Download Exchange Rate Overvaluation and Trade Protection: Lessons from

The Merits of Dual Pricing of
Natural Gas by Russia
David Tarr and Peter Thomson
Prepared for the World Bank Institute Course in Moscow, Russia
“Trade Policy and WTO Accession for Development in Russia
and the CIS”
March 28-April 8, 2005
1. WTO Negotiation Context
Demand for unified pricing by the EU of gas and some
support by the US.
Why the US—fertilizer producers complained about
competition from Russian exporters with lower costs. But
US took a back seat to the EU.
An effort to obtain cheaper prices for European consumers.
The EU indicates that this is part of their strategy for
integrated, competitive energy markets in Europe.
Set back discussions-Russians reacted very strongly and
very negatively. It would not agree to unified gas pricing in
Russia and Europe.
The World Bank saw the need for good analysis. The Financial
Times and all major Russian newspapers (except Commersant)
reported on a draft version of the paper in March 2003. But
inaccuracies in the stories.
2. Russians call the demand “WTO-Plus”
A subsidy must be specific to an industry or group of
industries. The price of gas is the same to all Russian
users, so it is not a subsidy.
3. Optimal Export Price
Russia has market power in European markets. 66% of
European imports are from Russia, and Russia supplies Europe
with about 27% of all its gas.
Cf. OPEC share of world oil markets is 33%.
The Russian and European markets are segmented. Pipelines
deliver the gas, so gas sold in Russia cannot be resold in
Europe.
These two facts together imply that Russia cannot supply significantly
more in Europe without lowering the price there. (Gazprom sells three
times as much gas in Russia as it does in Europe.)
That is, there is no “world price” at which Russia can sell all it
wants. Russian sales determine the market price in Europe in
an important way.
Then there is an optimal markup over marginal costs for Gazprom on
its European sales.
If gas suppliers play a Cournot game in Europe, the optimum is defined
p(q E )  (c  t ) dp q E q R  s where
as:


E 
p(q E )
dq E p q E
E
q
dqE p
 market elasticity of demand in Europe and s  R 
qE
dp q E
the market share of Gazprom in Europe, and the ratio is the perceived
elasticity of demand by Gazprom in Europe.
The optimal markup of Gazprom in the Europe market,
increases with the market share s and decreases as the
absolute value of market elasticity of demand increases.
The optimal price also increases as marginal costs c, or
transportation costs t increase.
Figure 1 depicts the optimum for Gazprom in Europe on the left
hand side.
Gazprom earns rents on present sales in Europe equal to the
value DD’E’E (P-costs)*Q= about $6 billion per year ($5
billion in 2000, $7.5 billion in 2001).
Triangle of deadweight loss equal to about $2.5 billion per year, if we
assume an elasticity of -1.5. (Estimate increases with the elasticity,
but it can’t be lower than unity assuming that Gazprom is optimizing.)
European consumers would gain more dollars than Gazprom would
lose if Gazprom lowered the price to marginal costs. Triangle of
deadweight consumption losses.
Price = LRMC in Europe would result in the EU gaining
$2.5 billion per year more than Gazprom loses.
One question: is there a cooperative solution that allows both Russia
and Europe to be better off? There are $2.5 in potential gains. A cooperative
solution may appear infeasible (there are over 20 countries involved (Eastern
Europe, the Baltics, Turkey in addition to the EU countries). But the question can
be posed non-cooperatively—can Gazprom design a price policy that would
allow it to capture the additional $2.5 billion from the EU?
4. Optimal Domestic Price
Gazprom is close to a monopoly domestically in Russia. The
World Bank supports competition in the Russian gas market.
But while Gazprom is a monopoly, the price should be
regulated to prevent monopoly restriction of output. There
is an offsetting consumer interest on domestic sales from
the Russian perspective which is not present on foreign
sales.
Price equal to the long run marginal costs LRMC
(including environmental costs) is the efficient price.
No world market price for gas—if there were, the
appropriate price in Russia would be the world price,
since that would be the opportunity cost of the gas.
We estimate that LRMC is about $40 per TCM in Russia, but
current prices are about $20 per TCM. Thus, prices should
double in Russia to be efficient.
Price increase are required to maintain production. Output is
forecast to fall by 7% per year unless investments increase.
Presently, Gazprom invests about $2-3 billion per year, but $8-9
billion per year is required over the next few years in order to
maintain production.
5. Comments and Criticisms
The whole point of the note is to clarify the issues for
Russia and the WTO members. We explain that the WTO
members are not helping Russia by demanding a single
price for gas in Russia and Europe. If WTO members wish
to continue the demand, that is their choice, but they
should be aware of the costs they are imposing.
Isn’t the LRMC higher, so the difference in price
between the two markets is smaller?
Gazprom estimates LRMC at $35. It is in their interest
to have a high LRMC for discussions with their
regulatory authority, so I would be wary of an estimate
very much higher than Gazprom’s own.
Hotelling rule from exhaustible resource models
would call for a depletion premium to be added to
the LRMC—so efficient price is greater than $40
TCM?
The depletion premium is inversely related to the size of the
reserves. With over 80 years of proven reserves remaining,
it would be close to zero.
Moreover, these models imply that the value of a unit of
remaining resources should increase over time. But in the
last 125 years, the real price of exhaustible resources has
not increased—contradicting these models. Either additional
discoveries or technological advance has mitigated the
impact of finite availability on their scarcity value in
production and consumption.
Environmental costs should increase the efficient price
in Russia.
We agree, but gas is probably the cleanest of the various
energy sources. There are no pollution costs of production of
natural gas, only greenhouse gas effects of consumption, as
with all fossil fuels. If we are putting pollution taxes on the cost
of energy, gas would have a relatively low tax since other
energy sources are much less environmentally friendly.
Biggest environmental issue is to allow the oil companies
access to the pipelines, so they stop flaring associated
(by-product) gas. About 20 Billion cubic meters (BCM)
out of 580 BCM of production is flared annually in
Russia.
The markup over marginal costs in Europe should be
tempered by consideration of long run competitive
pressures.
I agree that the price should be based on dynamic
considerations—the most appropriate model is the dominant
firm with a competitive fringe. The dominant firm will lower the
short run markup over marginal costs to deter entry. But it is
reasonable to assume that Gazprom maximizes profits and
takes this into account.
I assume a perceived elasticity of –1.5 in Europe. The
markup is a function of the elasticity. Elasticities could be
lower, then the estimated losses of profit of Gazprom are
overestimated.
The loss of profits are simply the rents on current sales;
therefore they are independent of the elasiticities.
Gazprom will become more profitable—can it be taxed.
We estimate that Russia will collect $6 billion in taxes from
Gazprom in 2003. (excise tax, wellhead tax, export tax and
profits tax). Only $0.3 billion in profits since Gazprom is not
very profitable. So it is being taxed. Moreover, it is necessary to
increase profits to expand investment.
Doubling domestic prices will create hardship.
We agree that in a cold climate these are life threatening
issues. The Bank is working on a well targeted safety net for
poor consumers to prevent severe hardship as energy prices
are raised. But cutoff of supply from lack of production will
also create hardship.
Why does Russia charge lower prices to the CIS than in
Europe—trying to be nice politically or economic reality?
Application of the same model (price discrimination in three
segmented markets (home, Europe and CIS) would imply a
lower price in the CIS than Europe. Prices are breakeven in the
CIS, and Gazprom shows it is willing to give this market up.
6. Press reports and recent developments
New EU Position
The EU now argues for competition in Russian gas markets and
especially non-discriminatory and transparent access to the gas
pipelines. This is a long standing position of the World Bank,
part of SAL II and SAL III.
Competition among Russian companies will drive down the
price in Europe to LRMC in Russia.
The Russian government can still extract the monopoly profit
by imposition of an export tax, but only an export tax regime
(or monopoly exporter) will be able to extract the monopoly
profit once there is competition in the Russian gas market.
EU-Russia protocol on Russia’s WTO accession of May
2004 reportedly calls for Russia to raise domestic prices
to roughly what we believe is LRMC, but does not
require.
Figure 1: Optimal Pricing of Russian Natural Gas in Europe and in Russia
$ per thousand
cubic meters
PERCEIVED DEMAND IN EUROPE
LRMC + TRANSPORT COSTS
$106
D
F
$67
E
D'
DEMAND IN RUSSIA
E'
C
LRMC
B
$40
B'
PERCEIVED
MARGINAL REVENUE
IN EUROPE
H
G
MR
126
billion cubic meters
A'
$20
0
Q
Q*
MR = Marginal Revenue in Russia
LRMC
A
375
billion cubic meters
Figure 1, footnote 1:
Optimum in Europe Market. We assume Gazprom maximizes profits on the quantity of
natural gas sales in Europe. This occurs at point E, where perceived marginal revenue
equals marginal production plus transportation costs. At this quantity (126 billion cubic
meters), the market clearing price is at point D ($106 per thousand cubic meters). For
quantities greater than at point E, marginal revenue is less than marginal production plus
transportation costs. Thus, expansion of sales to the point F, where the price ($67) equals
marginal production plus transportation costs, will result in losses on Russia’s exports
(relative to point D) equal to the value of the shaded triangle (EFG) (which is equal to the
rectangle DD'E'E). For quantities greater than point H, additional sales will reduce the
revenues received, and additional costs are also incurred.
Figure 1, footnote 2:
Russia Market Gazprom faces a controlled price at $20 per thousand cubic meters,
leading to quantity demanded (and sold) of 375 billion cubic meters of sales in Russia. The
social optimum for Russia is at point B where long run marginal cost equals price at $40.
An increase in the price in Russia from $20 to $40 results in an increase in welfare in Russia
equal to the triangle AA’B. Gazprom would maximize profits where marginal revenue equals
marginal costs, leading to point C. Since the value to Russia exceeds the marginal costs of
production for quantities less than at Q*, there is a triangle of losses equal to BB’C for an
increase in the price resulting in a movement from B to C.