The Energy Paradigm in Twenty-First Century Russia

The Energy Paradigm in Twenty-First Century Russia

"It is a riddle, wra­pped in a mystery, inside an enigma."

Winston Churchill

Abstract

This paper begins with a brief overview of the economic and demographic landscape of the Russian Federation since the fall of the Soviet Union. This review leads into a focus on the integral role energy markets play in the Russian economy and the nation’s future prospects. Two potential future scenarios are presented. The first is a “business as usual” approach using trend extrapolation method to project internal Russian dynamics within an international trajectory. The alternate scenario rests on the assumption that the world adopts a climate change treaty which limits the amount of carbon dioxide (C02) and green house gases diffused into the atmosphere and works to stabilize the concentration of these gases to 450 parts per million of C02-equivalent. Such a coordinated commitment on a global level would have a 50% chance of preventing the rise of the average global temperature beyond two degrees Celsius.[1] Therefore, it is important to integrate such reduction strategy in studying the future of Russia. I conclude with analysis of these two scenarios using assumptions that can be applied to Russia going forward. 

Background

As we look to Russia’s future in the next several decades, we must understand its recent past and inheritance. The changes that have impacted Russia since the fall of the Soviet Union in 1991 have been profound both in scope and magnitude. The disintegration of the Soviet Union into the Russian Federation and fourteen independent republics left the affected republics in a unique position. For the first time, the republics were free to institute their own systems of governance and market economies. However with freedom came the laborious task of overhauling their broken communist systems and choosing a new course of action. Given these challenges, these young nations remain the least developed of the developed world.

Russia experienced extreme unrest and instability for over a decade in transitioning from a centrally-planned system to a market economy. Most former Soviet nations, Russia included, are classified by the United Nations as “economies in transition”.[2] In governance, the Russian Federation has cooled off from its post soviet democratic ambitions and has morphed from a managed democracy to a centralized semi-authoritarian state. The power structure in Russia has been largely unchanged over the past 15 years due to the popularity of former President/current Prime Minister Vladimir Putin and the Kremlin’s influence and stake in the country’s most profitable energy producing firms. It can be argued that while Russia has tried to change its institutions and form of government, on the interior, many things have remained similar to Soviet times. For instance, during the years of privatization in Russia (1988-1998), many state agencies were turned into corporations, yet the government maintained an active stake. An example of such a corporation is Gazprom, a natural gas and oil company, which was formed from the Ministry of Gas Industry, and which the government currently has a controlling stake in. [3]

Demographic Analysis

The Russian Federation is the largest, by area (6,601,668.143 mi²), country in the world. Although it is not a land of many uses, being restricted by terrain and weather conditions in Siberia and Eastern Russia, its vast land mass spans 11 time zones. Only 7.17% of the country’s land mass is arable land, thus, the agricultural sector is 4.7% of the gross domestic product (GDP) and approximately 10.2% percent of the labor force. The industry sector, encompassing mining and extractive services, accounts for 37.6% of the GDP and 27.4% of the total labor force. While the service sector composes 57.7% of the GDP and 62.4% of the labor force. Russia’s labor force, however, is rapidly aging and the overall working-age population is shrinking.[4]

Russia currently has the ninth largest population in the world, at approximately 140 million people. However, there are several demographic trends that suggest that by 2050 its population will decrease approximately 22% from 1995 figures (approximately 149 million). The current population growth rate is negative at -.47%.[5] Russia’s population has been declining since the fall of the Soviet Union and in 1992 the country reached a demographic milestone experiencing more deaths than births. Birth rates and fertility rates have been consistently decreasing and the median population is ageing. The average life expectancy is 66 years, earning Russia the162^nd place in the world’s average life expectancy by country.[6] The demographic trends seen in Russia are an extreme example of the problems most developed nations will be faced with as this century unfolds.

Vladimir Putin, Russia’s current Prime Minister, has tried to address these issues with policies that target Russia’s “demographic degradation.” The Demographic Policy Concept has pushed to lower the national mortality rate, raise the birth rate, improve national health, and regulate immigration. Although a lower fertility and population growth rate is consistent with other developed countries, Russia’s projected future population trends are on the extreme end of the spectrum considering Russia is one of the top ten countries with the lowest projected population growths.[7] China, Russia’s up and coming neighbor to the East, on the other hand, has an annual growth rate of +.655% and its population is projected to be over fourteen million in 2025. In addition to China, the populations of India, Pakistan, Nigeria, and many developing states are projected to increase substantially.

Going forward, the Russian Federation must realign itself within the context of its demographic and economic position since the fall of the Soviet Union. The key strategy for the Russian Federation is twofold and intertwined; first, to determine and implement demographic mechanisms that work toward maintaining their population. Second, Russia must achieve a way to economically benefit from the expanding developing world by sharing its vast resources. The projected population of the developing world will require an enormous amount of energy and Russia is in a position to make this energy available. However, it must do so in a way that promotes the proliferation of its society. Funding and investment should be directed into social welfare, labor stimulus, infrastructure development and other relevant government programs that will improve the quality of life in Russia and subsequently its demographic figures.   

The Role of Energy

The driving force behind Russia’s economy is its new position in the world as an energy supplier. Russia is rich in such natural resources such as oil, natural gas, coal, timber and many valuable minerals. This asset is the base for Russia’s post Soviet economy and is accountable for the recent growth of its GDP. Russia’s GDP grew by 8.1 percent over the last decade, which was primarily driven by the energy export markets, given the country’s increased oil production and a high world price of oil.[8] However, Russia’s insistences on tying its economy to the energy sector will likely result in obstacles in the near future. Namely, the extraction of natural resources can be difficult and costly, as permafrost covers much of Siberia and impedes on development in this region. In addition, Russia’s producing reservoirs are close to depletion and finding capital investment to fund the development of new fields is problematic considering the lack of readily available financing during the current economic climate. 

With vast resources at its disposal, Russia has enjoyed a reasonable economic upsurge in the last decade. However, its recent success has been overshadowed by the world economic recession and this has confirmed suspicions that Russia’s economy is designed to operate only in the absence of any crises. The Russian economy is very closely tied to natural gas and oil exports. The economic crises has many implications on Russian energy markets, ranging from how much gas is produced and exported to how much investment is appropriate toward infrastructure improvements and new projects. A focus must be brought to stabilizing this mechanism of the Russian economy because it hinders modernization of the country. This wouldn’t be the case if the Russian economy wasn’t as dependent on energy exports and if it was diversified.

According to the United States’ Energy Information Administration, Russia holds the world's largest natural gas reserves, the second largest coal reserves, and the eighth largest oil reserves. Internally, over half of its domestic energy needs are met by natural gas. The share of energy derived from oil has decreased approximately eight percent since 1992. This shift was largely caused by the high prices of oil on the international energy market, thus, making it a lucrative export. This trend coupled with low domestic prices for natural gas also contributed to this shift. The use of coal and nuclear energy has maintained at a constant level (Figure 1).[9] Trailing the United States, Russia is the second largest consumer of natural gas - consuming 462 billion cubic meters (bcm) in 2008. Under the Soviet system, over-consumption of energy in the industrial and municipal infrastructure was purported by the abundance and low cost of natural gas. Similarly, the continued low price of natural gas has not provided adequate incentive to replace the ageing infrastructure and improve efficiency. In addition, Russia’s use of energy per unit of GDP is very high compared with other Organization for Economic Cooperation (OECD) European and Development and Non-OECD European nations (Figure 2). [10]

Figure 1: Total Energy Consumption in Russia, by Type (2005)

Figure 2: Energy Intensity of GDP in Selected Countries and Regions

Russia is a major exporter of gas to European markets, with both OECD Europe and the European Union relying on the country for one quarter of their total gas needs.  Also, significant portion of Russia’s exports are divided between former Soviet republics (Figure 3).[11] Prior to 2006, the price of imported gas was much lower than international market standards and was, therefore, insulated. However, more recently Russia has been pursuing both domestic price reforms and international market-based import price changing arrangements because the international gas prices rose in 2003 and left Russia with a large opportunity cost. In 2004, Russia established a stabilization fund to manage windfall oil receipts and by 2007 the fund was expected to be worth $158 billion, or close to 12 percent of the country’s nominal GDP. [12] The magnitude of the capital inflow from the energy sector during this decade was unprecedented and it is doubtful such demand will resurge. The gas and oil sectors generated more than 60% of Russia’s export revenues in 2008 and accounted for approximately 30% of total foreign direct investment.

Figure 3: Russia’s Gas Balance (2008)

Although Russia has the world’s largest gas reserves, extraction at its main producing fields has been in long-term decline (Figure 4).[13] Decline in production at Russia’s three main producing natural gas fields in the Nadym-Pur-Taz region of Western Siberia has put pressure on the industry giant, Gazprom, to invest in the development of new fields. It is estimated that currently producing fields could account for only 26% to 30% total projected demand of natural gas by 2030.[14] In order to pacify the issue in the short-term, Gazprom has adopted an acquisition policy to meet the current demand. Spending on acquisitions has totaled to over $43 billion since 2004. With the current economic recession, Gazprom has indicated that decreased earnings would cut its investment program by approximately half from the 2008 appropriated figure.[15]

Figure 4: Major Russian Natural Gas Basins

Russia is currently the second largest exported of oil in the world and is eighth in terms of proven oil reserves, projected at 60 billion barrels of crude oil (bbl) and located in Western Siberia (Figure 5).[16] Approximately 70% of the oil extracted is exported, estimated at 6.8 bbl/per day in 2007. Reliance on Russia crude oil exports has grown from OECD Europe nations approximately 17% percent in 2007. With the exception of the Lukoil Company, the Russian government has a stake in the major oil extracting and exporting companies, such as Gazprom and Rosneft. The Russian government also has control of the transportation of oil because it owns a stake in the company Transneft, which owns most oil pipelines. In addition, Gazprom owns the gas transmission pipeline system and, thus, has the monopoly on gas export.

 The oil sector, however, is facing an increasing rate of decline in the production from its active fields. With only a few new large fields planned in the short-term future, focus is being placed on extraction from fields that have already produced 60% of their total recoverable reserves.[17] Thus, projected oil extraction will be more difficult and costly, as advanced technology will be needed to tap into older reserves. In addition, a government instituted tax placed on both extraction and exportation of oil revenues has also been a contributing factor in low output growth of oil production.[18]  It is clear that the government’s influence on the energy sector is paramount and still growing. State encroachment on the energy sector is undermining and even limiting the growth and potential of the full energy spectrum.

Figure 5: Major Russian Oil Basins

Russia to 2030: Business as Usual

In the business as usual scenario, it is assumed that existing energy trends will continue in the same direction for the next twenty years, without any climate change policy interventions. Annual energy growth is projected at an increase of 1.5% a year. Fossil fuels will still be the primary source of energy in the following order of intensity of dependence – coal, natural gas, and then oil. Power generation and electricity drive the predicted coal and gas demand while the transport sector accounts for a 97% increase in oil demand. Electrification of China will drive the largest addition in power generation and it will be mostly powered by coal. The prevalence of non-hydro renewable energy sources will also be increased in the power generation sector from 2.5% in 2007 to a projected 8.6% in 2030. 

Green house gas emissions in this scenario can lead to an excess of 1000ppm of C02-eq and result in a world temperature rise of six (6) degrees Celsius, resulting in irreversible global climatic change.[19] In this scenario, Russia’s natural gas and oil reserves place them in a profitable position, as a primary energy supplier. With a focus to the European Union, China and India as importers, Russia would enjoy relative market power and influence in pricing arrangements. The energy market would become even more intertwined with their economy.

Russia’s predominant role as an energy supplier on the world market is slated to continue.  Internally, however, natural gas demand would decrease primarily due to the financial crises in the short term and pricing modifications in the mid to long term. Since domestic pricing reforms are projected to align the price of gas to the international export price, reductions in the inefficiency of natural gas consumption will be a primary national target. In anticipation, the Russian government announced its goal to reduce its energy intensity by 40% by 2020.[20]

 Since Russia has a high energy intensity unit per GDP, there is great potential for energy savings, especially in three identified sectors – power generation, industry, and residential sector. Energy investments in power plant generation would require an emphasis on energy efficient technologies, with a focus on modern combined-cycle units. Energy-saving measures and modernization of infrastructure are to be incorporated in industrial production. Increased energy performance of district heating systems and buildings require investment in new materials and modernization of the current low efficiency systems.[21] Higher prices of natural gas will also shift the use of gas to coal and nuclear power, in regions where it is economically reasonable to do so. Since half of Russia’s energy is generated from natural gas, it is assumed that higher domestic gas prices will trigger energy efficiency reforms, as they are indispensable to a healthy Russian economy.

Domestic pricing reforms are also projected to funnel investment into the development of new natural gas fields. The high price will trigger a new interest in domestic gas markets, as they will become equally profitable to export markets. Gazprom will still have the monopoly on both domestic and international gas sales, but non-Gazprom production is slated to intensify.[22] These predictions are based on the assumption that natural gas prices and demand will rise. However, if proper incentive isn’t there, a level of uncertainty arises as to whether investment in development will be made in a timely manner to meet potential demand. To meet the projected yearly 1.5% increase rate for world demand of natural gas, development of gas fields in the Yamal Peninsula must be secured with a reasonable anticipated date of peak production. The Yamal project has been launched by Gazprom but the financial crisis and environmental conditions have halted adequate funding to continue. Another offshore natural gas project in the Barents Sea that could deliver substantive production growth in Russia has also been stagnated as no final investment decisions have been made.[23] Both of these fields are integral to Russia’s prominence in the developing Atlantic Liquefied Natural Gas (LNG) market.

Transportation of energy supplies is also a focus of future investment. Recent disputes with Ukraine regarding the transportation pipeline that runs through it to export natural gas to Europe have triggered uncertainty as to whether Russia can be a reliable gas supplier. Russia has placed emphasis on new pipelines that would connect it as directly as possible to its buyers. A proposed project is a pipeline that would connect Russia directly to Germany across the Baltic Sea, called the Nord Stream. A pipeline is also proposed to connect the Yamal Peninsula directly to Europe. The South Stream pipeline, which would connect Russia to southeast Europe via the Black Sea, is a being developed in coordination with Italy’s Eni, an Italian multi-national oil and gas company. [24] In addition to new field production in the area, the transportation of natural gas via new pipelines in East Siberia and Russian Far East is also a potential source of economic development in the next several decades as exports will be extended to the East Asian markets. However, massive investments in infrastructure and field production are required to make this scenario a reality. Whether the gas industry will have the ability to make these investments is strongly linked with future demand and price of natural gas.

Russia to 2030: Climate Treaty

As the world unites to combat climate change, this scenario focuses on the effect of a comprehensive policy and regulatory framework to steer Russia toward low carbon options. As outlined in the World Energy Outlook 2009, this effort is taken to limit the concentration of greenhouse gases in the atmosphere to 450 ppm C02-eq, which has a 50% chance of limiting global temperature rise to two degrees Celsius. Mechanisms included in such an agreement would feature carbon trading markets, national emissions reduction commitments, energy efficiency policies and investments, and abatement strategies.

In this scenario, annual energy growth is projected at .8% globally. [25]A major policy objective is to decrease the amount of carbon emissions that are generated in the power sector. A goal is to reduce coal generation by half from the ‘business as usual’ scenario and put a clear emphasis on nuclear and renewable energy sources. In addition, the electrification of the transport sector has the potential to reduce 70% of the projected oil demand.[26] Investments in the transport sector and energy efficiency measures are expected mostly to come about through private sector. While developed countries agree to provide a pool of investment funds to developing countries for these initiatives. Investment is also to be generated through a function of the international carbon market.

Where there is a potential uncertainty in the previous scenario about the projected demand and price of natural gas, this scenario is clear in assuming that prices and demand are slow to recover the financial crisis and do not peek beyond 2008 levels. The anticipated demand for natural gas in East Europe and Eurasia is projected at 650 bcm in 2030, compared with 697 consumed in 2008 and 790 bcm in 2030 as projected in the previous scenario.[27] Although, demand for natural gas globally continues to expand due to low carbon technologies’ slow rate of consumption. However, with an emphasis on energy efficiency, renewable energy systems, and increased nuclear power implemented as a result of a coordinated climate change initiative, the growth of the demand of natural gas on a world level will slowly be phased out in favor of renewable and nuclear energy sources.

Coupled with the financial crisis, low demand of natural gas in the short term means that revenues will fall and investment will follow accordingly. Without investment in new fields, Russia’s production of natural gas will categorically decline.  Russia’s production output in this scenario is projected at 16% share of the world gas market, while the previous scenario was projected at an 18% share.[28] While this decline will result in the diminished role of natural gas in Russia’s economy, it will be consistent with their goal to decrease use of natural gas domestically to meet energy efficiency standards and lower energy intensity. This will lead Russia to pursue reforms in diversifying its economy with a push away from energy related markets.

Within this scenario, Russia must change its portfolio of energy sources for power generation to include an emphasis on renewable energy sources, hydro and wind in particular, nuclear and coal and gas carbon sequestration (Figure 6).[29] If such energy sources are implemented, then emissions from power generation would then be reduced by 17%. Investments must also be made to provide low carbon vehicles to reduce the carbon footprint of the transport industry. To reduce emissions from the industry and residential sectors, Russia must adopt and implement a sweeping policy to set new energy efficiency standards. Total investment in this scenario comes at a high upfront cost but will improve the overall energy intensity of the country and greenhouse gas concentrations in the atmosphere.

Figure 6: Russian Power-Generation Capacity in the Climate Treaty Scenario

Assumptions

Pursuing domestic price reforms and international market pricing arrangements is anticipated to have many positive effects. In both scenarios, this policy has the potential to substantially alter the energy landscape. It will create incentive domestically to change aging and inefficient infrastructure and conserve energy. On the world markets, it will help to stabilize the price of natural gas. If the government provided incentive to encourage renewable alternatives to natural gas, Russia could start investing in energy conservation for its future. Russia should diversify the energy used for the power generation sector by encouraging nuclear energy and creating a renewable portfolio. The enormous land mass of Russia gives it ample opportunity to develop and implement appropriate renewable energy sources. This would be in line with their energy efficiency pledge and also with reducing its dependency on natural gas.

If the demand for natural gas increases, the price changing policy also has the potential to allure private companies to energy sources in Russia. State encroachment of energy sources is limiting the growth potential of Russia’s energy industry. An argument can be made that it was important for the government to watch over the country’s resource during privatization because so many of the country’s industries were monopolized into the hands of instant oligarchs. However, being a decade removed from this, it is time that the state limit its influence of the energy sector. Bringing increased private and foreign investment into Russia will allow their energy markets to be flexible to its demands.

In addition, eliminating the state’s monopoly on energy markets would bring openness and transparency to Russia’s economy. Corruption in government and business sectors have been central problems plaguing Russia and increased transparency could help build positive social capital.  Russia’s social institutions are in a state of despair and this would be a step to instill confidence in government.  Russia must also work to diversify its economy. Reliance on energy resources has coupled its economy with one single industry and thus made it very susceptible to market trends. The instability of the economy and vast corruption have resulted in quality of life issues, effects of which can be visible in Russia’s demographic profile.

In thinking about its role as a future energy supplier, Russia must look to developing nations for customers. Dense populations are where a majority of resources are allocated in this world. India, China, Pakistan, Nigeria and other developing nations’ need for energy will only escalate in the coming decades. Those nations also have an obligation to provide their citizens with amenities of the civilized world, such as electricity. Russia’s energy sector should invest in the development of energy infrastructure to the East Asian market. Natural gas can be a stepping between coal and renewable energy sources.  Especially significant in China, where coal is cheap and plentiful, Russian natural gas can provide energy for the power generation sector and help China meet its carbon emission reduction.

Will Russia be the world’s energy superpower? The answer depends on future energy markets – namely the demand for natural gas and also Russia’s ability to invest in the development of new fields in a time appropriate manner. The country’s immense reserves are only the foundation but steps must be taken to ensure that the land provides for its people in a deliberate, energy efficient, and profitable way. While some steps are being taken today, Russia must focus on the proliferation of its society. Revenues from the energy sector must be used to promote social capital through investment in energy infrastructure, social welfare, and rehabilitation of the building stock, labor stimulus, market diversification, and government transparency. Otherwise the only people that may be left in Russia are oligarchs and peasants, and instead of looking to the future it would be on a path back to the past.

References

About the Company, Gazprom (2009). History of the Gas Branch

Congressional Research Service, The Library of Congress (2006). Russian Oil and Gas Challenges.

Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

Framework Convention on Climate Change, United Nations (2009). Essential Background

Human Development Report, United Nations Development Programme (2007/2008). Climate Change. Russia Country Paper

International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

The World Factbook, Central Intelligence Agency (2009). Russia  

United Nations in the Russian Federation, United Nations (2008). Demographic Policy in Russia: From Reflection to Action

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[1] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[2] Framework Convention on Climate Change, United Nations (2009). Essential Background.

[3] About the Company, Gazprom (2009). History of the Gas Branch

[4] The World Factbook, Central Intelligence Agency (2009). Russia  

[5] The World Factbook, Central Intelligence Agency (2009). Russia  

[6] The World Factbook, Central Intelligence Agency (2009). Russia  

[7] United Nations in the Russian Federation, United Nations (2008). Demographic Policy in Russia: From Reflection to Action

[8] Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

[9] Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

[10] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[11] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[12] Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

[13] Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

[14] Human Development Report, United Nations Development Programme (2007/2008). Climate Change. Russia Country Paper

[15] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[16] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[17] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[18] Country Analysis Briefs, U.S Energy Information Administration (2008). Russia

[19] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[20] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[21] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[22] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[23] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[24] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[25] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[26] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[27] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[28] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.

[29] International Energy Agency, Economic Co-operation and Development (2009). World Energy Outlook.