Effects of higher domestic gas prices in Russia on the European gas market: A game theoretical Hotelling model

Applied Energy 164 (2016) 188–199

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Applied Energy journal homepage: www.elsevier.com/locate/apenergy

Effects of higher domestic gas prices in Russia on the European gas market: A game theoretical Hotelling model q Anton Orlov ⇑ Center for International Climate and Environmental Research Oslo, Norway

h i g h l i g h t s
Domestic gas consumption in Russia could annually decline by 116 bcm.
Export supply to Europe could annually increase by 33.7 bcm.
Total gas consumption in Europe could annually increase by 17.5 bcm.
Export tax revenue from gas could annually increase by 38.4 billion USD.
Domestic gas subsidy could annually decrease by 34.1 billion USD.

a r t i c l e

i n f o

Article history: Received 8 September 2015 Received in revised form 10 November 2015 Accepted 26 November 2015 Available online 19 December 2015 Keywords: Gas pricing Gas-price reform Russia Europe Hotelling model

a b s t r a c t Domestic gas prices in Russia are substantially lower than export netback prices. The Russian government aims to increase the domestic price level in the long term. The objective of this paper is to analyse the long-term effects of higher gas prices in Russia on the European gas market. The analysis is based on a modified analytical and a numerical Hotelling model. The main findings are as follows. Under a price elasticity of demand equalling 0.5, a 70% increase in the domestic gas price in Russia results in an annual average reduction in domestic gas consumption of 116 bcm. The export supply to Europe could be affected via two channels: (i) a stock effect and (ii) scarcity rents. The results show that in the presence of a stock effect with an elasticity equalling unity, the annual average increase in the export supply to Europe could account for 33.7 bcm. Although Russia may not face a resource constraint in the short and medium terms, scarcity effects could become more relevant in the future. A reduction in domestic gas consumption could reduce the future scarcity rent, implying a higher potential for exporting gas in the long term. Overall, total gas consumption in Europe could annually increase by 17.5 bcm on average. As the stock elasticity increases, so does the increase in total gas consumption. Furthermore, the results show that increasing the domestic gas price is associated with an annual average increase in the export tax revenue from gas of 38.4 billion USD and an annual average reduction in the domestic gas subsidy of 34.1 billion USD. Ó 2015 Elsevier Ltd. All rights reserved.

1. Introduction 1.1. Motivation Domestic gas prices in Russia are regulated by the government and are substantially lower than export netback prices [1,2]. For example, in 2012, the regulated average domestic gas price in

q The contents of this paper are the author’s responsibility. They do not necessarily represent the views of the Center for International Climate and Environmental Research – Oslo (CICERO). ⇑ Tel.: +47 22 85 85 70. E-mail addresses: [email protected], [email protected]

http://dx.doi.org/10.1016/j.apenergy.2015.11.030 0306-2619/Ó 2015 Elsevier Ltd. All rights reserved.

Russia was $95.4/thousand cubic meter (tcm), whereas the average export netback price for gas to Western Europe was $325.2/tcm [2]. The Russian government has planned to increase the domestic price level in the long term [1]. Because Russia is one of the largest exporters of gas, the gas-price reform may have a significant effect on export gas markets. Russia likely has some market power in the European gas market. The objective of this paper is to assess the long-term effects of higher domestic gas prices in Russia on the European gas market, Russia’s main gas-export market. Recently, several publications have assessed the economic effects of an increase in domestic gas prices in Russia. For example, Heyndrickx et al. [3] analysed the effects of an annual 10% increase

A. Orlov / Applied Energy 164 (2016) 188–199

in taxes on the final and intermediate consumption of gas from 2012 through to 2020 in Russia. Orlov [4] analysed an optimal price level for gas in Russia. Orlov [5] analysed the economywide effects of an energy tax reform in Russia. Nevertheless, their analyses were based on single-country Computable General Equilibrium (CGE) models, which are unable to show the effects of the gas-price reform on export gas markets. Previously, Sagen and Tsygankova [6], using an analytical and numerical model, analysed the effects of higher domestic gas prices in Russia on export supplies to Europe. They showed that increasing the domestic gas-price level would be unlikely to have a significant effect on gas-export supplies to Europe because higher export supplies tend to reduce the gas-export price. Nevertheless, their results were based on a stylised model that did not take into account important factors such as strategic interactions between gas producers and intertemporal resource constraints. In contrast to previous studies, our analysis is based on a gametheoretical Hotelling model that addresses their limitations. This is one of the few papers to analyse the long-term effects of Russian gas price policy on the European gas market. Furthermore, we contribute to the literature by developing an applied numerical Hotelling model, which captures important factors such as a large number of gas consumers and producers, imperfect competition, a finite planning horizon, and stock-dependent extraction costs simultaneously. Our numerical Hotelling model is formulated as a mixed complementarity problem (MCP). The remainder of the paper is organised as follows. Section 2 provides a literature review and present the methodology, which is followed by a presentation and discussion of the results (Section 3). The final section provides conclusions, focusing on policy implications. 1.2. The Russian gas sector Russia has the largest proved reserves of natural gas in the world [7]. Moreover, Russia is one of the world’s largest producers and exporters of natural gas [8]. Paltsev [9] analysed different scenarios for Russia’s natural gas exports to 2050. He found that over 20–40 years Russia has sufficient gas reserves and capacity to supply to both the European and Asian gas markets. Furthermore, over the last several decades, there has been even oversupply of gas in the domestic gas market since non-Gazprom producers have expanded their production and capacity [10,11]. The largest domestic producer of natural gas in Russia is Gazprom, whose share accounted for 71.3% of total gas production in 2013 [12]. Open joint stock company Gazprom is a state run company with a government ownership share of slightly above 50%. Gazprom operates as a vertically integrated company that operates production, distribution and transmission of natural gas [13]. Gazprom is a proprietary organisation in Russia’s unified system of gas transmission and therefore has control over all domestic and export transmission of natural gas from Russia [14]. Nevertheless, Gazprom does not have absolute control over production of natural gas in Russia. The role of independent gas producers has increased recently, with their production share accounting for 28.7% of total gas production in 2013 [12]. The domestic market, the European market, and the Commonwealth of Independent States (CIS’s) are the main gas markets for Russia. Russia is not only a large producer of gas, but it is also a large gas consumer. The domestic market is the largest market, whose share accounted for approximately 70% of total gas supply in 2012 [15]. Russia is one of the world’s largest exporters of natural gas: for example, its export share of gas by pipeline was 30% of the world’s pipeline export of natural gas production in 2013 [7]. According to Federal Law No.117 from July 18, 2006, [16] among Russian gas producers, only Gazprom is entitled to export natural

189

gas, which means that in addition to its pipeline monopoly Gazprom also has a legal monopoly with respect to exports of natural gas. On export markets, Gazprom operates under long-term contracts, which usually last for 25 years [17]. Gazprom exports natural gas to 32 countries such as CIS, EU as well as Turkey, Japan and other Asian countries [2]. Russia is one of the largest exporters of gas to Europe, followed by Norway, Algeria, and Qatar [18]. Russia plays an import role in the European gas balance. Fig. 1 shows the market share of Gazprom in total imports of gas in Western Europe from 2003 until 2013. The largest importers of Russian natural gas are Ukraine and Germany. Russia is likely having some market power in the European gas market; for example, natural gas consumption in countries such as Slovakia, Finland, Latvia, Lithuania, Bulgaria, and Belarus consists mainly of gas deliveries from Russia [7,19]. Due to administrative regulation, domestic gas prices are substantially lower than export netback prices; for example, the average domestic gas price was approximately 30% of the average export netback price for Western Europe in 2012 [2]. The Russian government has implemented a gradual increase in domestic gas prices for industries and households over the last several years. Moreover, Russia plans to eliminate administrative regulation of wholesale gas prices in the long term. ‘‘Export netback parity” (or ‘‘unified gas pricing”) was set as a medium-term target. According to Government Decree No. 1205 from December 31, 2010 [1], the Russian government has planned to switch from regulation of domestic wholesale gas prices to regulation of transmission tariffs starting from 2018. Domestic gas prices for residential gas consumers will probably remain regulated. Previously, deregulation of domestic wholesale gas prices have been scheduled to 2012 and then in 2015, but the gas price reform has been postponed for a long time because of increases in the oil price and the economic crisis.

2. Methodology and data 2.1. Literature and contributions 2.1.1. Previous findings The literature of the theory of exhaustible resources is rich. Here, we provide a brief overview of the literature, with the focus on the basic Hotelling model and its modifications. The main conclusion from the basic Hotelling model [20] is that extraction should decrease and the net resource price should increase at the interest rate, i.e., the so-called Hotelling rule. Nevertheless, empirical evidence regarding the Hotelling rule is at best mixed. The Hotelling rule is related to the net resource price, which is an unobservable variable that is difficult to measure [21]. For example, Stollery [22] found empirical support for the Hotelling rule with respect to the nickel industry. More recently, Livernois et al. [23] conducted an empirical test using data for old-growth timber; they found empirical support for the Hotelling rule for timber production in the USA. In contrast, Halvorsen and Smith [24], using an econometric model for the Canadian metal mining industry, rejected the hypothesis of increasing net resource prices. Heal and Barrow [25] found that changes in resource prices are associated with changes in the interest rate rather than the level of the interest rate, as described by the basic Hotelling model. A review of other studies verifying the Hotelling theory can be found in a survey paper by Berk [26]. In a recent paper, using a simulation model, Hart and Spiro [27] showed that scarcity rents of coal and oil have not been substantial in determining market outcomes; i.e., scarcity rents account for a small part in coal in oil prices. Livernois [28], in his survey paper on the empirical significance of the Hotelling rule, came to the same conclusion that scarcity

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35 28

30

Per cent

25

30

22

23

23

24

24

27

26

25

23

20 15 10 5 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Fig. 1. The market shares of Gazprom in total gas imports of Western Europe. Source: Gazprom [17].

rents have not been an empirically significant determinant of market prices. Lin [29] used a basic Hotelling model calibrated to annual data on the world oil price and consumption from 1965 to 2006 under various specifications of demand elasticities and market structure. Although she found that the model did not fit the data well, it was nonetheless able to provide several realistic results regarding the changes in the market structure and demand. Lin [30], using an empirical dynamic model, found the estimated shadow prices for the world oil market jointly significant, which supports the hypothesis of the Hotelling model. In fact, though empirical studies do not provide strong support for the Hotelling rule, they also do not provide convincing evidence against it. Over time, the basic Hotelling has been modified through the incorporation of other relevant factors that can explain a constant or decreasing resource-price path. For example, introducing an imperfect competition in a market of exhaustible resources does not counteract the Hotelling rule, but it can have some qualitative and quantitative effects on the market outcome. Stiglitz [31] compared the rate of exploitation of an exhaustible resource under a perfectly competitive setting with that under a monopoly. He found that the ability of a monopolist to sell an exhaustible resource to exercise its market power is rather limited. Moreover, assuming an increasing price elasticity of demand, a monopolist tends to extract less in the beginning than under perfect competition, whereas the opposite is true when a declining extraction cost is assumed. There is also a body of literature on the theory of exhaustible resources, which contains gametheoretical considerations using concepts such as the open-loop Nash equilibrium, the open-loop Stackelberg equilibrium, the feedback Nash equilibrium, and the feedback Stackelberg equilibrium [32]. Van Long [32] provided an overview of this literature in his survey paper. For example, Loury [33] analysed the open-loop Nash equilibrium in a Cournot oligopoly in an extractive industry. Gilbert [34] formulated an open-loop Stackelberg equilibrium in an exhaustible resource cartel. Apart from scarcity, many other factors, such as technological change and revisions to expectations, can significantly influence the resource-price path [28,35]. One reason the Hotelling rule may not hold could be a sequence of new deposit discoveries, which could lead to a declining path of net resource prices [36,21]. Venables [37] analytically showed that a resource price could be constant and independent of the interest rate when endogenous field openings are assumed. Moreover, the abundance of shale gas and unconventional fossil fuels tends to reduce the scarcity rents of fossil fuels [38]. The empirical evidence also shows that new discoveries and technological changes could substantially reduce the effects of resource scarcity [39]. Furthermore, Tahvonen and Salo [40] formally showed that a declining resource price might result from

technical changes in extraction and a decrease in extraction costs due to overall technical development. Moreover, Farzin [41] found that in general, the time path of scarcity rents is non-monotonic. Another explanation for decreasing resource prices could be a finite time horizon. Many studies based on a Hotelling model underlie the assumption of an infinite time horizon. However, an infinite time horizon is a rather unrealistic assumption that has often been criticised. The standard Hotelling model underlies the assumption of perfect information. In reality, the development of future demand and prices for exhaustible resource and production costs is uncertain. Spiro [42], using an analytical and a calibrated numerical model, showed that assuming a large stock of an exhaustible resource and a rolling planning horizon could relax the scarcity consideration. In other words, the resource constraint could become non-binding when a finite time horizon is assumed.1 In this case, extraction tends to increase, and the net resource price can decline over time, given the assumption of a declining marginal production cost. This result is the opposite of that of a classic Hotelling model. What can we conclude from this literature review? Depicting the intertemporal behaviour of producers of exhaustible resources (i.e., forward-looking behaviour under resource constraints) is the key feature of a basic Hotelling model. An empirical verification of the Hotelling rule is a difficult task because resource rents are unobservable variables. Livernois [28] concluded that there are empirical tests that do not support the theory of exhaustible resources, but they also do not provide convincing evidence against the theory. Although the empirical significance of the Hotelling model could be challenged, the Hotelling model (or the Hotelling rule) is nevertheless widely used among economists. For example, prominent papers related to the Green Paradox hypothesis are based on the Hotelling model (cf., [43–50]). The Hotelling model remains a widely used tool to analyse the effects of climate policies because it enables the depiction of the intertemporal behaviour of fossil fuel producers [28]. Given the assumption of large gas reserves in Russia, we can expect that Russian gas producers may face a non-binding resource constraint, at least in the short term. To depict this constraint, we incorporate a finite planning horizon following Spiro [42]. Although scarcity may not be an issue for Russian gas producers in the short and medium terms, scarcity effects could be a limiting factor in the long term. The Hotelling model is relevant for the long run, when scarcity could become more pronounced [51,42]. This could justify the use of a Hotelling model with a finite planning horizon. 2.1.2. Novelty and contributions There are many different variations of analytical Hotelling models, but numerical Hotelling models are scarce. Many analytical Hotelling models have a simple structure, being focused on a specific mechanism at work, whereas other key factors driving the results are neglected. We contribute to the literature by developing an applied numerical Hotelling model that includes many important features, such as (i) a high number of consumers and producers, (ii) stock-dependent extraction costs, (iii) a finite planning horizon and (iv) a Cournot oligopoly in the gas market. Though analytical Hotelling models provide useful insights, the advantage of a numerical Hotelling model is that it enables the analysis of different driving factors simultaneously and an estimation of their magnitude. Many other applied models on energy markets do not take into account the intertemporal behaviour of producers of exhaustible resources (e.g., 52,53). Furthermore, our model is formulated as a mixed complementarity problem (MCP), which

1 It should be noted that in comparison to Spiro’s model, we consider many markets, imperfect competition, and a stock effect.

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allows for an easier incorporation of that model into a CGE framework because many well-developed CGE models are formulated in MCP format. The model is calibrated based on the data of WEO13 [54] and IEA [15]. The developed model framework can also be further elaborated by including other features. Furthermore, the paper addresses a relevant political issue, i.e., the effects of the Russian gas policy on the European gas market. Although this analysis is focused on Russia, the model framework could be further applied for other analyses related to exhaustible resources.2

The properties of implicit functions are described in Appendix A, Supplementary Data. Russian gas producers are assumed to maximise the net present value of profit arising from the gas markets subject to an intertemporal resource constraint. We define a Lagrangian function to solve this dynamic optimisation problem:

ð1 þ rÞt  ððPðtÞ  EðtÞ  CðtÞÞ þ ðpdðtÞ  DðtÞ  CDðtÞÞÞ ! T T X X LðE;D;PRÞ ¼ EðtÞ  DðtÞ þPR  Sð0Þ  t¼0 T X

t¼0

2.2. Analytical model In our analysis, we consider the long-term effects of gas-price reform in Russia on the European market. Although scarcity may not be an issue for Russian gas producers in the short term, it could be a limiting factor in the future. Therefore, we base our analysis on a Hotelling model. For the purpose of the analysis, we modify the Hotelling model as follows. First, we consider a single gas producer (Russia), which distributes the supply of gas to a domestic market and an export market (Europe).3 Europe is the largest export gas market for Russia. In the context of our analysis, Europe represents the EU and CIS markets. Second, we assume that Russia has market power in the European gas market (i.e., a Cournot oligopoly). Third, following Spiro [42], we implement a rolling planning horizon (i.e., finite planning horizon). A rolling planning horizon implies that agents plan for a finite future by regularly revising the plan [42]. Indeed, as we discussed in the previous section, Russia has large gas reserves that could be sufficient to satisfy the demand for gas in Europe and China [9]. Therefore, Russia may face a non-binding resource constraint in the short and medium terms. Fourth, following Lin et al. [55], we incorporate a stock effect, which depicts the relationship between the marginal production cost and the remaining stock. Hence, the implicit cost of gas supply is depicted by the resource (scarcity) rent, whereas the stock effect represents the explicit cost, which is depicted by a supply function. We start our analysis with a simple analytical model to highlight the key mechanisms at work. The model is as follows.

max

ðE;D;PRÞ

T X ð1 þ r Þt  ððPðtÞ  EðtÞ  CðtÞÞ þ ðpdðtÞ  DðtÞ  CDðtÞÞÞ t¼0

T T X X s:t: Sð0Þ P EðtÞ þ DðtÞ t¼0

t¼0

where EðtÞ is the supply of gas to Europe DðtÞ  DðpdðtÞ; tÞ is the domestic demand for gas in Russia PðtÞ is the export netback price of gas to Europe pdðtÞ is the domestic gas price in Russia PðtÞ  PðEðtÞ; tÞ is the inverse demand function for gas in Europe CðtÞ  CðEðtÞ; SðtÞ; tÞ is the production cost function for supplying gas to Europe CDðtÞ  CDðDðtÞ; SðtÞ; tÞ is the production cost function for supplying gas to Russia SðtÞ is the resource stock r is the interest rate

2

The model code can be received from the authors upon request. In this analysis, we consider the entire Russian gas industry, which consists of Gazprom and non-Gazprom producers. Only Gazprom is entitled to export natural gas in Russia. Therefore, we do not expect that an explicit disaggregation of the Russian gas industry into Gazprom and non-Gazprom producers will change the results significantly, if at all. 3

t¼0

This is a constrained optimisation problem. The objective function of the maximisation problem is concave, and the associated constraint is convex, which means that Karush–Kuhn–Tucker conditions are both necessary and sufficient for a global optimal solution (i.e., unique solution). Differentiating the Lagrangian with respect to E; D and PR, we obtain the following Karush–Kuhn–Tucker conditions:

PðtÞ þ EðtÞ  PE ðtÞ  C E ðtÞ  C S ðtÞ 6 PRðtÞ pdðtÞ  CDD ðtÞ  CDS ðtÞ 6 PRðtÞ T T X X EðtÞ þ DðtÞ Sð0Þ P t¼0

? EðtÞ P 0

? DðtÞ P 0

? PR P 0

ðA1Þ ðA2Þ ðA3Þ

t¼0

where PRðtÞ ¼ PR  ð1 þ r Þt pdðtÞ ¼ pd  ð1 þ r Þt PR is the scarcity rent pd is the initial domestic gas price (exogenous variable) PE ðtÞ is the partial derivative of the inverse demand function with respect to the export supply C E ðtÞ is the partial derivative of the production cost function with respect to the export supply CDD ðtÞ is the partial derivative of the production cost function with respect to the domestic supply C s ðtÞ ¼ CDs ðtÞ is the partial derivative of the production cost function with respect to the total production (i.e., a stock effect) Eqs. (A1) and (A2) are the static efficiency conditions, which ensure that the marginal profit equals zero. Eq. (A3) determines the intertemporal resource constraint. C E and CDD depict the marginal cost associated with supplying gas to the export and domestic markets, respectively (e.g., transportation cost). C E is the marginal production cost, which indicates a stock effect. Analogously, we find the Karush–Kuhn–Tucker conditions for the period t þ 1. If the resource constraint is binding, we can combine the first-order conditions for profit-maximisation in both periods to obtain:

Pðt þ 1Þ þ Eðt þ 1Þ  PE ðt þ 1Þ  C E ðt þ 1Þ  C S ðt þ 1Þ ¼ 1 þ r ðA4Þ PðtÞ þ EðtÞ  P E ðtÞ  C E ðtÞ  C S ðtÞ pdðt þ 1Þ  CDD ðt þ 1Þ  CDS ðt þ 1Þ ¼1þr ðA5Þ pdðtÞ  CDD ðtÞ  CDS ðtÞ This is an implication of the Hotelling rule, where the marginal profit should increase over time at the interest rate. These equations determine dynamic efficiency conditions. More details on the analytical model and its solution can be found in Appendix A, Supplementary Data. 2.3. Numerical model Based on the analytical model, we build a numerical model. For the numerical model, we use explicit supply and demand functions (i.e., isoelastic functional forms). The main difference between the

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A. Orlov / Applied Energy 164 (2016) 188–199

analytical and numerical models is that the export supply of the rest of the world (RoW) is endogenously determined in the numerical model to depict a more realistic price response.4 The model is as follows:5

  SHðtÞ 6 MCðtÞ þ PR  ð1 þ rÞt PðtÞ  1 þ ede   SHRðtÞ 6 MCRðtÞ ? ERðtÞ PðtÞ  1 þ ede MCðtÞ ¼ admcðtÞ  ðEðtÞ þ DðtÞÞes MCRðtÞ ¼ admcrðtÞ  ERðtÞ EðtÞ SHðtÞ ¼ ETðtÞ SHRðtÞ ¼

ERðtÞ ETðtÞ

ETðtÞ ¼ adetðtÞ  PðtÞ DðtÞ ¼ addðtÞ  pdðtÞ T X

T X

t¼0

t¼0

EðtÞ þ

edd

DðtÞ

ðN1Þ ðN2Þ ðN3Þ ðN4Þ ðN5Þ

? SHRðtÞ

ede

? MCðtÞ

? MCRðtÞ

? SHðtÞ

ETðtÞ ¼ EðtÞ þ n  ERðtÞ

sP

esr

? EðtÞ

ðN6Þ

? PðtÞ

ðN7Þ

? ETðtÞ

ðN8Þ

? DðtÞ

ðN9Þ

? PR

ðN10Þ

where PðtÞ is the export netback price of gas to Europe PR is the resource price pdðtÞ is the domestic gas price in Russia SHðtÞ is the market share of Russian gas in the European gas market SHRðtÞ is the market share of RoW gas in the European gas market ede is the price elasticity of demand in the European gas market ðede < 0Þ edd is the price elasticity of demand in the Russian gas market ðedd < 0Þ es is the stock elasticity for Russia esr is the stock elasticity for the RoW MCðtÞ is the marginal production cost of Russia MCRðtÞ is the marginal production cost of the RoW admcðtÞ is the shift parameter for the marginal cost function adetðtÞ is the shift parameter for the import demand function in Europe addðtÞ is the shift parameter for the domestic demand function in Russia EðtÞ is the export supply of gas from Russia to Europe DðtÞ is the domestic demand for gas in Russia ERðtÞ is the export of gas from the RoW to Europe (from a single firm) ETðtÞ is the total demand for gas in Europe s is the resource stock of Russia n is the number of gas-exporting countries r is the interest rate Eqs. (N1) and (N2) are first-order conditions (FOC), which describe the profit-maximisation strategies of Russia and the RoW under an oligopolistic market structure, respectively. The RoW represents all other gas producers. We assume that Russia and the RoW exercise market power in the European gas market by playing a Cournot non-cooperative game, the solution to which 4 It should be noted that these differences between the analytical and numerical model do not change the general conclusions. 5 Exogenous variables are noted in small letters, whereas endogenous variables are noted in capitals.

underlies the Nash equilibrium concept.6 Therefore, the numerical Hotelling model can be characterised as a game theoretical model. Assuming a Cournot oligopoly with a Nash equilibrium is a common way to model a strategic behaviour in a regional gas market [56,52,57,53,58]. The choice of an oligopoly is justified by the fact that a regional gas market is served by a relatively low number of large companies, where gas is a homogenous good. In the core model, the marginal cost is assumed to be an exogenous variable for Russia and the RoW. For the case where we consider a stock effect for Russia and the RoW, Eqs. (N3) and (N4) are introduced in the model, depicting the dependence of the marginal production cost on the remaining resource stock. The magnitude of the stock effect is depicted by stock elasticity (es and esr). The stock elasticity is taken from 0 to 1.3, which is in line with other studies on fossil fuel markets. For example, in their large-scale applied CGE model, Burniaux and Chateau [59] assumed a price-supply elasticity for gas supply equalling 0.8. In some other numerical models, the price-supply elasticity for gas varies between 0.5 and 1 (see [60– 63]). Lin and Wagner [64] empirically estimated global stock elasticities based on World Bank data; they found that the stock elasticity for natural gas could be 1.32. Eqs. (N5) and (N6) determine market shares of Russia and the RoW in the European gas market, respectively. Eq. (N7) shows the market-clearing condition that determines the gas price. Eq. (N8) is the demand function for the total consumption of gas in Europe. Eq. (N9) is the demand function for domestic demand for gas in Russia. Following Sagen and Tsygankova [6], we assume that the core value of the price elasticity of domestic demand for gas in Russia (edd) equals 0.5, and in Europe (ede), it is assumed to equal 0.7, which is in line with other studies on the European gas market [65,52]. The domestic gas price is an exogenous variable because domestic prices are regulated in Russia. Eq. (N10) is the intertemporal resource constraint of Russia. The model is run from 2012 until 2080.7 The numerical model is coded in the General Algebraic Modelling System (GAMS; [66]) as a mixed complementarity problem (MCP) and solved using PATH solver [67]. The model is calibrated based on data from Gazprom [14], New Policies Scenario of World Energy Outlook 2013 [54] and IEA [15]. A more detailed description of the numerical model including the GAMS code and the calibration are presented in Appendix B, Supplementary Data.

3. Results and discussion 3.1. Results from the analytical model 3.1.1. Export supply and the resource constraint Using the analytical model, we want to show the effects of a marginal increase in the domestic gas price on the export market under a binding and a non-binding resource constraint. To simulate an increase in the domestic gas price in Russia, we solve the analytical model with respect to the domestic gas price. Because we consider a finite planning horizon, two cases are possible: The resource constraint can be either binding or non-binding within the planning horizon8: Case 1: PR > 0 if Sð0Þ ¼ Case 2: PR ¼ 0 if Sð0Þ >

PT

t¼0 EðtÞ

þ

t¼0 EðtÞ

þ

PT

PT

t¼0 DðtÞ

PT

t¼0 DðtÞ

6 In a Cournot oligopoly, firms make decisions on how much to produce, whereas in a Bertrand oligopoly, the price is the decision variable. 7 According EIA (2015), proved reserves of natural gas in Russia in 2015 accounted for 1688.23 Tcf, whereas the total production of natural gas in 2012 was 21.76 Tcf. Given the assumption that an annual growth rate of total production of gas equals 0.5%, proved reserves of natural gas could be sufficient until 2076. It should be noted that Russia also has large unproved reserves of gas. 8 Rolling planning horizon means a period, which Russia considers by optimising its production strategy.

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In the first case, the resource constraint is binding, meaning that the net resource price increases according to the Hotelling rule. The first case implies a small resource stock and a large planning horizon. In this case, all markets are connected via a resource rent, which depicts the implicit cost (the opportunity cost) of gas extraction. Gas producers aim to equalise the marginal profit across markets. In the second case, the resource constraint is non-binding, meaning that the resource rent is zero.9 The second case implies a large resource stock and a short planning horizon. The planning horizon could differ by country and resource sector. There are many reasons why a planning time horizon could differ. For example, risk aversion could be one explanation. Low-income countries tend to be more risk averse; they focus on short- and medium-term profits. Moreover, there are uncertainties regarding future demand for gas in Europe. The consideration of these two cases reveals how a resource constraint may affect the bargaining on export supplies of gas to Europe. Below, we analyse the effects of an increase in the domestic gas price on the export supply of gas to Europe under a binding and non-binding resource constraint. For the sake of transparency, we ignore any stock effect, which implies that

@CðtÞ @SðtÞ

¼ 0 and

@CDðtÞ @SðtÞ

¼ 0.

Case 1: Binding resource constraint Completely differentiating Eqs. (A1)–(A3) making some algebraic manipulations, we obtain: dPRðtÞ

dEðtÞ dpdðtÞ ¼ dpdðtÞ ð2  PE ðtÞ þ EðtÞ  PE;E ðtÞ  C E;E ðtÞÞ

ðA6Þ

T T X dEðtÞ X dDðtÞ þ ¼0 dpdðtÞ dpdðtÞ t¼0 t¼0

ðA7Þ

Inserting Eq. (A6) into (A7), we obtain:

dPR ¼ PT dpd t¼0

PT t¼0

 Dpd ðtÞ

1 ð2P E ðtÞþEðtÞP E;E ðtÞC E;E ðtÞÞ

<0

ðA8Þ

This implies that

dEðtÞ dPðtÞ > 0 and <0 dpdðtÞ dpdðtÞ

ðA6Þ and ðA9Þ

An increase in the domestic gas price in Russia results in a higher export supply and a lower export price of gas to Europe. A reduction in the domestic consumption of gas in Russia implies a higher resource stock, and therefore, there is a decline in the scarcity rent because gas resources become less scarce. As a result, Russia re-optimises its intertemporal profit-maximisation strategy by increasing the export supply to Europe. An alternative interpretation is that Russia will be less tough in bargaining on gas prices with Europe, when gas contracts will be re-negotiated. Case 2: Non-binding resource constraint Nevertheless, Russian gas producers may face a non-binding resource constraint, given the assumptions of large gas reserves and a short planning horizon. If the resource constraint is nonbinding, the domestic and European gas markets are disconnected, and there is no incentive to re-optimise export supplies to the European gas market:

dEðtÞ ¼ 0 and dpdðtÞ

dPðtÞ ¼0 dpdðtÞ

ðA60 Þ and ðA90 Þ

9 However, there are oligopolistic rents associated with the structure of gas markets.

In other words, the implicit cost of supplying gas to the domestic gas market is zero under a non-binding resource constraint. Hence, the equilibrium quantity and the price are determined solely by the explicit production cost and demand, which are not affected by other markets. It should be noted that all changes in export supplies should be considered in the medium and long terms. It is unlikely that there will be a short-term supply response because Russia exports gas under long-term contracts. However, gas contracts with some countries will terminate in the short term so that re-negotiations will take place. 3.1.2. Export supply and the stock effect In the previous section, we ignored any stock effect. In reality, there may be a stock effect, where the marginal production cost depends on the remaining stock [55]. In other words, a stock effect implies an explicit production cost. In the numerical model, the magnitude of a stock effect is depicted by stock elasticity (Section 2.3). An intuitive explanation for a stock effect could be heterogeneity in resource deposits (i.e., low- vs. high-cost deposits). A stock effect could be another factor that forces Russia to re-optimise its intertemporal profit-maximisation strategy. Therefore, we consider a third case (Case 3), where the resource constraint is non-binding, but there is a stock effect. When the domestic consumption of gas in Russia declines, the remaining stock becomes larger so that the marginal production cost decreases compared to the baseline. Given the assumption of a stock effect, a reduction in the domestic consumption of gas in Russia will have an effect on the export supply to Europe via a reduction in the marginal production cost: dDðtÞ C E;S ðtÞ  dpdðtÞ þ dPRðtÞ dEðtÞ dpdðtÞ ¼ dpdðtÞ ð2  P E ðtÞ þ EðtÞ  PE;E ðtÞ  C E;E ðtÞ  C E;S ðtÞÞ

> 0 and

dPðtÞ <0 dpdðtÞ ðA600 Þ and ðA900 Þ

Even under a non-binding resource constraint (i.e., no scarcity concern), Russia will re-optimise its export supply to Europe driven by a decreased marginal production cost. In other words, in the presence of a stock effect, Russia would bargain for a lower gas price with European gas consumers. The magnitude of the stock effect determines how strongly the gas price will decline. 3.2. Results from the numerical model Fig. 2 outlines a flowchart that illustrates the mechanisms behind the numerical model at work. An increase in the domestic gas price (pd") results in a lower domestic demand for gas in Russia (D#). The regulation of domestic gas prices operates as an implicit subsidy. Therefore, an increase in the domestic gas price implies a lower subsidy on domestic gas consumption. When we assume a stock effect and a binding resource constraint, a lower supply of gas to the domestic market leads to a lower export gas price because of a decreased marginal production cost (MC#) and resource rent (PR#). As a result, Russian gas becomes more competitive in the European gas market. There is an increase in the gas-export supply from Russia to Europe (E"), so the market share of Russian gas (SH") also increases. The European gas market is depicted as a Cournot oligopoly. A higher market share of Russian gas in the European market implies more market power of Russia in that market. In this analysis, we assume that Russian gas and gas exports from the RoW to Europe are perfect substitutes. Additional gas exports from Russia crowd out some gas exports from the RoW; i.e., the export supply of gas from the RoW (ER#) and its market share (SHR#) decline. This implies

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MCR↓

Supply from the RoW (Eqs. N2, N4, N6)

ER ↓ SHR ↓ European demand

Domestic market (Eq. N9)

(Eqs. N7, N8)

D↓

ET↑ P↓ pd↑

Supply from Russia

MC↓

(Eqs. N1, N3, N5, N10)

E↑ SH↑

PR↓

Fig. 2. The flowchart of the numerical model.

3.2.2. Export supplies to Europe Additional gas from the domestic market could potentially supply export markets. Fig. 5 shows the increases in the export supply of gas to Europe associated with a 70% increase in the gas price under different planning horizons and without any stock effect.

2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

-20

Billion cubic meters

3.2.1. Domestic consumption To show the response of the domestic demand for gas in Russia, we increase the regulated domestic gas price in the numerical model by 30%, 50%, and 70%, respectively, in 2016. Orlov [4] showed that the domestic gas-price level should be increased by approximately 70% to achieve economic efficiency in the domestic gas market. In 2012, the domestic consumption of gas in Russia accounted for approximately 423 bcm, which was sold at an average price of $95.4/thousand cubic meters (tcm) [15,2]. Fig. 3 shows the reductions in the domestic gas consumption in Russia associated with increases in the domestic gas price. An increase in the domestic gas price could release a substantial amount of gas. For example, a 30% increase in the domestic gasprice results in an annual average reduction of domestic gas consumption by approximately 61 bcm; for a 50% increase in the domestic gas price, it is 91 bcm; and for a 70% increase in the domestic gas price, it is 116 bcm. For comparison, the amount of gas exported to Western Europe was 151 bcm in 2012 [2]. Domestic demand for gas in Russia is assumed to be inelastic, meaning that a relative increase in the price is stronger that a relative reduction in the quantity. The results are very sensitive to different values of the price elasticity of demand. The core value of the price elasticity is assumed to equal 0.5. Fig. 4 reveals the reductions in the domestic gas consumption in Russia associated with a 70% increase in the gas price under different price elasticities of demand. Obviously, as the price elasticity of demand increases, the reduction in domestic demand becomes more pronounced; for example, under a price elasticity of demand equalling 0.7, the annual average reduction in the domestic gas consumption accounts for approximately 155 bcm, and for a price elasticity of demand equalling 0.9, it is 189 bcm. The share of gas in total energy consumption is large in Russia because the Russian economy heavily relies on gas. Even a relatively small increase in the gas price provides a substantial amount of gas in absolute terms (e.g., bcm). In fact, the regulation of domestic gas prices operates as an implicit subsidy. The domestic gas market provides a large reserve for expanding export supplies.

0

-40 -60 -80 -100 -120 -140 30 %

50 %

70 %

Fig. 3. Reductions in the domestic gas consumption in Russia under different price increases: Deviations from BaU.

0 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

-50

Billion cubic meters

that other gas exporters lose their market power in the European market with a decreasing market share. Assuming a stock effect for the RoW diminishes the reduction in the export supply from the RoW because of a decreasing marginal production cost (MCR#). Overall, there is an increase in total consumption of gas in Europe associated with a reduction in the average gas price.

-100

-150

-200

-250 edd=-0.5

edd=-0.7

edd=-0.9

Fig. 4. Reductions in the domestic demand for gas in Russia resulting from a 70% increase in the domestic gas price under different price elasticities of domestic demand: Deviations from BaU (edd is the price elasticity of domestic demand for gas in Russia).

We consider three planning horizons: 70, 50, and 30 years. The planning time horizon has a significant effect on the exportsupply strategy. If we assume a short planning horizon of 30 years, there is no increase in the export supply of gas to Europe until 2052. This is because Russian gas producers face a non-binding resource constraint until 2052. In other words, until 2052, the scarcity rent is assumed to be insignificant. Russia has large gas reserves, so it has the potential to increase export supplies even without reducing the supply to the domestic market. Therefore, there is no incentive to re-optimise the profit-maximisation strategy on export markets in response to a lower domestic consumption of gas. Although scarcity rents may be insignificant in the present, they could become more relevant in the long term. In other words, scarcity rents could play a more important role in

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200

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150

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200 150

100 50 0

100

2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

-50

50

-100

0

Export tax revenues

2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

th=70

th=50

th=30

Fig. 5. Increases in the export supply of gas to Europe resulting from a 70% increase in the gas price under different planning horizons and without any stock effect: Deviations from BaU (th is the planning time horizon).

Domestic subsidy

Fig. 6. Changes in the export tax revenue from gas and domestic gas subsidy resulting from a 70% increase in the gas price under a planning horizon of 30 years and with a stock effect: Deviations from BaU.

350

10 A 30-year planning horizon is assumed because the duration of long-term gas contracts is usually approximately 25–30 years.

300

Billinon cubic meters

future gas prices. Gas is an exhaustible resource, and therefore, we could expect that Russian and foreign gas producers will behave in the ‘‘Hotelling mode” in the future. Given the assumption of a planning time horizon of 30 years, after 2052, Russia faces a resource constraint; i.e., the scarcity rent becomes more significant in the gas price. A reduction in domestic gas consumption ultimately reduces the ‘‘future” scarcity rent for Russia, providing a larger potential for exporting gas in the long term, as indicated by an increase in the export supply of gas after 2052. Assuming a large planning horizon of 70 years, the model behaves as a classic Hotelling model; the additional gas released from the domestic market is distributed to export markets over the entire extraction period. Scarcity rents represent the implicit costs of resource extraction. However, lower domestic gas consumption may also affect explicit production costs via the so-called stock effect, where the marginal production cost depends on the remaining stock; i.e., as it becomes more extracted, the extraction becomes more expensive. In the numerical model, a potential stock effect is depicted via a supply function, and the magnitude of the stock effect is determined by stock elasticity. Fig. 7 illustrates the increases in the export supply of gas arising from a 70% increase in the domestic gas price in Russia under different stock elasticities. The planning time horizon is assumed to be 30 years.10 A zero stock elasticity implies that there is no stock effect, whereas a stock elasticity equalling unity implies that a 1% increase (decrease) in total extraction results in a 1% increase (decrease) in marginal production cost. A lower domestic consumption of gas in Russia results in a reduction in the marginal production cost. A decline in the marginal production cost encourages Gazprom to re-optimise its profit-maximisation strategy in the European gas market by increasing the export supply (Fig. 7). For example, under a stock elasticity equalling 0.5, the export supply of gas to Europe increases annually by approximately 20 bcm on average from 2016 until 2052; under a stock elasticity equalling 1.0, it increases by 33.7 bcm; and under a stock elasticity equalling 1.3, it increases by 43.4 bcm. For comparison, the export supply of gas to Germany was 41 bcm in 2013 [2]. Here, we assume a planning time horizon of 30 years so that Russia faces a non-binding resource constraint until 2052. After 2052, there is an additional effect arising from the decreased resource scarcity. A reduction in domestic gas consumption relaxes the future scarcity rent, implying a larger potential to export gas to Europe.

250 200 150 100 50 0 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

es=0

es=0.5

es=1.0

es=1.5

Fig. 7. Increases in the export supply of gas to Europe resulting from a 70% increase in the gas price under different stock elasticities: Deviations from BaU (es is the stock elasticity for gas production in Russia).

The results, however, should be taken with caution. High increases in the export supply after 2052 reveal the potential of Russia’s production capacity to increase the export supply to Europe. Nevertheless, increases in the export supply could be less pronounced when transportation capacity is taken into account. Paltsev [9] estimated that the Europe-bound export capacity could reach approximately 13 Tcf (368 bcm) by 2020 if two more pipelines of the Nord Stream and an additional pipeline of Yamal-Europe were built.11 Our results show that the capacity constraint will be likely non-binding until 2051, but it could become binding after 2051; for example, as a result of a lower domestic gas consumption, the total export supply of gas from Russia to Europe in 2052 accounts for approximately 418 bcm, and in 2080, it is 497 bcm. This means that the transportation capacity could be a limiting factor for a higher export supply to Europe. In Russia, there is an export tax of 30% on exports of natural gas; therefore, an increase in export supplies leads to higher export-tax revenue. Fig. 6 shows the changes in the export tax revenue and domestic gas subsidy. Here, we assume a planning time horizon of 30 years and a stock effect with an elasticity equalling unity. For example, a 70% increase in the domestic gas price could result in an annual average increase of the export tax revenue by approximately 38.4 billion USD, whereas the domestic gas subsidy declines annually by 34.1 billion USD on average. This is because an increase in the domestic gas price leads to a lower marginal production cost and a lower future scarcity rent, and thereby, Russia re-optimises its profit-maximisation strategy by increasing the 11 13 Tcf = 368 bcm, See http://natgas.info/gas-information/online-gas-unitconverter.

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40

250

35

Billion cubic meters

200 150 100 50 0 -50

2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

Billion cubic meters

300

30 25 20 15 10 5

-100

0

-150

2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

-200

ede=-0.5 Imports from RoW

Imports from Russia

Fig. 8. Changes in total gas consumption of gas in Europe and imports from the RoW and Russia resulting from a 70% increase in the gas price in Russia: Deviations from BaU.

export supply to Europe. Additional revenues from the export tax and the reduced domestic subsidy on gas consumption could be used to diminish a possible regressive effect of higher domestic gas prices on low-income household groups or to reduce distortionary taxes, such as capital taxes in Russia. 3.2.3. European gas consumption Though increases in the export supply of gas from Russia to Europe may be substantial, the overall increase in European gas consumption is less pronounced due to a substitution effect. Less expensive gas from Russia replaces some gas imports from the RoW. Fig. 8 reveals the changes in total gas consumption and imports from the RoW and Russia. Here, we assume a planning time horizon of 30 years and a stock effect of Russia with an elasticity equalling unity. According to the results, the annual average increase in European gas consumption from 2012 until 2080 accounts for approximately 17.5 bcm (Fig. 8), where the gas import from Russia increases annually by 114.3 bcm, and the gas import from the RoW declines annually by 96.8 bcm on average. The core value of the price elasticity of demand for gas in Europe is assumed to equal 0.7. Fig. 9 reveals the increases in the total gas consumption in Europe under different price elasticities of demand. The planning time horizon is assumed to equal 30 years, and the stock elasticity equals unity. Increases in total gas consumption become more pronounced under a higher price elasticity of demand; however, the results are not very sensitive to different values of price elasticities of demand. In contrast, the stock elasticity of gas production in the RoW has a significant effect on the results. In the previous policy simulations, no stock effect for the RoW was assumed. Assuming a stock effect for foreign gas producers results in a higher total consumption of gas in Europe.12 When we assume that foreign gas producers also have a stock effect with an elasticity equalling unity, the annual average increase in total gas consumption accounts for approximately 67.7 bcm, whereas without any stock effect, it is 17.5 bcm (Fig. 10). This is because a reduction in the export supply of gas from the RoW leads to a lower marginal production cost of foreign gas producers. In other words, a stock effect dampens the substitution effect, and thereby, less imported gas from the RoW is replaced by gas from Russia. Increases in the consumption of gas in Europe are driven by lower gas prices. The annual average reduction in the export gas 12 There is little consensus on supply elasticities. Many numerical models take the value of the supply elasticity for fossil fuels to be somewhere between zero and unity.

ede=-0.7

ede=-0.9

Fig. 9. Increases in total consumption of gas in Europe resulting from a 70% increase in the domestic gas price in Russia under different price elasticities of demand for gas in Europe: Deviations from BaU (ede is the price elasticity of demand for gas in Europe).

200 180

Billion cubic meters

Total consumption

160 140 120 100 80 60 40 20 0 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

esr=0

esr=0.5

esr=1.0

esr=1.5

Fig. 10. Increases in total consumption of gas in Europe resulting from a 70% increase in the gas price in Russia under different stock elasticities for the RoW: Deviations from BaU (esr is the stock elasticity for gas by other gas producers (RoW)).

0 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2080

-5

Percentage change

-250

-10 -15 -20 -25 -30 esr=0

esr=0.5

esr=1.0

esr=1.5

Fig. 11. Percentage changes in the export gas price resulting from a 70% increase in the gas price in Russia under different stock elasticities for the RoW: Deviations from BaU.

price without any stock effect of the RoW accounts for approximately 2.9%, whereas under a stock elasticity equalling unity, it is approximately 10% (Fig. 11). In this analysis, the European gas market has been considered the only export market for Russia, but the growing Asian gas market represents large potential for Russian gas exports. In May of 2014, Russia and China signed a $400 billion gas contract. According to this contract, Russia will supply 38 billion cubic meters

A. Orlov / Applied Energy 164 (2016) 188–199

(bcm) of gas annually over 30 years, beginning in 2018, via the socalled ‘‘eastern route” (the Power of Siberia pipeline; [68]). A few months later, Russia and China signed a framework for a second gas agreement. According to this second gas agreement, Russia will supply 30 bcm annually over 30 years via the so-called ‘‘western route” (the Altai pipeline) [69]. In the context of our analysis, this means that the gas from the domestic market will not necessarily be delivered to the European market; rather, it could supply the Chinese market. This implies that increases in export supplies to Europe could be less pronounced than estimated.

4. Conclusions and policy implications Domestic gas prices are regulated in Russia and are substantially lower than export netback prices. The Russian government aims to increase the domestic price level for gas in the long term. Russia is one of the largest exports of gas to European economies. Therefore, domestic gas policy may have a significant effect on the European gas market. This study assesses the long-term effects of an increase in the domestic gas price in Russia on the European gas market. The analysis is based on a modified analytical and a numerical Hotelling model. The main findings are as follows: (1) Increasing the domestic gas price level in Russia could release a substantial amount of gas for export markets. Under a price elasticity of demand equalling 0.5, a 70% increase in the domestic gas price could result in an annual average reduction in gas consumption from 2016 until 2080 by 116 bcm; as the price elasticity of domestic demand for gas increases (decreases), the reduction in gas consumption becomes greater (smaller). (2) A reduction in domestic gas consumption could affect the export supply to Europe via two channels: (i) a stock effect and (ii) scarcity rents. In fact, Russia has large proved reserves of natural gas. Given the assumptions of a short planning horizon and large gas reserves, Russia could face a non-binding resource constraint. In this case, there is no incentive to re-optimise the profit-maximisation strategy in the European gas market, at least in the short and medium terms, unless there is a stock effect. (3) Although the resource constraint may not be an issue for Russian gas producers in the short and medium terms, scarcity effects could become more relevant in the future; i.e., the scarcity rent could be a significant component of future gas prices. A reduction in domestic gas consumption could reduce the future scarcity rent, implying a higher potential for exporting gas in the long term. (4) Furthermore, a lower domestic consumption of gas may affect the explicit production cost via a stock effect, where the marginal production cost depends the remaining stock. As a result of a lower domestic consumption of gas in Russia, the marginal cost of gas production could decline, which will make Russian gas more competitive in export markets, encouraging export supplies to Europe. The results show that under a stock elasticity equalling unity, a 70% increase in the domestic gas price could lead to an average annual increase in the export supply of gas to Europe by approximately 33.7 bcm. As the stock elasticity increases (decreases), the increase of the export supply decreases (increases). (5) Increasing the domestic gas-price level in Russia is associated with a lower implicit subsidy on domestic gas consumption and a higher revenue from the export tax on gas. Under a planning time horizon of 30 years and a stock effect

197

with an elasticity equalling unity, a 70% increase in the domestic gas price could annually increase the export tax revenue from gas by 38.4 billion USD on average, whereas the domestic gas subsidy declines annually by 34.1 billion USD on average. (6) The overall increase in total consumption of gas in Europe resulting from higher domestic gas prices in Russia tends to be less pronounced than the increase in the export supply from Russia because of a substitution effect. Less expensive gas from Russia could crowd out some gas from other exporters in the European market. Under a planning time horizon of 30 years and a stock effect with an elasticity equalling unity, on average, the total consumption of gas in Europe could increase annually by approximately 17.5 bcm in response to a 70% increase in the domestic gas price in Russia. As the price elasticity of gas demand increases (decreases), the increase in gas consumption in Europe increases (decreases); however, it should be noted that the results are not very sensitive to different values of price elasticity. (7) Crucial is the response of other gas producers to higher export supplies from Russia. Given the assumption of a stock effect of foreign gas producers, a decline in export supplies may result in a lower marginal production cost of other gas producers. The results show that under a stock elasticity equalling unity for the RoW, total gas consumption in Europe could annually increase by approximately 67.7 bcm on average. Intuitively, a less elastic supply of other gas exporters counteracts the substitution effect so that less gas from the RoW is replaced by Russian gas. Increasing the domestic gas price level is expected to encourage a more efficient and sustainable use of gas resources in Russia. Moreover, this analysis shows that increasing domestic gas prices could result in a substantial increase in export supplies to Europe. Nevertheless, there are factors that could limit the estimated increases in the export supply. For example, the additional gas from the domestic market could alternatively supply the booming Asian market. This becomes relevant particularly in the course of gas agreements between Russia and China. Therefore, the estimated increases in export supplies to Europe could be less pronounced, at least by 30 bcm annually, if the second gas agreement were signed. The transportation capacity is another factor that could limit the estimated increases in the export supply of gas to Europe. Moreover, increases in the import demand for Russian gas in Europe could be less than estimated due to energy security considerations because Europe may not want to become dependent on Russian gas deliveries. Furthermore, there are large uncertainties regarding the value of the price elasticity of gas demand in Russia and Europe. The magnitude of the stock effect is also uncertain. Therefore, in our analysis, we consider different values of the price elasticity of gas demand and stock elasticity. Moreover, we assume that scarcity rents will be more important in the future, which is a plausible assumption. Nevertheless, a rapid development of renewables and a large potential of shale gas could mitigate future scarcity effects; the development of gas demand in Europe after 2050 is uncertain. Under non-binding resource constraints, only stock effects drive the results. Despite these limitations and uncertainties, we think that our analysis provides useful insights on the possible outcomes of the gas-price reform in Russia. Acknowledgements I would like to thank two anonymous referees for their very helpful comments and suggestions which substantially improved

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the paper. This study has been carried out as a part of the centre for ‘‘Strategic Challenges in International Climate and Energy Policy” (CICEP) at the Center for International Climate and Environmental Research – Oslo (CICERO). The CICEP centre is mainly financed by the Research Council of Norway (No. 209701). The views expressed here and any errors are my own.

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