- ENERGY SECURITY IN THE EUROPEAN UNION -

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ENERGY SECURITY IN THE EUROPEAN UNION

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A comparison study between the Russian and the European Gas Industry

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By: Arjen Boef Landbouwstraat 19 9648 GA Wildervank 06-21696533 s1578693@student.rug.nl Student number: 1578693 June 2008

Supervisor: Ph.D. N.A. Lillie Co-assessor: Drs. H.C. Stek

Institution: University of Groningen

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Abstract

Countries within the EU more and more rely on imported gas from Russia in order to meet consumption levels. Gazprom as a state-owned company has a monopoly on Russian exports to Europe. European worries in relation to energy security focus on source dependence, Gazprom’s domestic monopoly position as a result of its connection with the Russian state and the company’s aim to increase its presence on European downstream markets. This study shows that overall Gazprom does not hold a strategic advantage over its western counterparts as a result of the composition of the business environment in both the EU and Russia. Gazprom is strategically advantaged over western companies in Russia whereas western firms are strategically advantaged over Gazprom in Europe. National champions within the EU turn out to control European downstream markets and Gazprom turns out to control the upstream market in Russia.

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Management Summary

In terms of gas supplies, Russia plays a central role in the discussion regarding Europe’s reliance on energy. From an European perspective, gas is mainly provided by Russia. 43% of European imported gas came from this country in 2004. Diverse European countries and CIS states largely rely on Russian gas in order to meet their daily needs. Certain oil producing countries, in the Middle East or South America, may not be considered reliable partners. Looking at Russia, several issues which took place in previous years are brought up to disqualify the country from being a reliable supplier. The dispute between Gazprom and the Ukraine in 2005 over gas prices is an example of this. The gas war between Gazprom and Belarus is another one. Three critical factors form the basis of energy security concerns within the EU. The first factor is source dependence. EU countries more and more rely on a single country for gas. The second factor concerns Gazprom’s monopoly position in Russia and its strong connection with the state. The third factor adding to European concerns relates to Gazprom’s commitment to conquer the European markets and acquire stakes in European energy companies. As a result, the EU and several separate member countries openly discuss Gazprom’s aim to serve European consumer markets. Combining European source dependence with Gazprom’s commitment to penetrate European downstream markets, western companies’ loss of upstream operations in Russia and the fact that the EU aims to liberalize the European energy market, questions arise whether Gazprom is or becomes a threat to European energy security. This paper describes European worries and asks whether Gazprom as a state-owned company holds a strategic advantage over its western counterparts.

The question this paper aims to answer is:

“Does Gazprom hold a strategic advantage over its western counterparts?”

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counterparts in the EU, the gas industry’s in France, Italy, Spain and Germany are described. For both territories, opportunities and constraints for Gazprom and western competitors are investigated. We explore how the relationship between a company and its critical stakeholders is characterized and how this relationship creates incentives and constrains for Gazprom and western companies. Due to the specific nature of the industry we have marked five stakeholders, considered most critical to conduct business. These are; suppliers, customers, competitors, governments and shareholders. The analyses shows that if we combine the opportunities and constraints Gazprom and its western counterparts experience in both the European and the Russian business environment, while taking into account that western companies are eager to obtain upstream assets in Russia and Gazprom is eager to obtain downstream assets in Europe, we must conclude that overall Gazprom is not strategically advantaged over its western counterparts. Therefore the research question: “Does Gazprom hold a strategic advantage over its western counterparts” is rejected.

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Preface

I would like to express my gratitude to my supervisor, Mr. Nathan Lillie for his comments and remarks during the meetings we had. The useful, clarifying conversations have contributed to the formation of my master thesis.

June 2008,

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Introduction

1.1 Background

These days, governmental organizations, agencies and various media pay a lot of attention at energy security. Oil and gas reports concerning existing reserves, skyrocketing prices and potential future shortages are being published on a daily basis. As fossil energy reserves are not indefinite and supply comes from countries often marked as political unstable, this attention seems to be legitimate. Within the EU, source dependence is a critical issue in relation to energy security. In terms of gas supplies, Russia plays a central role in the discussion regarding Europe’s reliance on energy. 43% of European imported gas came from this country in 2004 (BP 2005). Diverse European countries and CIS states even largely rely on Russian gas in order to meet their daily needs. Several other factors contribute to EU energy security concerns. In order to address the problems that form the foundation of the perceived energy insecurity, the EU acts as a governing body purposing to liberalize the energy market whereby the creation of one common market is a spearhead. Introduced legislation aiming to enhance energy security in Europe has its influence on separate member governments on the one hand and energy companies on the other hand. Due to the involvement of many parties, energy security is a delicate topic with sometimes conflicting interests among its stakeholders. How the Russian government and the state owned company Gazprom should be treated and be dealt with is therefore not always clear among western governments and companies.

1.2 Problem Indication

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war between Gazprom and Belarus is another one. Three critical factors form the basis of energy security concerns within the EU. The first factor is source dependence. EU countries more and more rely on a single country for gas. The second factor concerns Gazprom’s monopoly position in Russia and its strong connection with the state. The third factor adding to European worries concerns Gazprom’s commitment to conquer the European markets and in relation to this the acquisition of stakes in European energy companies. As a result, the EU and several separate member countries openly discuss Gazprom’s aim to serve European consumer markets. Combining European source dependence with Gazprom’s commitment to penetrate European downstream markets, western companies’ loss of upstream operations in Russia and the fact that the EU aims to liberalize the European energy market, questions arise whether Gazprom is or becomes a threat to European energy security. From a European perspective it seems legitimate to ask whether the Russian government pursues an active strategy to keep western companies from Russian territory while it supports Gazprom to conquer Europe.

1.3 Research question and objectives

Though foreign policy issues (country level) are the foundation of tensions in relation to energy security, we translate these issues into a research question which is appropriate for a business study (company level).

The research question this paper aims to answer is:

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shareholders) are highlighted. Moreover, how these relationships create incentives and constrains for Gazprom and its western counterparts becomes clear.

The main goal of the study is to find out whether Gazprom holds a strategic advantage over its counterparts in a world that seems to become more and more reliant on fossil energy. This creates knowledge regarding two fields. Firstly, the field of foreign policy; how governments (country level) should respond to the extend a strategic advantage for Gazprom exists. The outcomes of this study may for example lead to the introduction of new laws and legislation. Secondly, for western companies (company level) operating in the energy sector, knowing to what extend a strategic advantage for Gazprom exists provides knowledge regarding how to deal with the company and the Russian state on European- as well as on Russian soil. In this case companies can adapt their strategies to the outcomes of this study.

1.4 Structure of the Thesis

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Literature Review

2.1 The foundation of Europe’s perceived energy insecurity

Factor 1:

Source dependence

A large body of literature has been developed that describes the importance of energy to the macro- and micro-economy. In the 1980s, several authors conducted research upon the relationship between oil prices and GDP (Mork 1989, Bohi 1989) This work has been expanded which has lead to a wider understanding regarding the important role of oil price fluctuations and the importance of availability of energy in general for countries’ economies (Talwar 2007, Guo and Kliesen 2005). The fact that governments’ attempt to secure the supply of energy, as a part of their energy policy, therefore seems logical. Next to oil, in recent years more and more literature has focused on the critical role of availability of natural gas. Tensions between Russia as a major natural gas supplier and its customer countries is often referred to. Increasing European consumption and its increasing dependent role in relation to Russian natural gas lies at the base of these tensions (Walker 2007, Goldthau 2008A).

Speaking of energy security, literature often refers to reserves. Reserves of oil and gas, divided into proved, probable and possible amounts, give an indication of potential future production and supply. Various institutions and governmental bodies report estimations based on calculations that differ markedly. Table 1 gives an overview of the largest oil and gas reserves by country provided by the Energy Information Administration (EIA). Taking a closer look at Russia’s estimated oil reserves for example, it amounts to 60 billion barrels. Brunswick UBS, a consultancy firm, however calculated that estimated reserves amount to 180 billion barrels. For the short term,

knowing what the precise numbers are is not the most _{Table 1: Oil and Gas reserves} by country (Source: EIA 2006) Oil Reserves by Country, 2006

reserves

Rank Country (billion barrels) 1 Saudi Arabia 264.3 2 Canada 178.8 3 Iran 132.5 4 Iraq 115.0 5 Kuwait 101.5 8 Russia 60.0

Natural Gas Reserves by Country, 2006

reserves

Rank Country (trillion cu feet) 1 Russia 1680

2 Iran 971

3 Qatar 911

4 Saudi Arabia 241

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important issue in terms of energy security. Janssen (2005) mentions that Russia’s ability to increase its exploration activities and its production to meet demand are more paramount issues. Fact is that Europe to a large extend relies on Russia for oil as well as for natural gas. BP (2005) figured that the EU including Turkey, in 2004 imported 42% of its oil and 43% of its natural gas from Russia. The oil and gas market differ markedly from each other in terms of where supply is concentrated. Supply of gas in Europe is a regional issue whereas oil supply is mostly concentrated in the Persian Gulf. Regarding energy security, oil supply disruptions from Russia would not be substantial compared to supply disruptions from the Persian Gulf. A decline in supply of Russian gas however would harm the security of supply in Europe (Correljé and Linde 2006). At the moment, Norway, The Netherlands and Great Britain are important “internal” suppliers of gas. Supply from these three countries will decrease over years as production capacity has peaked (IEA 2002A). This will result into a less diversified portfolio of gas suppliers among EU gas consuming nations. Table 2 provides an overview of European countries’ gas imports in 2005 from Russia. We have calculated the I/C ratio by taking countries’ total imports from Russia as a percentage of their consumption. Predicted numbers concerning future gas imports show increasing dependence. In 2020, Russia will have an average market share of 50% in terms of European imported natural gas (Mintopenergo 2003).

European gas imports 2005

Country Russian import share (%) I/C Ratio Russian import share (%) I/C Ratio Country Austria 78,3 75,5 Lithuania 100,0 *103,53 Belgium 1,4 1,7 Luxembourg 0,0 0,0

Bosnia Herzegovina 100,0 *50,85 Macedonia 100,0 *125,00 Bulgaria 100,0 *79,77 Netherlands 16,9 7,0

Croatia 96,3 *41,5 Poland 62,7 43,7

Czech republic 75,2 77,4 Portugal 0,0 0,0

Denmark 0,0 0,0 Romania 62,9 *21,67

Estonia 100,0 *118,29 Serbia & Montenegro 100,0 *93,22 Finland 100,0 98,6 Slovakia 100,0 102,1 France 23,5 24,0 Slovenia 50,9 *51,55 Germany 40,3 38,0 Spain 0,0 0,0 Greece 83,9 88,2 Sweden 0,0 0,0 Hungary 76,9 57,4 Switzerland 13,0 11,2 Ireland 0,0 0,0 Turkey 66,0 65,7

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The security of supply literature is divided into two parts; system security and quantity security. The former discusses to what extend energy can be guaranteed to consumers, the latter covers adequate (future) energy supply in general (Spanjer 2007). The initial motive for this paper concerns European energy dependency, therefore the emphasis in this paper is on quantity security. Focusing on quantities, broadly two streams of research are distinguished. Firstly, authors focus on the relationship between the countries that supply and the countries that demand. Secondly, literature focuses on the products themselves. The first body of literature explains how Europe as a block, or as separate European countries can formulate strategies in order to secure (future) energy needs (Finon and Locatelli 2008). The creation and implementation of EU level legislation which is highlighted in more detail in section 2.2 exemplifies this. According to Stern (2002) Europe’s reliance on Russian gas brings three types of risks with it. These are; source dependence, transit dependence and facility dependence. Chichester, chairman of the EC energy committee in 2006, indicated that the gas dispute between The Ukraine and Russia in 2005 displayed that Europe’s strategy in relation to energy supply security should focus on source dependence and transit dependence (European Parliament 2006). The second stream of research focuses on diversification of products. It describes different types of energy sources like for example LNG. This direction of literature is behind the scope of this thesis and will therefore not be discussed. If, from a European standpoint, the Russian gas market was to be perceived competitive and accessible for western firms, issues regarding source dependence and the lack of diversification of countries’ gas supply portfolio would be considered less problematic. In case of free competition, the existence of multiple (western) suppliers would reduce Europe’s perceived insecurity of supply.

Factor 2:

Gazprom’s position in Russia

The position of Gazprom in Russia is the second source of European worries regarding energy security. In this section we show why European worries in relation to Gazprom are relevant by means of a description of the company’s domestic position and its connection with the state.

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upstream activities. Transportation, sometimes called transmission, is labeled midstream. The latter two activities; refining and distribution are named downstream activities. Gazprom has a monopoly on transport of gas and owns the majority of distribution grids and storage facilities in Russia. Moreover, the company has a monopoly on export of gas through its subsidiary Gazpromexport (Spanjer 2007, Grigoryev 2007). Next to gas and to a smaller extend oil; the company holds activities in the mass media, hotel, insurance, telecommunication and several other industries. See appendix A for its activities structure. Gazprom has various connections with the state. The company has a direct link as a result of the fact that in 2004 the Russian state-owned companies Rosneftegaz and Rosgazifikatsiya purchased large blocks of Gazprom shares. Consequently, Gazprom which was owned by the state for 38,37% before 2004 was renationalized. (Gazprom 2005). Next to this direct link several indirect links exist. According to the IEA, Gazprom’s sales accounted for 20% of the federal budget and 20% of the convertible currency reserves in 2000 (IEA 2002B). Moreover, in 2006, its GNP share was 10,6%. (Gazprom 2007) In terms of market value, the company ranked eight in the world in 2007 and the company employs 232.200 people worldwide (Forbes 2007, Gazprom 2007) Another indirect link with the Russian state concerns the fact that from the 1990s until now heavyweight politicians like Viktor Chernomyrdin, Dmitri Medvyedev and Alexei Miller, which were very close to the Kremlin, lead the company. As stated earlier, largely depending on a single country for gas creates worries. In this case the single source country contains only a single supplier which only increases perceived insecurity.

Literature concerning the international creation and adoption of regulatory standards stresses that the size of the domestic market is an essential determinant of market power on an international level. Large markets can push standards internationally and regulatory capacity in this case transforms market size into market power. In other words, the larger a domestic market relative to the global market is, the better a country will be able to export its domestic rules and regulation. (Bach and Newman 2004) Although the aim of this paper is not to find out to what extend Russia aims to export its rules and regulations, we do investigate whether Gazprom holds a strategic advantage in Europe over its western counterparts. As the size of the domestic market may

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determine market power on an international level, European worries are valid in the sense that Gazprom may be able to use its domestic size to translate this into international market power. Misuse of bargaining power or the willful acquisition or maintenance of power as distinguished from growth or development as a consequence of a superior product or business in this case may exemplify Gazprom’s strategic advantage. (Vickers 2005)

Factor 3:

Gazprom’s position and its behavior in Europe

The previous section emphasized European worries as a result of the position of Gazprom as a state owned company on the Russian market. Focusing on the Russian domestic market only does not cover the variety of external “problems” outside Russia contributing to European worries. This section provides room for the third factor adding to concerns, it gives a description of Gazprom’s commitment to increase its presence in European countries.

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to put more emphasis on coal energy in order to reduce domestic demand for gas. Only one month later Gazprom announced its intentions to merge with the Siberian Coal Energy Company (SUEK) while holding majority control (Sabonis-Helf 2005, Walker 2007). These are clear examples of state intentions to use Gazprom for its strategic motives. Goldthau however rejects the idea that Gazprom is an instrument of the state, stating that business motives, namely profits, instead of strategic motives prevail. The author concluded that Russia’s foreign policy is driven more and more by Gazprom’s interests rather than visa versa. (Goldthau 2008B) This way of reasoning implies the assumption that the Russian state and Gazprom are more or less separated entities in terms of their strategic interests. This is not the case however. To align Gazprom’s objectives with state interests a majority share in the company was obtained in 2004. Moreover, as stated earlier, heavyweight politicians have lead the company for many years. The current CEO, Dmitri Medvyedev, even successes Putin as a president of Russia this year.

Conducting research upon strategic behavior, the body of literature that explains privatization is found useful. Aiming to change the economic culture in a country, from a central planned- to a market oriented economy, privatization is regarded to be a key driver, ultimately leading to the restructuring of firms (Schröder 2000, Amadeo 1994). In the end, the rationale behind privatization is (economic) efficiency. (UNESCAP 2002) How firms’ behavior changes is researched by Schröder (2000) who analyzed changes in labor productivity, employment and social benefits after firms in Eastern Europe were privatized. In the case of (re)nationalization of Russian companies it is not proven that companies like Gazprom are to change their behavior again equal but in opposite direction. From an economic perspective, taking privatization literature as described above into account, we may conclude that (re)nationalizing energy companies is not efficient. It is therefore logical to assume that these (re)nationalizations occurred as a result of strategic reasoning. Expecting firms’ overall economic behavior to change, like it did on a large scale during the waves of privatization in the 1990s, is not valid since the overall economic and political environment in which companies are embedded did not change significantly in recent years.

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Country Entity Interest Joint Venture partners Description of Activity

Austria Gas und Warenhandels 50% OMV Gas marketing, gas trading

gesellschaft m.b.H. and general trading activity

Bulgaria Overgas Inc. AD 50% Overgas Holding AD

Gas marketing (wholesale and retail),

construction and operation

of gas transportation network

Estonia Eesti Gaas AS 6.38% E.ON Ruhrgas AG, Fortum Marketing of natural gas,

Corporation, Itera-Latvia, development of Estonia's gas

ООО “Lentransgas”, others transportation networks

Finland Gasum Oy 25% Fortum Corporation, Gas transportation and marketing

E.ON Ruhrgas AG,

the Republic of Finland

France FRAGAZ 50% Gaz de France

Gas distribution and trading activities

Germany WIEH GmbH&Co KG 50% Wintershall Gas marketing, gas supply

WINGAS GmbH 35% Wintershall Gas transportation and supply

Greece Prometheus Gas S.A. 50% Copelouzos Bros. Corp. Gas marketing and construction

of gas transportation network

Hungary Panrusgaz Rt. 40% E.ON Foeldgas Trading Rt. Gas marketing and distribution

Italy Promgas SpA 50% ENI Gas marketing and distribution

Latvia Latvijas Gaze AS 34%

Itera-Latvia, E.ON Ruhrgas AG,

Marketing of natural gas / liquefied gas, development & modernization

other shareholders of Latvia's natural gas

Lithuania Lietuvos Dujos AB 37,06% E.ON Ruhrgas AG, Marketing of natural gas,

The Republic of Lithuania, development of Lithuania's

other shareholders gas transportation networks

Netherlands Blue Stream 50% ENI Gas transportation

Pipeline Company B.V.

Poland

SGT EuRoPol GAZ

S.A. 48%

PGNiG S.A., Gas Trading

S.A. Transportation, construction and

operation of the Polish section

of the Yamal-Europe pipeline

Gas Trading S.A. 16%

PGNiG S.A., Bartimpex

S.A., Gas marketing, liquefied

WIEH, Wenglokoks gas trading

Serbia Progresgas- 25% Progres DSO, NIC Gas supply, gas marketing

Trading d.o.o.

Switzerland

Gas Project

Development 50% Centrex Gas Production and development

Center Asia AG (Zug) & Energy Europe AG of oil and gas fields in Central Asia

WIEЕ 50% Wintershall Gas marketing, gas supply

Nord Stream AG 51% E.ON Ruhrgas AG, Gas transportation

Wintershall

Turkey Turusgaz 45% Botas International Ltd., Gas marketing

Gama Industrial Plants

Manufacturing / Erection

Corp.

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2.2 Business Environments as a facilitator for a strategic advantage

The aim of this section is to describe how energy security related issues on governmental level lead to the creation and implementation of new laws and legislation finally leading to a new character of the business environment. Consequently companies can obtain a strategic advantage as a result of the environment including its different stakeholders and institutions. Section 2.2.1 explains how governing bodies come to implement policies and describes how literature characterizes the configuration of the business environment in both Europe and Russia. Section 2.2.2 shows how the EU has created and introduced laws and legislation replacing separate member countries’ regulation regarding energy. Section 2.2.3 explains that within a specific business environment, stakeholder roles in relation to firms are essential for firms’ sustainable wealth over time.

2.2.1 International Scenarios

From an European perspective, three critical challenges in relation to the energy sector are identified. In relation to these challenges and other related issues, various institutions like the

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Building further upon energy scenarios, The Clingendael International Energy Programme (2004) proposed two storylines, or trends, along which the future international political and economic system will develop. In line with this, Correljé and van der Linde (2006) argued that “energy relations in the world will take shape along the lines of the organization of the future international political and economic system”. These storylines are labeled “Markets and Institutions” and “Regions and Empires”. The first storyline assumes ongoing internationalization of world markets. Further development of a multilateral system in which institutions on an economic and political level cooperate to govern international relations is described. The Regions and Empires storyline assumes opposite characteristics. Instead of globalization, less integrated economic and political blocks will exist. In this case, the world will consist out of separate parts all competing for resources and markets. In the latter storyline, security issues both national and international, bilateralism and regionalism will all be part of a geopolitical game, disabling the process of economic integration, to compete between regional blocks. In their report, the authors conclude that the most pessimistic storyline, Regions and Empires, seems to be most in line with developments in recent years. The unilateral approach of US foreign relations, the Iraq war and the Kyoto ratification process are mentioned amongst others to motivate this claim. A study is conducted upon the consequences each storyline would have for different countries and regions. It seems clear that for the EU and its future ascension countries the Markets and Institutions storyline is most beneficial. Integration of Eastern European countries in its broadest terms will enlarge markets. Tensions over issues regarding energy policy in this case are to be solved within the existing framework of EU institutions.

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domestic energy markets. In this case, control over oil resources shifts and the WTO becomes an important institution able to enforce a new energy architecture. (Menotti 2006) This initiative may give the impression that the world directs towards a Markets and Institutions storyline. It is contrasting with the claim made earlier that the world directs towards a Regions and Empires storyline proposed by Correljé and van der Linde. We therefore assume both extremes to exist in the world. Pointing attention to the European countries and Russia, it seems reasonable to conclude that the former fits better in a Markets and Institutions storyline whereas Russia’s political and economic environment is better characterized by the Regions and Empires composition. In the end Europe not only seeks for integration of countries into one Union but also aims for integration of markets and institutions for example by means of harmonization of regulatory areas in relation to investments in the energy sector. Russia however opposes economic integration and does not want to align its legislation with the rules of the market (Finon and Locatelli 2008). Rephrasing, different countries are proposed to create a unique political and economic environment in which companies are embedded. Consequently, the EU or separate member countries can compose or recompose their business environments to adapt to Gazprom’s expansion in Europe. Section 2.2.3 describes essential stakeholder roles in relation to a firm operating in a business environments. First section 2.2.2 will briefly highlight Europe’s efforts to create a unified energy market in line with the Markets and Institutions storyline.

2.2.2 A unified European energy market

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that is accessible, secure and affordable for all consumers in the EU. Thirdly, creating not 15 single open national markets but one open market. (EC 2001) A year later the EC adopted two new proposals to increase the security of oil and gas supply. This package included harmonization measures purposing to guarantee joint and coordinated action among EU members to secure supply of energy. (EC 2002) The latest gas directive stems from 2003 and replaces directive 92/30. (EC 2003) It describes issues like the role of regulators, unbundling and distribution. In 2005 the latest set of new regulation was introduced, including access conditions to gas transmission networks in the EU. (EC 2005) These various sets of legislation, aiming to harmonize separate national energy markets in order to secure supply in the future, replace national laws and legislation. Whether all member countries have implemented these “new rules” remains uncertain however. The following section explains the important role of different stakeholders for companies. Governments, both national and international are one of these stakeholders that create an environment companies operate within. The results section will show to what extend European governments as separate member countries comply with the measures described above and how this has affected Gazprom’s expansion in Europe.

2.2.3 Stakeholder Relations

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inevitable relation, necessary relation and desirable relation stakeholders are assigned to. Though stakeholders can be grouped in different ways and be assigned to groups with different relations to firms it is obvious that for a firm the composition of the business environment is critical for its operations. Whether a country directs towards a political and economic system which is in line with a Regions and Empires storyline or to a Markets and Institutions storyline will have significant influence on companies and their strategies. A country that directs towards a specific business environment will create a unique setting that has its own characteristics in terms of the degree of importance of various stakeholders in relation to a firm. As Europe is considered to follow the Markets & Institutions storyline while Russia directs towards a Regions and Empires storyline both are

proposed to create a unique setting. Whether Gazprom has been able to obtain a strategic advantage as a result of the composition of both business environments should be explored.

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Research Design

This chapter explains which method is used in order to answer the research question. By means of a conceptual framework the research project is visualized. Next to the method, the data sources used are described.

3.1 Method and conceptual framework

An exploratory research is conducted in order to answer the research question. The conceptual framework used in this study is presented below.

Figure 3: Conceptual Framework; source: author

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environment in both Europe and Russia. The box “C” in the EBE represents western companies. This arrow is connected with the RBE. The box “C” in the RBE represents companies in the RBE, in this study Gazprom, and is connected with the EBE. The arrow pointing towards the EBE is a symbol for Gazprom’s commitment to operate on the European market. The arrow pointing towards the RBE symbolizes western companies’ commitment to enter the Russian market.

The research question this paper aims to answer is:

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shareholders are considered companies’ shareholding partners in upstream, midstream and downstream ventures and projects.

3.2 Data

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Results

4.1 Critical stakeholder relations within Russia’s Business Environment

In order for western energy companies to conduct business in the Russian gas industry, strong ties with the stakeholders considered as being inevitable by Podnar and Jancic (2006) are critical. Russia is a single market, within the value chain several activities ranging from upstream to downstream activities are distinguished. Taking a closer look at the role of competitors, customers and suppliers, it is clear that the gas industry is largely owned by Gazprom. Regarding gas reserves, 62,4% was controlled by Gazprom in 2006 and 21% was controlled by other companies. The remaining share was undistributed. In total, 84,6 percent of domestic production was performed by Gazprom (Gazprom 2007). According to Datamonitor (2007A), the company held a total share of 67.10% over the Russian gas utilities sector. This number is calculated as “the total value of natural gas used by industrial, (including energy generators purchasing gas from utilities), commercial,

residential, and other end-users (including transport and agriculture users).” This number reflects a lack of competition in the upstream business. As Gazprom has control over transmission grids, storage facilities, export facilities and holds the majority of distribution grids, western upstream businesses rely on Gazprom as the single

consuming entity to sell or distribute gas (Stern 2005, IEA 2002B). Regarding midstream business, Gazprom can restrict access to the system and has control over all exports (Spanjer 2007, Goldthau 2008A). Figure 4 visualizes how the Russian Unified Gas Supply System, that is

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under control of Gazprom, is connected with CIS, Baltic and European countries. Looking at the end of the value chain where gas is sold to consumers and industries on the domestic market, again Gazprom turns out to be the largest entity involved. Russian federal law states that Gazprom has a mandatory obligation to serve the domestic consumer market, except from industrial users. In 2007 it supplied gas to 85.4% of all domestic consuming entities. (Gazprom 2007). Customer power is therefore considered low. The price paid by consumers is regulated by the state under the Russian Federation act on natural gas supply introduced in 1999 which is based on the principle that prices should be indexed to their pre-reform levels before 1990. Russia has various pricing zones which prices are determined by their distance to the wellhead, see appendix B (Spanjer 2007, Gazprom 2007, Grigoryev 2007). Though domestic prices have increased in recent years, they remain very low compared to the prices charged to European consumers. Grigoryev (2007) found that average residential prices for gas in Russia are € 37,- per thousand cubic meters (TCM) whereas prices for European consumers average €196,- per TCM. As a consequence, Gazprom largely depends on sales on the European market due to loss making domestic sales (The Economist 2008). Over the years, demand on the Russian market has been growing steadily. As a result, Gazprom’s gas sales to Russian consumers increased as well, see table 4. Combining increasing sales on the Russian market with the fact that the company experiences difficulties with increasing production levels, see figure 4 as well, it is clear that export volumes get under pressure more and more. Taking these facts into account, Gazprom’s obligation to serve the domestic market is a burden. From an economic perspective, unless restrictions on price levels are lifted, western competitors will not be interested in downstream activities to serve consumers, even if access would be granted. In the light of this paper, looking specifically at the role of stakeholders in the gas sector, western companies will always rely on Gazprom being its customer of gas. The company’s bargaining power is therefore

considered high and other competitors are seriously disadvantaged. As domestic demand can hardly profitable be served, the Russian market is mostly interesting for its upstream activities. Gazprom is seriously disadvantaged by the fact that it must serve the domestic market. Though the inability to increase production levels is a company issue,

Gazprom suffers under low domestic prices which are a result Table 4: domestic sales and production.

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introduced in 2005 provides that the Russian government can exclude participation of western companies to develop oil or gas reserves (Locatelli 2006). In practice, reinterpretation of existing laws and the introduction of new (discriminatory) laws seem to be favoring Gazprom whereas legal uncertainty is created for western competitors.

Next to its role as a shareholder and a legislator, the Russian state fulfills a role that stretches further than national borders. It is a role which is not in line with market logic and is exemplified by the following example. For years, Gazprom provides natural gas to Transnistria, a so called pro Russian rebel republic within Moldavia. The republic has never been able to pay the bill and threats to cut off gas supply by Gazprom have never been implemented. Moreover, due to Gazprom’s investments in 2006 in South Ossetia, which is part of Georgia, it now receives gas from North Ossetia which is part of Russia (Klussmann 2006). These examples at least raise serious doubts upon Gazprom’s motives to let gas flow into these regions. Strategic motives by means of supporting pro Russian groups seem to overrule the conditions of the free market. Though western companies will not be harmed directly by this non market logic behavior, it does indicate how the Russian state uses the company Gazprom and gas in general as strategic tools.

4.2 Critical stakeholder relations within Europe’s Business Environment

Before the countries France, Italy, Spain and Germany are highlighted separately we first analyze the role of the EU as a stakeholder in the business environment. We do this because the EU functions equally for all of the four countries as a political and legislative entity. Moreover, the role of suppliers in EU countries is touched upon.

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rules to create a single European market. To benefit consumer markets, it purposed to provide transparent and non-discriminatory access to pipelines to third parties (EC 2003). Moreover, in order to make markets more competitive, in September 2007 a new package of legislation was proposed to unbundle the vertical integration of national champions in countries, which means the separation of midstream activities from up- and downstream activities. In this package, safeguards were included. Companies from third countries, aiming to acquire a significant stake or aiming to gain total control over a network within the EU, have to comply with equal unbundling requirements as EU companies. In case direct and indirect independence from supply and generation activities can not be demonstrated the EC may intervene (EC 2007A). Divergence of interests and priorities among EU member states remain an important element that has harmed a united policy. In 2006, 17 member states received a formal notice as a result of not being compliant with EU directives related to the internal market for gas (Shuttleworth 2006). In relation to this, in a report published in 2007 the European Commission concluded that the midstream and downstream markets in Europe remain national in scope and that national champions which existed before the reforms still control the market (EC 2007B). It is clear that the role of the EU in Europe’s energy policy replaces the role of separate member governments more and more. Judging upon the role of the EU in terms of how its legislation affects the business environment, it should be stated that in principal a non discriminatory framework for all companies is purposed. Its latest proposals, referring to the safeguards including mandatory equal unbundling of third country companies, do however have a discriminating effect on third country companies that hold upstream activities. This issue will be discuss in more detail in chapter five.

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of time compared to Russian fields, the upstream business in the EU can be considered less interesting for companies. Competition within the upstream sector is certainly not strong. Regarding supply security in the EU, Centrica and NAM are important, however their critical role as upstream providers of gas will diminish along with their reserves over time.

4.2.1 France

Conducting research upon the mid- and downstream market of France, we find that only one large companies dictates the national market (see table 5). Gaz de France served 76% of the population in 2006. Regarding infrastructure the company owns the 185.000 km long national distribution network (Gaz de France Annual Report 2006). Due to its historical function, the company has held a monopoly on midstream and downstream facilities. Taking into account the number of competitors and their market shares, competition can certainly not be considered strong. As stated, upstream gas is mainly found in the UK and The Netherlands. France produces a very marginal amount of gas. The country however ranks among the 10 largest importers of gas in the world. Imports mainly originate from The Netherlands, Norway, Russia and Algeria holding shares of respectively 17%, 29%, 24% and 15% in 2005. (World Oil and Gas review

2006) Analyzing the role of suppliers, it is clear that France strongly depends on Russian gas. Better said, it depends on Gazprom as a critical supplier. Looking at the consumer market we find that for large commercial users, the gas market is open since the year 2000. Whether or not under pressure of EU legislation, competition in the downstream segment and the separation of midstream activities from downstream activities started in 2007. This enabled consumers to choose their own provider of gas. Whether this leads to strong competition remains uncertain. Switching costs have increased; in case a consumer leaves the existing regulated tariff, which is

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below EU average, they can never return to the tariff. Returning to the provider is possible but only to the unregulated tariff which is higher (EC 2007C, Datamonitor 2007B). Under the code of conduct, as a part of EU legislation, free access to the transmission network for third parties on a non-discriminatory basis is guaranteed. In 2006, Gaz de France provided access to Gazprom to 3% of its distribution system enabling the company to serve the French market until 2010. In return, Gaz de France received security of supply for 30 years (Gaz de France 2006B). As Gazprom, being a third country company, has not unbundled its activities in Russia and is not independent in relation to supply in France it may encounter serious problems in the future in case that its interests in gas distribution grows. Though Gaz de France will retain its leading position as a result of the fact that it owns the transmission (midstream) and the distribution network (downstream) and therefore enjoys the benefits of third party access (TPA) services, it should be stated that the large industrial downstream market has become more competitive in recent years (EC 2007C). Providing space within the distribution system to other parties is a first step towards a fair non-discriminatory market. However as long as the midstream business is not completely separated from downstream activities, overall relative power over competitors for national champion Gaz de France will remain existent. Not only Gazprom is disadvantaged here, other western competitors suffer under the same market conditions as well. Looking at the role of governments, here the French state, we find that this stakeholder equal as in Russia has a role as a shareholder. Until 2007 the French state held a 79,8% stake in Gaz de France. Last year the company agreed to merge with Suez, another French energy company. The transaction is to be closed mid 2008 and the French state is proposed to retain a share of 35% in the new company. The role of the state as a legislator is taken over by the EU. In this perspective the French state as a stakeholder stands on the sideline holding a minority stake in the new merged company. Summing up, the business environment in France in relation to the different stakeholders and their power shows that national champion Gaz de France has a strategic advantage over existing competitors and (potential) new entrants. Looking at Gazprom’s position; the company has been able to trade French security of supply in return for minor access to Gaz de France’s distribution system.

4.2.2 Italy

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markets, the Italian Antitrust authority has voiced concerns over Eni S.p.A.’s cooperation with Gazprom several times in recent years. In 2006, the cooperation between the companies was not considered to benefit consumers and therefore blocked by authorities (Energy Business Review 2006). Today, top level negotiations between the close allies Putin and Berlusconi take place to align the countries’ strategic opportunities. In recent years, the two national champions have swapped assets already. Today national interests seem to be prevailing in Italy. Negotiations regarding future assets trading and joined pipeline construction may be expected as further cooperation between Gazprom and ENI S.p.A. is likely (RFE/RL 2008). Summing up, the existence of a national champion creates overall relative power to one entity which not only harms Gazprom but other western competitors as well. Entrance for new companies should be possible under EU legislation, in practice however the national champion remains very powerful as a result of its vertical integration. Gazprom seems to have an advantage over other western competitors to enter the Italian market as a result of its upstream holdings in Russia which are traded with ENI S.p.A. In addition, an increasing commitment of the Italian state to cooperate with Russia seems to advantage Gazprom.

4.2.3 Spain

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SDG SA. This interest is owned by La Caixa, a Spanish government owned savings bank (Gas Natural SDG SA Annual report 2006). Next to its role as a shareholder, the Spanish government and other national authorities have been very active in recent years aiming to protect the domestic energy market from companies that do not originate from Spain. In 2006 industry minister José Montilla said: "Every nation tries to protect industries it considers strategic," and "No government should neglect any resource. It has to protect interests it considers legitimate and within law." (Rix and Leaniz 2006) After a bid from the German energy giant E.on on the Spanish electricity company Endesa, the government threatened to impose a new law that would limit voting rights of partly or fully state-owned non-Spanish companies. In reaction to this the EU antitrust regulator approved E.on’s bid. The EC concluded that the takeover would not harm effective competition. (EC 2006). In 2007, after eighteen months E.on withdrew the bid made and Endesa was taken over by Italian Enel and Spanish Acciona. Complicated assets trading by which E.on obtained Endesa activities throughout Europe accounting to 10 billion euros made an end to the struggle (Acciona 2007, BBN 2007). As a stakeholder in the business environment, the Spanish state stands on the sideline as a shareholder. The role it fulfills as a government is one of being protective. National interests, not in line with goals set by the EU seem to harm a united legal energy framework. As in the case with France and Italy, western competitors as well as Gazprom suffer under these national market conditions that harm individual companies’ expansion strategies.

4.2.4 Germany

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Conclusions and Discussion

After the analyses upon the roles of different stakeholders in the Russian business environment in relation to the gas industry it is clear that the role of Gazprom is very important. As a supplier of gas, the company has control over the upstream business in Russia. Moreover, as midstream activities and export licenses are owned by Gazprom, western companies are seriously disadvantaged. As a result of Gazprom’s monopoly, competition is low and it is not possible to conduct business behind Gazprom. Regarding downstream activities we have shown that Gazprom is obliged to serve the consumer market. As these activities create losses, we consider this obligation to create a disadvantage for Gazprom. The role of the Russian government is significant. The state not only serves the role of a shareholder, holding the majority of shares in Gazprom, it also has an important role as a legislator that creates incentives and constraints for companies that operate in the business environment. The state clearly creates an environment that benefits Gazprom at the cost of its western counterparts. Re-interpretation of laws and the distribution of “strategic” projects to Gazprom without having held a fair auction exemplify this. It is true that Gazprom is disadvantaged in the sense that it has the obligation to serve the growing, loss making domestic market, while the company is not able to increase its production. However, as the company holds the majority of total Russian gas reserves we partly relate this disadvantage to Gazprom’s own inability to increase output. In terms of opportunities we conclude that due to the composition of the business environment in Russia, Gazprom has a favorable and powerful position whereas western companies are discouraged and encounter more constraints. Consequently, Gazprom holds overall relative power over its counterparts. Taking these facts into account we conclude that in Russia Gazprom does hold a strategic advantage over its western counterparts.

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customers as markets are opening up due to liberalization measures. However as the national champions still own distribution networks, third party access (TPA) services are a new source of earnings. Moreover switching costs tend to keep customers from choosing an alternative supplier. Competition in the midstream and downstream business therefore remains low. Compared to the past, the role of national governments in separate EU member countries, we conclude is decreasing both in terms of ownership of companies as well as in terms of being a legislative body. This role is taken over by the EU that aims to unbundle the sector and to create a non-discriminatory legal framework. However the role of national governments is still more important than expected. National governments remain a stakeholder that create uncertainty for foreign companies due to divergent national interests. Consequently, some countries’ midstream and downstream markets are more accessible than others. It is clear that the current non-competitive landscape creates constraints for Gazprom due to national interests resulting into non-compliance of member states regarding legislation introduced by the EU. This fact puts serious constraints upon Gazprom’s aim to expand in Europe. Not only Gazprom’s expansion in Europe is harmed, other western energy companies suffer from non-compliance of EU member countries in relation to introduced legislation as well. Though the aim of the creation of a common European energy market should imply opportunities for expansion, national governments and powerful national champions impose barriers. The existence of a common energy market and countries’ non-compliance with EU legislation however also creates opportunities for Gazprom. We found examples of Gazprom getting access to midstream and downstream markets as a result of assets trading. In practice, we conclude that Gazprom does not hold an overall relative power position over its western counterparts in the EU. Gazprom’s Russian upstream assets we conclude, are an essential component necessary to get access to European mid- and downstream markets.

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From these conclusions we derive a few points for discussion. Firstly, the fact that we concluded that overall Gazprom does not hold a strategic advantage over its western counterparts is by no means a result of a competitive energy market in both Europe and Russia. The European downstream market for the most part is closed for Gazprom and the Russian upstream market is predominantly closed for western firms. These two observations made us answer the research question negatively. Though one can state that all companies operating within the European business environment have to comply with the rules of the game and therefore discrimination does not exist, we think that Gazprom is actually harmed as a result of the fact that it is holding upstream activities. According to EU legislation, holding these activities to facilitate European imports in principal implies no access to European midstream facilities as this goes against unbundling legislation. As the European national champions also hold upstream, midstream and downstream activities, discrimination between European companies and Gazprom seems to exist. As Russian state behavior in terms of its laws and legislation acts in a discriminatory way to western companies one may state that both sides protect their own market and that in a sense all companies are equally harmed. The claim of the EU to create a unified and competitive internal market may be non-discriminatory for western energy companies, third country companies however seem not to be purposed to be part of this internal market.

Secondly, it seems that we can divide the aims and strategies of governments and companies into two groups. Whereas the companies tend to strategize to obtain profits, countries tend to strategize to protect national interests. On itself these observations are logical, however as we have seen that EU goals are not always in line with separate member governments’ goals we foresee that Gazprom will be able to get more control over Europe’s (unified) energy sector in the future unless separate member nations put aside national interests.

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6-

Implications, limitations and recommendations

The results of the study implicate that energy security is a very complicated issue due to the involvement of various governments, companies and other stakeholders. Next to technical expertise from Western and Russian companies, diplomatic expertise from both sides’ governments will be necessary in the years to come to secure both sides’ interests. Strong dependence between Russia and European countries exists. This fact is, and will remain the key factor that asks for continuous cooperation in the future.

Limitations of the study lie in the fact that only four countries within the EU have been investigated. A more comprehensive study, including all EU countries could provide a more complete overview of the composition of the European gas market. Another limitation concerns the fact that the conclusions of the study in relation to the research question are not absolute proof. Though we concluded that overall Gazprom does not hold a strategic advantage over its western counterparts, other standpoints and ways to explain remain possible.

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