Winter is Coming: Energy Policy Towards Russia

Editors’ note: This column is part of a Vox debate on the economic consequences of war.

In the heat of summer, most Europeans think of flying to distant beaches, winter can seem far away. But it will be here soon, and it could turn into a winter of discontent, with European unity once again sorely tested.

So far, the EU’s response to Russia’s aggression in Ukraine has been general and strong in terms of sanctions but weak and divided in terms of energy. This partly reflects the differential dependence on Russian gas across countries and the desire to build ‘own’ buffers and storage. It does not bode well for energy sharing and solidarity, the coming winter will be difficult. And, of course, Russia has every incentive to increase the pain and play countries against each other. Uncertainty about the North Stream One restart after the summer visit could be a foreshadowing of upcoming strategic games.

Results of the policy so far

So far, energy policy has aimed to secure quantity at all costs. As a result, EU gas storage stands at around 65%, a high fill rate at this time of year. However, total underground storage capacity is about 100 billion cubic meters while consumption was about 400 billion cubic meters in 2020 (European Commission 2022). Storage fill rates are public information, and it’s unlikely that Putin is ignoring them when planning his deliveries.

Meanwhile, Russian federal budget revenues increased by 34% in the first four months of 2022 compared to the same period in 2021 (Bank of Finland 2022), with revenue growth driven entirely by higher oil and gas prices. This suggests that the sanctions have not been very successful in achieving their primary goal of increasing the cost of waging this war for Russia and making it more difficult to finance it. At the same time, rising energy prices are hurting Europeans as they are a key driver of inflation. Energy prices are still rising as Russia cuts off gas supplies, citing technical difficulties or non-compliance with payments in rubles.

Several ways to make sanctions more effective and less costly for European households and firms have been suggested: a ban, tariffs and price caps.

Future restrictions on oil

The embargo on Russian energy products (oil and/or gas) has been the subject of fierce debate, with varying estimates of the growth impact, from comparable to the Covid-19 shock to considerably smaller in countries less dependent on Russian gas (e.g. Bachmann et al.). 2022, Baqaee et al. 2022).

On 30 May 2022, the EU decided to impose a ban on imports of Russian oil and petroleum products, but this will only be in effect for six months. The announcement caused oil prices to rise (about 5%), but this was already prior to the upward trend since mid-May when more sanctions were likely. Anticipation of the announcement therefore created a headwind for Russia. As for gas, since the start of the war, expectations of possible future sanctions have also driven price increases. Natural gas prices are nearly nine times higher than before the war.

Arguably, the prospect of future energy bans without immediate action leads to the worst of both worlds: higher economic costs for EU countries due to rising energy prices. And Increased revenue for Russia.

The US has pushed for oil price caps to reduce Russian revenues, and the G7 announced they would “explore additional measures such as price caps” at their last meeting in Elmau (European Council 2022). However, organizing a cartel of buyers for oil, a much larger market with many buyer-supplier relationships, is going to be extremely difficult. We argue that a temporary import tariff on Russian oil would be easier to enforce and a price cap would make more sense for Russian gas.

An import duty on oil

A tariff on Russian oil imports would have several benefits: it would reduce imports from Russia as buyers would have a strong interest in substituting other sources, and it would likely pressure Russia to lower its prices to EU customers, as it has already done. Other countries with 30% discount on oil. It can be gradually increased to prepare for an infinite tariff amount of sanctions.

Rents currently charged by the Russian authorities would be partially taxed by the EU, which could use the money to compensate the most fragile families and organizations and/or start financing the reconstruction of Ukraine. Relative to an immediate ban, the economic costs for the EU (especially for the companies and countries most dependent on Russian oil and gas) would decrease as the remaining (high-value) imports would go to those who need them most.

An import tax is not an ideal instrument – it would create incentives to avoid it and could further increase oil prices. How much oil prices rise will depend on the incidence of the tax, that is, how much Russia will be forced to lower its export prices to be competitive with other producers unaffected by the tariffs. Substitution of non-Russian imports is easier for oil than for gas.

Single buyer and wholesale price schedule of Russian gas

Pipeline gas is special. It is characterized by infrastructure that directly connects sellers and buyers and, in principle, creates market power on both sides of the pipeline. Currently, Russia is exercising market power but Europe is not, instead allowing different buyers to compete for gas and driving up prices. A single European buyer platform has been created but it is voluntary and therefore cannot exercise buyer power. This is very different from the single-buyer consortium that allowed the EU to successfully secure and share vaccines during the pandemic.

A single European buyer would change the rules of the game from being at the mercy of Russia to a truly strategic negotiation: the buyer would offer a price and quantity schedule. Prices may even be higher than historical values ​​and production costs, but not excessively so. If Russia ‘defaults’ on the quantity, the single buyer will lower the offer price.

Today’s unusually high gas prices reflect Russia’s market power under exceptional circumstances, as well as the uncertainty of future sanctions and disruptions. Pipeline gas prices were around €20 per megawatt hour before the outbreak of tensions with Russia, around €80 per megawatt hour (MWh) by mid-June, and climbed to €185/MWh in mid-July.1

A credible wholesale pipeline gas price cap set by the EU at today’s levels of, say, around €100 could remove uncertainty about future price increases. Market participants will not speculate on future price increases in the event of a disruption. To be credible, such price caps require a well-defined protocol of possible rationing both internally and between countries. The price cap should then be gradually reduced and may be clarified with a progressive ban.

A price cap set at a high level can generate lucrative profits for some wholesalers. In the present exceptional circumstances, tax on exceptional profits in the energy sector should not be waived. A single buyer will only apply for Russian pipeline gas, not liquefied natural gas (LNG). But in view of the integrated European market, the same offer price will apply to other gases; Suppliers like Norway and Algeria will still enjoy huge windfalls.

It is important to distinguish between single-buyer price wholesale pipeline price caps and schemes to limit energy price increases at the retail level. Many EU governments have tried to protect households from the impact of higher energy prices through price caps, rebates, tax cuts and market segmentation. Such interventions at the retail level are not only very expensive financially, they are mostly ineffective and send the wrong signal on climate change. They favor the rich, who consume more energy than poor households. A cheaper and fairer intervention would be targeting low-income families and those most affected, for example by poor access to public transport.

Conclusion

A single buyer is not the first-best instrument, with import duties on oil and price caps on pipeline gas. But they are the best response to an extremely bad situation. It is not acceptable for European consumers to receive a partial increase in fuel prices to Russia due to the announcement of future sanctions. Also, it should not be accepted that Europe is at the mercy of aggressive Russian strategic gaming with gas supplies during the winter.

Both instruments are temporary, targeted and aligned with an accelerated green transition. The European Council has already forced the European Commission to study a temporary price cap, which should be extended to import tariffs on Russian oil. A single buyer for pipeline gas would not only help implement price caps but also balance market power and revenues away from Russia.

This winter will be a major stress test of European unity and solidarity. Exposure to gas depletion varies greatly from country to country. Flanagan et al. (2022) show that Scandinavian countries are virtually immune to gas depletion, while Eastern European countries are highly exposed. Furthermore, the magnitude of output losses will depend on whether energy markets are integrated or fragmented. For example, Germany’s output loss in a cut-off case is estimated to be about -3% in a fragmented case, as opposed to -1% in an integrated case. Solidarity and sharing must be ‘flowed’ in new ways this winter. To get through the winter, common energy buying, storage and sharing arrangements need to be agreed and tested now.

reference

Bachmann, R, D Baqaee, C Bayer, M Kuhn, A Löschel, B Moll, A Peichl, K Pittel and M Schularick (2022), “What if Germany disengages from Russian power?”, VoxEU.org, 25 March .

Bank of Finland (2022), “Russia’s economic slowdown is felt in government budget revenues; Military Spending Rises”, BOFIT Weekly, 25 May.

Baqaee, D, C Landais, P Martin and B Moll (2022), “Economic Consequences of Stopping Energy Imports from Russia”, Conseil d’analyse économique Focus #84.

Chepeliev, M, T Hertel and D van der Mensbrughe (2022), “Cutting Russia’s fossil fuel exports: short-term pain for long-term gains”, VoxEU.org, 9 March.

European Commission (2022), “Questions and answers on new EU rules on gas storage”, 23 March.

European Council (2022), “G7 Leaders’ Communiqué – Executive Summary”, 28 June.

Flanagan, M, A Kammer, A Pescatori and M Stuermer (2022), “How a Russian natural gas cutoff could weigh on Europe’s economy”, IMF Blog, 19 July.

Schropp, S and M Tsigas (2022), “Searching for ‘favorable’ sanctions on Russia”, VoxEU.org, 17 June.

Endnote

1 Visit www.powernext.com/spot-market-data

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