gas reserves the UK became a net
importer of gas in 2004, ahead of expectations, and of oil in 2006 25. In addition to the
UK’s resultant dependence on imports, particularly of gas26, to fuel their economy the
demand for gas is increasing across Europe and globally. Coupled with these demand
concerns are those over the threat to energy supply from terrorism and from producer
countries which are seen, in the UK, as being unreliable. This combination is seen as
constituting a threat to energy security which, in turn, ‘has resulted in a threat to market
oriented tendency(ies)’27. The argument is that those who seek national energy security

23
Bob Blackhurst 2004, Foreign Policy Centre: http://fpc.org.uk/articles/264
24
Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), University of Dundee (2006)
Security of International Oil and Gas: Challenges and Research Priorities: A Project for the Economic and
Social Research Council:
http://www.dundee.ac.uk/cepmlp/Research/ESRC%20CEPMLP%20FinalReport.pdf
25
Lee, Julian (2007) ‘The UK-Russia Energy Relationship’ in Monaghan, Andrew ed. The UK and Russia:
A Troubled Relationship Part 1. Conflict Studies Research Centre: http://www.defac.ac.uk/colleges/csrc
26
Alistair Darling, the UK Minister for Trade and Industry, expects that the UK will have to import between
80% and 90% of its gas needs by 2020. Gas is expected to supply up to 80% of our electricity needs.
27
Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), University of Dundee (2006)
Security of International Oil and Gas: Challenges and Research Priorities: A Project for the Economic and
Social Research Council: http://www.dundee.ac.uk/cepmlp/Research/ESRC%20CEPMLP
%20FinalReport.pdf
are more often than not states but, conversely, ‘liberalized energy markets circumscribe
the potential for government intervention’.28

There are a number of further effects of liberalization on the UK gas sector, and on the
ability of the UK government to provide ‘energy security’. The legacy left behind of the
depolitization of energy supply has implications for the current need to secure stable
supplies of gas at affordable prices in the future 29. Since privatization the gas sector has
been run by the private sector and its rationale of profit maximization means that the
spare capacity in gas storage that had been built up by previous generations has now
gone30 This means that the UK needs to invest heavily, and swiftly, in adding storage
capacity in order to be physically able to import gas in the quantities required to supply
future needs without heavily impacting prices31. The issuance of a ‘Gas Balancing Alert’
in the winter of 2005 served as a warning to government and private industry participants
that a lack of ‘joined up’ action with regard to future energy needs is at odds with the
aims of provision of energy security. Excess storage of gas is recommended by the
International Energy Association (IEA) in their guidelines on methods of providing
stability of energy supplies in times of oil and gas ‘crisis’. Liberalization has also
provided for a ‘greater role of the financial markets in the oil and gas business’ 32. Gas is
traded in short-term contacts and over-the-counter. The ‘city’-based financial companies
and exchanges which are involved have a vested interest in keeping gas trading volumes
high, thus keeping volumes of commissions high.

All of this is in stark contrast, as already mentioned above, to how Russia organizes its
energy sector which would be of little significance were it not for the fact that Russia is
expected to be one of our main sources of gas, and oil, in the future. Although the UK
2007 Energy White Paper looks to alternative sources of energy to help reduce future
consumption of hydrocarbons, both the Trade and Industry Secretary, Alistair Darling,
and the Foreign Office acknowledge that, for the decades to come, the UK will need to
import large quantities of gas. While the White Paper emphasize the UK’s commitment
to the free operation of a competitive UK market in gas and the encouragement of market
liberalization ‘abroad’ it also states that the UK will rely, like the rest of Europe, on
Russia for much of its gas supply. The British Foreign Office points to Russia as having
‘an important role to play in ensuring global energy security’33. The Nord Stream
pipeline will, as of 2010, directly connect the UK to supply from Russia for the first time.
Gazprom is already operating in the UK via Gazprom Marketing and Trading (UK)
Limited, which purchased Pennine Natural Gas Limited, and is supplying commercial

28
Ibid
29
Energy White Paper (2007) at the Government News Network website:
http://www.gnn.gov.uk/environment/fullDetail.asp?
ReleaseID=245255&NewsAreaID=2&NavigatedFromDepartment=False
30
Ibid
31
Alistair Darling, ‘Statement of Need’: http://www.dti.gov.uk/files/file28952.pdf
32
Ibid
33
British Foreign Office website, ‘Country Profile: Russia’: http://www.fco.gov.uk/servlet/Front?
pagename=OpenMarket/Xcelerate/ShowPage&c=Page&cid=1007029394365&a=KCountryProfile&aid=10
19744935436
enterprises in the Midlands with their gas needs. Gazprom is reported to have said that it
‘hopes to raise its market share (in the UK) to 10% by the end of the decade’34

The rhetoric of the UK government is still an emphasis on continued liberalization and on

multilateral action, specifically through the European Union’s dialogue with Russia.
Some recent actions, however, raise questions about the practice and efficiency of this
approach. For example, since 2001-2002, the UK gas capacity markets have moved
towards long term auctions which have replaced the previously preferred short term spot
markets. As a result, 80% of capacity trading is now based on long term commitments of
between fifteen and sixteen years. Short term capacity trading was considered to be
insufficient incentive for the kinds of long term investment required by the capacity
network. At the same time, the UK remains an active supporter of a competitive
approach in the cross border market trade. Moreover, in the light of Russia’s increased
control, via Gazprom, over supply and transportation of gas, their lack of willingness to
ratify the Energy Charter Treaty, and their, thus far, marked intention not to support
further liberalization of gas markets in Europe, the UK’s continued faith in liberalization
as a key component in the provision of energy security is questionable.

2. Russian historical background: re-nationalization and bilateralism

Supply and export structures for natural gas within the FSU area are inherited from the
Soviet Union, where the command economy dominated production and supply. After the
break down of the USSR, new Joint Stock companies were established on the basis of the
former Ministries. The largest gas monopoly within the FSU, Gazprom, emerged after the
restructuring of the MinNefteGazStroi in 1989. After 1992, a Joint Stock Company,
Gazprom, was created and later privatized. The state lost a majority of shares holding
only 36% of Gazprom. However, the privatization project did not lead to major sector
restructuring, like the unbundling of oil companies. Oil and gas privatization always
remained purely Russian: Russian legislation of 1992 defined Gazprom as a natural
monopoly and on these grounds limited foreign participation within Gazprom to only 10
percent.

In 2005, an important reform was accomplished: in exchange for 51 % control by the

state, Gazprom opened up to foreign capital up to 49 %. At the same time, Gazprom
increased its involvement in the oil sector receiving a loan to purchase the Russian oil
company Sibneft35. Gazprom’s intent being that the gains in the oil sector would
compensate for the loss of gas sales in the internal market, which remains low due to
Russia’s cross-subsidy system. The potential benefits from oil exports also remove the
necessity to open gas networks to third parties in case of low rates of Gazprom’s own
exports.
34
Katinka Barysch (2007), ‘Why the UK needs to back Commission Energy Plans’:
http://centreforeuropeanreform.blogspot.com/2007/01/why-uk-needs-to-back-commission-energy.html
35
RIA-Novosti, 29.09.2005.
In mid 2006, a new bill was adopted by the Russian Parliament, the State Duma, on gas
exports. It iterates the export monopoly of Gazprom, including non-pipe gas, such as
LNG and Condensate36. It also limits the action of private companies in gas trading. In
addition, Gazprom elaborates on a strategy to establish a gas alliance with Central Asian
producers, which would allow the company to dominate the international trade in gas,
similar to Saudi Arabian state domination of their oil sector. Consequently, Gazprom
would become the unique market player in Russian gas exports.

In addition, Gazprom holds interests in infrastructures of the new EU Member States,

especially in the Baltic States. Gazprom concluded long term contracts with Poland,
where it reserves 100% of capacities. Consequently, if Poland wants, in the future, to
switch supplier it would then have to consult with Gazprom. Gazprom’s logic in
reinforcing long term contracts for the capacities are due to the concern of the potential
discrepancy between long term contracts for supplies and short term agreements for
transport capacity. In turn, long term contracts allow for, and encourage, much needed
investment in the capacity networks.

This logic explains Gazprom reluctance towards spot markets in gas trading and
secondary short term markets for capacities. The capacity auctions are considered as the
main danger for gas suppliers: an auction allows for extra benefits for traders but do not
have any positive impact on long-term capacity investments.

In order to defend itself from market uncertainties, such as those related to the capacity
auction system, Gazprom considers a strategy of gaining control of distribution markets
in Europe. It provides an opportunity of market demand distribution. For instance, with
the new system, Gazprom can play on the markets bypassing the intermediate European
companies. For instance, on the basis of EU Competition law, the European Commission
forced the companies to revise particular clauses of their contracts, which establish
destination clause and the “most favored customer clause”37. At the same time, the
European Commission can use its power of Competition law against Gazprom: being a
monopoly inside its own country, Gazprom’s participation on the distribution markets can
be restricted due to the reciprocity principle. The principle has been integrated in the EU
internal market Directives in order to attribute a power for the EU Member States to
restrict the degree of market opening for those countries, who did not liberalize their
markets. The reciprocity principle might allow the European Commission to avoid
Gazprom getting important shares in the distribution markets.

The situation represents a major concern for Gazprom. Rather, the Russian monopoly
perceives in that a deliberate strategy of decreasing Gazprom’s role in the EU markets.
On the grounds of concerns related to the liberalization, the Russian State Duma
36
Neftegazovaya Vertikal, Lenta, 5.07.2006.
37
L Hancher and I del Guayo, The European Electricity and Gas Regulatory Forums, in Barton, B.,

Barrera-Hernández, L.K., Lucas, A.R. and Ronne, A. (eds), Regulating Energy and natural Resources (edn

2006), 243-261.
considered legal steps towards reinforcing Gazprom as a response to the liberalization
within the EU. Moreover, Gazprom always considered the liberalization within the EU
markets as the main danger for the security of gas demand. The spot markets put under
question long term pay back period for the gas infrastructure projects. Indeed, the long
term contracts include the “take or pay” clause, which requires the buyer to pay for the
gas regardless the actual demand.

By contrast, spot markets integrate price flexibility and hence an insecurity for the
investment return. Furthermore, the ownership unbundling, proposed by the European
Commission in its latest energy package, contains a subsequent danger of loosing the
Nord Stream pipeline and other infrastructures in Europe. In this context, Gazprom
considers the monopolistic structure as necessary to ensure both security of demand for
Russia and the security of supply for Europe. It involves a logic to control the whole
chain of the gas market from the production to the distribution markets.

3. Gazprom and Centrica purchase: a test for the cooperation

Conflicting approaches of the gas market regulation have been felt during the Gazprom’s
strategy in getting EU distribution markets. Gazprom is largely present in the markets of
the Baltic States and has concluded two important contracts with Italy and France at the
end of 2006, where both countries committed to import Russian gas on the long term
basis and to allow a partial access of Gazprom to their distribution markets. However,
Gazprom failed the similar strategy in the UK. In 2006, it has offered to purchaise shares
in Centrica, which, in turn, would create positive conditions for the long term investments
in the Nord Stream pipeline going under the Baltic Sea. Notwithstanding the political
support to the deal from the Prime Minister, the British Parliament has rejected the
possibility of Gazprom’s investment in Centrica due to the lack of reciprocity. Moreover,
the European Commission backed the opposition to the deal for the similar reasons.

The British concerns regarding Gazprom are motivated by the ideological factor: as
Gazprom opposes to a competition in Russia, it should be restricted to have non-
discriminatory approach in the fully competitive market. This argument becomes even
more aggravated since the renegotiation of upstream oil and gas contracts between BP
and Shell on one hand and Russia on the other, both resulted in favor of Gazprom.

In addition to the ideological factor, some experts advance a security argument. For
instance, British concern is based on the risk of under investments in Russia itself.
According to the latest report of the International Energy Agency on Russian gas,
Gazprom’s upstream investments have been significantly reduced in favor of the export
transport capacities. It might result into the drastic decrease of production rate and then of
the supplies to Europe. Gazprom’s representatives refute this threat by arguing the
production rates increased in the recent years. Again a difference in interpretation arises:
Gazprom point out that a decrease of upstream investments is possible in case of the
downstream insecurity of demand.
Consequently, a vicious circle of clashing approaches is formed: the UK opposes
Gazprom’s participation in the downstream markets due to an uncertainty of upstream
investments, Gazprom might reduce upstream investments in case of the demand
insecurity. This puts under question the logic of the liberalization as a remedy for the
security of supply.

Conclusion

The UK-Russia relations in energy relations are analyzed in the context of the
transforming European gas markets. The latter are characterized by an ongoing
liberalization and by attempts of creating spot markets. Historically, the UK has been
seen as the reference country for the liberalization of gas markets, being an initiator of the
idea in 1980s. Nevertheless, we have observed that the liberalization is a relatively recent
process and, moreover, has been increasingly substituted by the long term market
agreements (for instance, in the capacity trading). Hence, notwithstanding the general
political opinion, the spot gas markets in the gas trade become rather an exception than a
rule.

However, Gazprom considers even a low level of liberalization as a peril for the security
of demand. Indeed, two factors constitute the major worry for Gazprom: first, is the
renegotiation of long term “take or pay” contracts by the spot markets, second is a
possible ownership unbundling of gas transmission networks. Both factors create
negative incentives for the investments and increase the level of uncertainty of the stable
return. Consequently, in the long run, the liberalization can even constitute a risk for the
security of supply for the consuming countries, the risk which stems from
underinvestment. Therefore, risks stemming from the liberalization can be felt in the long
run: investments in gas sector have a long pay back period.

In this context, Gazprom moved towards a reinforcing a control over the gas chain from
the upstream to the downstream. By contrast to its European partners, Gazprom refutes
any competition logic and has moved to an opposing direction. It has established tougher
control of both upstream and exports, which are hardly to be in the logic of the
company’s strategy in getting the European distribution markets. Moreover, it remains
unclear whether Gazprom can take on its own charge the LNG projects initiated by Shell
and to ensure all Russian gas export without partially opening the access to upstream and
to the networks. Therefore, steps towards a further reinforcing of the gas chain control are
motivated by political values, which provoke a further reticence in the UK. As a result:
Gazprom could not get into the distribution markets in the UK via the purchase of
Centrica. Those political events did not interrupt, however, the trading of the Gazprom
Marketing and Trading (UK).
In summary, the UK-Russia energy relations rather depend on political values, which do
not always reflect the economic reality. However, it remains impossible to separate the
economic relations from the choice of political values. Whereas the choice between
Russia and the UK remains opposite, the energy relations will remain difficult. Those
difficulties might furthermore have an impact on both security of demand and supply of
the two rather interdependent actors.

Conclusion

The energy security in international relations theories is related to a number of

approaches, which are often overlapping and coexistent. Theorization involves
prioritizing the changes and influence of economic structures and shows how political
institutions are created to respond to these changes - not how they structure or affect
economic forces. Also, theories explain the existing ideas related to economic policies,
which can facilitate the ideological unity to socio-economic interests and by legitimating
institutional change.

The energy security definition involves a variety of interactions at international level. A

different casual explanation of the “agent-structure” interaction: rational or irrational
(ideology-driven) strategies of international actors, political or economic essence of the
energy trade. An empirical observation links each perspective on energy security in their
historical context. For instance, energy shocks of 1970s influenced the creation of the
international organizations, such the International Energy Agency and the Energy Charter
Treaty. The latter has been particularly promoted in aftermath of the victory of liberal
values first in Europe and then in the world. The concept of sustainable development and
a subsequent Kyoto protocol have been a result of perceived threats of the end of
resources and climate change due to an excessive use of the fossil fuels. Similarly,
economic and technological structures became more complex with penetration of new
market players in gas and electricity sectors. More complex structures constitute in turn
an additional difficulty for agents to assess losses and gains: failure of privatization in
Russia, Californian syndrome, conflicts between liberal and national-control values. New
categories of the actors’ motivations and structural constraints might appear within the
instable and unforeseeable IR system.