Transporting Russian Gas to Western Europe - A Simulation Analysis. Christian von Hirschhausen, Berit Meinhart, Ferdinand Pavel

Transcription

1 Globalization of Natural Gas Markets Working Papers WP-GG-08 Transporting ussian Gas to Western Europe - A Simulation Analysis Christian von Hirshhausen, Berit Meinhart, Ferdinand Pavel Preprint of The Energy Journal, Vol. 26, No. 2, 49-68, April 2005 German Institute for Eonomis Eonomi esearh DEWAG-Chair for Energy Dresden niversity of Tehnology

2 Transporting ussian Gas to Western Europe - A Simulation Analysis ef. no. 02/77 forthoming in The Energy Journal April 2005 Christian von Hirshhausen*, Berit Meinhart**, and Ferdinand Pavel*** * Corresponding author: Dresden niversity of Tehnology (DEWAG-Chair for Energy Eonomis), and DIW Berlin (German Institute for Eonomi esearh) D Dresden (Germany) tel.: tel.: hirshhausen@diw.de ** Berit Meinhart Berlin niversity of Tehnology, Workgroup for Infrastruture Poliy (WIP) Straße des 17. Juni 135 D Berlin (Germany) mei@wip.tu-berlin.de *** Ferdinand Pavel DIW Berlin, and German Advisory Group on Eonomi eforms in kraine, Kiew fpavel@diw.de

3 Transporting ussian Gas to Western Europe - A Simulation Analysis 1 Abstrat This paper examines the options of transporting ussian gas to Western Europe, an issue that has thus far been dominated by a single transit ountry, kraine, whih has reently witnessed substantial politial turmoil. The ompletion of a new transit orridor through Belarus in 1999, the so-alled Yamal-Europe pipeline, has modified the situation profoundly. The paper develops a model of different strategies of ussia and kraine, and derives the analytial solution for ussian gas exports to Western Europe, pries, and the expeted profits for the players; we also alibrate numerial results and perform simulations. It turns out that kraine suffers a loss from the market entry of Belarus, ussia's profits signifiantly inrease, and ussia has an inentive to expand its gas transit apaity through Belarus further. The gas prie for West European importers falls in the ase of ooperative behavior of ussia and kraine, 1 This paper is an output from a long-term poliy advie program to the government of kraine, and the researh projet The Globalization of Gas Markets, run jointly by DIW Berlin and Dresden niversity of Tehnology; the theoretial analysis was initially based on the Master Thesis of Chollet (2001). The authors are indebted to four anonymous referees as well as to Friedel Bolle, Ahim Czerny, Katherina Dittmann, Viola Ehrenstein, Dieter Helm, Manfred Horn, Franz Hubert, Heinrih Lennartz, Karsten Neuhoff, Kay Mitush, Wolfgang Pfaffenberger, and Wolfram Shrettl for omments on this or on earlier versions, and to Anne Neumann and Deborah Bowen for researh assistane. Thanks also to partiipants of the 12th krainian-german Eonomi Symposium (June 2000, Kiev, kraine), a seminar at the Carnegie Endowment for International Peae (Washington, D.C., September 2001), the 25th Annual IAEE International Conferene (June 2002, Aberdeen, Sotland), the 6th European Conferene of the International Assoiation for Energy Eonomis (IAEE, September 2004, Zurih), the 31st onferene of the European Assoiation for esearh in Industrial Eonomis (Berlin, September 2004), and the 3 rd Conferene on Applied Infrastruture esearh (Otober 2004, Berlin niversity of Tehnology). The usual dislaimer applies.

4 and/or new pipeline onstrution through Belarus. However, both developments would also imply a higher European import dependene on ussian gas. 2

5 1 Introdution The West European dependene upon gas imports from the Soviet nion and, sine 1991, from ussia has been and ontinues to be a ritial issue studied from the perspetives of both energy eonomis and geopolitis. The issue has been dealt with in the literature sine the first long-term ontrats between Europe and the Soviet nion in the late 1970s (see Greer and ussel, 1982, Banks, 1983). Faed with an inreasing demand for gas and dereasing own reserves, the European nion has reently plaed gas supply issues at the top of its poliy agenda (European Commission, 2000), while putting partiular weight on the strategi E- ussia Energy Dialogue. Not only is ussia's share of E gas imports expeted to inrease from the present 40% up to 70% by 2020, but ussia is also onsidered to be the swing supplier of gas to Europe for the foreseeable future. Given the expeted demand hike for gas in Europe, environmental onerns regarding other fuels (mainly oal), the phasing-out of nulear power, and the dash for gas going on in other regions of the world, the future of ussian gas has beome a hot topi far beyond Europe's borders. The question of how ussian gas reahes the European market was negleted for some time, sine there was no "transit" issue during Soviet times, when kraine belonged entirely to the Soviet nion. Sine 1991, and through all of the 1990s, kraine was the sole transit ountry upon whih ussia had to rely. The sensitivity of this situation has been highlighted reently by the politial turmoil surrounding the presidential eletions in kraine. It ame by no surprise, therefore, that ussia has tried to hange the rules of the game: first, ussia has, in ooperation with Belarus and West European gas importers, ompleted the parallel pipeline for gas exports via Belarus to Poland and on to Germany, the so-alled "Yamal-Europe Pipeline" (see Figure 1). Seond, ussia and the West European gas industry have made onrete plans to onstrut a bypass pipeline from Belarus through Poland to Eastern Slovakia, in order to irumvent the politially unstable kraine even further. Third, there is now serious talk about a diret onnetion between ussia and Germany, the so-alled "North Transgas Pipeline" 3

6 through the Balti Sea. Thus, the former monolithi gas trade between ussia and Western Europe through kraine has beome a multi-player game with signifiant effets on strategies and potential outomes. The issue of ussian gas transit to Europe has not reeived suffiient attention thus far in the literature. Stern (1999) assesses the strategy of ussia, and more speifially, Gazprom, towards Europe and observes an attempt at diversifying export routes. IEA (2002, 138) observes that Gazprom has enountered transit problems in its exports to Europe, although it onfirms high expetations of future Gazprom exports to Europe (rising to about 200 bm in 2020, against 130 bm in 2000). Golombek et al. (1995, 1998) analyze the potential effet of liberalizing the gas industry in the supplying ountries. They onlude that if the West European gas exporters (Netherlands, Norway, K) liberalize their markets and split up their monopolisti gas industry, they will win market shares and inrease profits, whereas ussia, as a monopolisti supplier through Gazprom, would lose. Conversely, this implies that a liberalization of the ussian gas industry would strengthen ussia's role on the European market even further, and thus require higher transit apaities as well. Boots, ijkers and Hobbs (2004) develop a suessive oligopoly approah to the European natural gas markets and show that under ertain irumstanes, vertial integration along the value added hain inrease overall welfare; this might also apply to ussian exports towards Europe. An extensive quantitative analysis of interdependene in European East-West gas trade was arried out by Grais and Zheng (1996): using a hierarhial Stakelberg game approah, they show that an improved reliability of gas supply from ussia is benefiial to the ussian gas exporting industry, to the gas transiting ountries and to the West European gas importers. More reently, Hubert and Ikonnikova (2004) have modeled the pipeline onstrution in the Eurasian gas market as a bargaining proess between one produer (ussia) and several potential transit ountries (kraine, Poland, Slovakia). They assume equal bargaining power between produer and transit ountry and apply a Shapley-value analysis to ompare the returns to eah of the players from different possible oalitions. It turns out that a redible option to onstrut the ommerially unviable North Transgas pipeline an strengthen the 4

7 negotiating power of ussia in negotiations with kraine. Hubert and Ikonnikova onlude that, given the low redibility of kraine in ommitting to long-term transit ontrats, (foreign) investment in the krainian pipeline system appears not to be likely in the near future, as "expanding failities in kraine would strengthen this ountry too muh in ex-post negotiations to make the projet interesting for other players." (p. 28). However, reent developments seem to paint a different piture: in 2003, ussia signed an agreement with kraine to enter into a transit pipeline onsortium, with the objetive of expanding gas exports to Western Europe, and streamlining their poliies vis-à-vis the European gas importers. Following that, joint work began in 2004 to expand the transit apaity of natural gas through kraine by another 30 bm. Whether the good relations between ussia and kraine persist under a new krainian president remains to be seen. This paper models the options of transporting ussian gas to Western Europe, with a fous on the relations between ussia and kraine. We develop different senarios of ussian gas exports to Europe in the light of potential strategi behavior and pipeline developments in kraine and in Belarus. The paper is strutured in the following way: Setion 2 provides a survey of reent developments in ussian gas exports. The ore of the paper is the modeling and subsequent quantifiation of various development senarios: Setion 3 models the exporttransit game between the gas produer (ussia) and the main transiting ountry (kraine), to whih we add Belarus as a supplier of additional transit apaity. We model non-ooperative and ooperative strategies for the two- and the three-player game, respetively. Based on the alibration of the model in Setion 4, we alulate export volumes, pries, and profits for the partiipating parties. We also provide results for simulation analyses, the variables being the transit apaity through Belarus, and the West European demand for ussian gas. We find that ussia an gain signifiantly, both in the ooperative game with kraine and from pipeline expansion in Belarus; kraine gains from ooperation, but loses signifiantly after the introdution of a parallel pipeline through Belarus. Western Europe benefits from ooperation between kraine and ussia, as well as from expanded pipeline apaity through Belarus, as 5

8 import pries fall. However, for Europe, this omes at the prie of inreased import dependene. Setion 5 onludes. 2 eent Developments in ussian Gas Exports and Transit to Western Europe In spite of the politial, eonomi and soial upheaval of the transition risis in the former Soviet nion, the transport of ussian gas to Central and Western Europe has not only ontinued but even inreased. ussian gas exports to non-cis ountries have inreased from 107 bm (1994) to 132 bm (2003). The European Commission (2000, 45) expets a further inrease of gas imports from ussia of up to 250 bm by 2020 (i.e. 38% of expeted onsumption, about 70% of imports); the ussian energy strategy, too, foresees exports outside the CIS of bm by However, until very reently, the reliability of ussian exports was onsidered by some observers to be limited due to the politial and eonomi instability in kraine, the only available transit ountry. The dissolution of the Soviet nion and the independene of kraine made it possible for the latter to exerise "monopolisti" power in transit. Evidene of this an bee seen in kraine's harge of a transit fee of about S $ tm 100km S $, whereas its marginal osts were about tm 100km (Opitz and Hirshhausen, 2001, 155). 2 Whereas ussia did not seem to objet to kraine's dominant role in gas transit in the first half of the 1990s, it seems to have beome more onerned with it in the seond half of the deade. Subsequently, besides inreasing the politial pressure on kraine, 3 ussia, supported by West 2 In addition, kraine was regularly aused by ussia of illegally withdrawing transit gas. In 2000, Gazprom estimated the gas theft by Naftogazkrainy at 15 bm (Infodienst 44/2000, 17); in ontrast to this, the krainian government admitted only 8.2 bm of "unsantioned removals" of ussian gas (IEA, 2002, 138). 3 Among other things, ussia has required debt-equity swaps for the krainian debt stemming from unpaid energy bills; as of 2003, unpaid bills to ussia amounted to over 1 bn. S$. 6

9 European gas importers, tried to reate alternative transit apaity to weaken the monopoly power of kraine, and to meet additional demand on the West European market via other export routes (see Figure 1): New apaities to transport gas through Belarus and Poland were built within the Yamal- Europe-pipeline projet whih transports gas from Western Siberia through Belarus (Minsk - Nesvizh) and Poland (Kondratki - Wlolawek) to Germany (Frankfurt/Oder, Mallnow). The onnetion of the first 56'' trunk was ompleted in November 1999 with a nominal apaity of 28 bm, to whih a seond (and third) line ould be added to arry the apaity to 56 bm (84 bm, respetively). Due to laking ompressor apaity along the Belarus and Polish trunk, the apaity was 18 bm in 2002, a figure that we adopt in the senarios as base ase; the next possible step to irumvent kraine is the so-alled bypass (or: Yamal-2 Pipeline) onneting Kondratki (Poland) to Velke Kapuzany (Slovakia), with a projeted annual apaity of 60 bm. This would allow ussia to export gas via the Central orridor (with its high apaity and onvenient onnetions to West European markets) while still not depending entirely upon kraine for transit; more reently, the diret undersea pipeline between Vyborg (ussia) and Germany (Peenemuende), the so-alled North Transgas pipeline, has attrated muh attention. By building this pipeline, ussia would avoid transit of its gas through foreign territory, thus strengthening its export position onsiderably (Hubert and Ikonnikova, 2004). At this point in time, however, the high osts of the projet (up to 20 bn. S$) and the lak of proven natural gas reserves in Northwest ussia make the North Transgas pipeline a medium-term rather than a short-term option. 4 4 Other pipeline projets for ussian gas export exist (e.g. the Blue Stream Pipeline onneting ussia and Turkey through the Blak Sea, finished in 2003), but they do not affet the onstellation analyzed in this paper, and will therefore not be disussed here. For details, see IEA (2002) and Stern (2002). 7

10 These measures adopted by ussia to urtail kraine's strategi importane as a transit ountry seem to have worked out: in early 2003, kraine gave in and aepted a proposal made by ussia to reate a joint "gas onsortium" and to harmonize their gas export and transit poliies. The main objetives of the onsortium are to establish the krainian gas-transit system as a reliable, safe and stable delivery option for ussian gas to European markets, and to attrat further investments for the neessary modernization and expansion of the pipeline system. 5 West European gas importers have shown a strong interest in joining the onsortium. In essene, ussia s efforts to seure greater flexibility and reliability in gas exports have not altered the physial transit business muh, sine most of the gas still flows through kraine. However, it has altered the strategy spae signifiantly, and has thus modified the negotiating options of the players. The next setion provides a formal approah to modeling these options, whih are then quantified in the subsequent setion. 3 Modeling the Export-Transit Game 3.1 Non-ooperative versus ooperative solution strategy Before speifying our model of ussian gas exports to Western Europe through kraine and Belarus, we start by identifying the fundamental differene between the two possible strategies to ooperate or not to ooperate for the ountries involved with general properties. Let x denote the amount of gas transported from ussia through kraine to Europe, t the per-unit transit fee harged by kraine, and and the onstant per-unit osts of ussia and kraine, respetively. Furthermore, let us assume that using the pipeline through kraine is the only option for transporting ussian gas to Western Europe, and that x p denotes the 5 nder the agreement, ussia and kraine set up a new ompany, whih is in harge of transporting ussian gas to the E; it also has the responsibility to invest in the grid. 8

11 orresponding demand funtion for gas imports with x p 0 and x/ p < 0 for all p 0, so that the inverse demand funtion p = p x 0 exists with p/ x < 0. 6 For ussia and kraine we define the following two strategies: Non-ooperative strategy: ussia and kraine determine transit quantity (or the final prie for gas) and transit tariff independently so as to maximize their respetive profits; Cooperative strategy: ussia and kraine determine the profit-maximizing transit quantity (or final prie) jointly and share total profits. 7 Furthermore, we denote: () = ( p t)x π as ussia's profits for the non-ooperative strategy and x n = arg max { π ( x) } (or p arg max { π ( p) } x 0 = ) as solution for ussia s n p 0 profit-maximization problem; π as kraine's profits for the non-ooperative strategy and () t = ( t )x { π () t } t = arg max as solution for kraine's profit-maximization problem; t 0 π () = π () + π ( t) n as aggregate profits of the non-ooperative solution; π as total profits of the ooperative solution and () = ( p )x x = arg max { π ( x) } (or p = arg max { π ( x ) } x 0 kraine's joint profit-maximization problem. p 0 ) as solution for ussia's and 6 Given that the other transit ountries to Western Europe (Poland, Hungary, Slovakia, Czeh epubli) already joined the European nion, we do not model their behavior speifially. Neither do we onsider the role of Central Asian gas suppliers (Kazakhstan, Turkmenistan) in this paper. Furthermore, we do not differentiate between the strategies of the ountries (ussia, kraine, Belarus) and of the firms (Gazprom, Naftogaz kraine, Belarus Gas) at this point. 7 Both strategies are plausible, and have in fat been observed during the past deade, as the ountries seem to move from non-ooperative strategies to more ooperation. 9

12 Finally, we assume that profit funtions that x ( ) n p, n t, π, x exist and are unique). π and π are ontinuous and quasionave (so Then: Proposition 1: Profits of the ooperative strategy are always greater than or equal to aggregate profits of the non-ooperative strategy: π π n. Furthermore, the transit quantity (the gas prie) in the ooperative strategy is always greater (below) or equal its level in the non-ooperative strategy: x x n ( p p n ). Proof: For the non-ooperative strategy, maximum aggregate profits are π n maxx 0 π t 0 ( x) + max π ( t) = ( p ) ( ) ( ) + = t x t x p x = n n xn xn π n = max p π p + maxt 0 π t = pn x p n (or ( ) ( ) ( ) x n (or 0 ). However, beause p n ) and t are hosen within two separate problems, aggregate profits π n annot n exeed maximum profits for the ooperative solution in whih x is diretly hosen to π 0 (or = maxx π x = p x x maximize the same expression: ( ) ( ) ( p) = ( p ) x π = max 0 π ). p p Next, quasionavity of π = ( t )x requires that x / t 0 or t / x 0. Thus, if kraine sets t = (zero profits from transit) in the ooperative strategy ( = ( t ) x = 0 π ) and shares total profits π with ussia, 0 π for any nonooperative strategy requires that x x (otherwise t < ) and thus, p p n n. q.e.d. 10

13 In the subsequent setion, we apply this general result to a proper speifiation and provide simulation analysis with real data. 3.2 Non-Cooperative Strategy (Two Players) ntil 1999, prior to onstruting the bypass pipeline through Belarus, ussia transported all of its gas exports to Western Europe through kraine. This point of ineption an be haraterized as follows: ussia, the main supplier of natural gas to Europe, sets an export quantity x to maximize profits Π = ( p t)x where p = p(x) is the prie for imported (pipeline) gas in Europe with p ( ) / x < 0, are variable osts for ussia and t is the transit tariff set by kraine. Furthermore, due to its influential position and bargaining power vis-à-vis kraine, ussia is also able to inorporate the best-response funtion of kraine w.r.t. transit tariff t(x) t =, where t ( ) / x > 0. One an justify this struture of the game beause ussia s dominant role in the region has repeatedly allowed it to influene politial and eonomi deisions in kraine. 8 The First Order Condition (FOC) for ussia s profit-maximization problem implies that the optimal solution for x satisfies: () t() p p x) + x = + t x x ( (1) kraine's problem is to set transit tariff t to maximize profits Π = ( t )x at given osts. Ceteris paribus, inreasing t raises profits. The highest-possible transit fee (t ) would alloate the entire profits from gas exports to kraine and leaves no profit to ussia. If, however, ussia has bargaining power vis-à-vis kraine, it an redibly ensure to stop exports even if kraine asked for a transit fee below t. As e.g. Hubert and Ikonnikova (2004) show, suh bargaining power an stem from the existene of alternative transport routes not expliitly 8 For example, this is refleted by the presene of former Gazprom Chairman and ussian Prime Minister Vitor Thernomyrdin as Ambassador to kraine, as well as by anedoti evidene suh as quite favorable debt-equity swaps for krainian debts from unpaid energy bills, use of kraine's 11

14 onsidered in our analysis, or even from planned pipeline routes used as bargaining hips. 9 In this paper, we assume that ussia s bargaining power is desribed by the funtion x = x(t) whih determines the maximum quantity x that ussia is willing to ship through kraine at transit fee t. Then, with full information, kraine s problem is to maximize profits subjet to x = x(t). 10 Obviously, existene of an optimal solution with < t < t to be bounded, and thus x () / t < 0 0 requires the problem. This means that ussia s bargaining power enables it to punish kraine by reduing the maximum transit quantity in response to any inrease in the transit fee. From the orresponding FOC, the optimal solution for t must satisfy: ( ) x x + ( t ) = 0 (2) t In the following algebrai speifiation we assume for simpliity and tratability that the inverse demand funtion of Western European onsumers for imports of natural gas is given by p = ax + b (3) where a <0 and b >0 are exogenous parameters, 11 and that the slope of the funtion x = x(t) that desribes ussia s bargaining power is onstant: x t = σ < 0 (4) To solve this model we use (4) in equation (2) to obtain the best-response funtion of kraine w.r.t. transit quantity x : t 1 x σ = (5) gas-storage failities at zero-ost by Gazprom until 2001, or the expliit prohibition of krainian gas sales to Europe by ussia as stated in the transit ontrats until E.g. the North Transgas Pipeline running diretly from ussia to Germany through the Balti Sea. In ontrast, this bargaining power does not stem from fators suh as time lags, asymmetri information et. Note that this funtion is not a best-response funtion of ussia as we do not derive it out of ussia s optimization problem. ather, we take it as exogenously given. Hene, inorporation into kraine s maximization problem does not put kraine into a leading position in this game. We thank one of the referees for partiularly in-depth remarks on the leader-follower issue. See Setion 4.1 for further interpretation of this inverse demand funtion. 12

15 Substituting (3) and (5) into (1) we solve for the profit-maximizing transit volume x * of ussian gas: x * + b = 1 2( a ) + σ (6) Finally, using (6) in kraine's best-response funtion the optimal tariff reads t * = + b 1 2σ ( a + σ ) The logi of this solution is as follows: transit fees set by kraine inrease with higher transit quantities ( sine (5) inreases in x ). On the other hand, if kraine will fae a strong redution of transit quantities in response to higher transit fees due to very high bargaining power of ussia (that is, if σ << 0 ), then it an only harge a modest fee as (5) is inreasing in σ. At the same time, ussia is aware of its high bargaining power ( σ << 0 ) and exports rather large quantities through kraine sine by equation (6) x is dereasing in σ. This solution is alled non-ooperative sine it does not onsider ollusive behavior between ussia and kraine. In ontrast to this, the following subsetion onsiders a ooperative strategy. 3.3 Cooperative Strategy Nash Produt Solution (Two Players) In the ooperative strategy, ussia and kraine optimize their joint profit and then distribute this profit between themselves. We assume that surplus is divided aording to Nash bargaining. The Nash produt is the produt of eah ountry's profit in ase of agreement (ooperative strategy) minus the profit in ase of non-agreement (non-ooperative strategy): NP2 = ( Π Π )( Π Π ) (7) oop non oop oop non oop where NP 2 stands for the Nash produt in the two-player ase. If both players ooperate, ussia gets the profit: Π oop = Π T oop = px x( + ) T oop (8) 13

16 by ompensating kraine with a fixed margin T oop = x t. The profits in the nonooperative game are those in the situation prevalent until now, i.e. the krainian transit monopoly senario Π Monopoly and Π Monopoly Nash-produt solution an be written as:. Hene, the profit maximization funtion in the NP2 = ( Π T Π )(T Π ) (9) oop Monopoly oop Monopoly We an now derive the profit maximizing transit fee T and from there, derive the optimal export and thus transit quantity. Therefore, we maximize the Nash produt (9) w.r.t. whih implies that T oop, NP2 T oop =! ( T ) + Π T Π = 0 oop Π (10) Monopoly oop Monopoly and T Π = + Π Π Monopoly Monopoly 2 (11) indiating that kraine gets half of the profit-maximizing surplus in the Nash-produt solution. Substituting T in the Nash-produt relation (9): NP 2 Π Π + Π Monopoly Monopoly = Π Π 2 Π Π + Π Monopoly Monopoly Π Monopoly 2 ( ax + b) x x( + ) Π Π Monopoly = 2 ( ax + b) x x( + ) Π Π Monopoly 2 Monopoly Monopoly Monopoly (12) Maximizing (12) w.r.t. x implies: 14

17 NP2 x (2ax + b ) = 2 2 ( ax + x( b ) Π 2 Π Monopoly Monopoly )! = 0 (13) from whih we solve for the profit-maximizing transit quantity: x = + 2a b (14) The optimal export quantity x depends only on the players ost struture and the exogenously given parameters of the demand funtion (a, b). In ontrast to the non-ooperative solution (6) it does not depend on the marginal impat of kraine's transit fee. 12 Furthermore, as stated by Proposition 1, total profits of ussia and kraine in the ooperative solution are always above the sum of their profits of the non-ooperative solution. Nevertheless, the severe politio-eonomi onfrontation between ussia and kraine still explains why both ators have preferred their non-ooperative strategies for so long. This may also be explained to a ertain extent with orporate governane problems (that are not expliitly treated in the model): neither Gazprom nor its krainian ounterpart, Naftogaz krainy, are rational profit maximizers, but rather they should be thought of as representing a multitude of prinipal-agent problems. Conflits have always existed, e.g. between the national governments and the top management, but also within the management itself. These orporate governane issues may have delayed the deision making proess further, in partiular in kraine. 3.4 Non-Cooperative Strategy (Three Players) We now turn to the three-player game by introduing the "Northern option" of ussian gas exports to Western Europe through Belarus. The role of Belarus in this politial proess is somewhat inonsistent and diffiult to model: on the one hand, Belarus laims independene of 12 Sine x / t = σ < 0 the optimal solution x * in (6) is below its level in the ooperative solution (14). This is onsistent with Proposition 1. 15

18 its energy poliy, and might thus be modeled as an independent ator with an individual objetive funtion. On the other hand, however, the ountry not only insists on an eonomi union with ussia, but also leaves to ussia to arry the entire burden of investing about three bn. S$ in the pipeline extension. We take aount of this ontradition by modeling Belarus as a mere provider of transit apaity without an individual objetive funtion; the apaity deision itself is taken by ussia. Belarus will aept any ussian deision to inrease transit apaity beause it benefits from it. We define x as the quantity whih is transported through kraine on the Southern route, and x B as the quantity transiting via the Northern route through Belarus. The total quantity whih is transported to Western Europe is then defined as: x = x + x B (15) The new pipeline through Belarus is tehnially more effiient than the old krainian one whih is notoriously outdated, leaky, and has high operation osts. Also, the transport distane along the Northern route to the E border is shortened by almost 1,000 km. Sine the total transport osts from ussia to Western Europe are learly lower on the Northern route, ussia will prefer to transport gas through Belarus, subjet to the prevailing apaity onstraint. kraine then gets to transport only the residual quantity. Assuming that Belarus is not a selfontained ator and that ussia and kraine will not ooperate, we an alulate the quantity x, whih will be transported through kraine: 13 Π Monopoly B = p( x + x B ) x B ( + B ) x ( + 1 x σ ) Π Monopoly B x = 2 aσ( x 2! + xb ) + σ ( b ) + x = 0 σ + b 2axB x = (16) 2( a + ) σ 1 13 In our numerial simulations, we assume for simpliity that the value of the oeffiient σ is onstant and determined by the ombination of alternative transit routes. 16

19 Similarly to the non-ooperative solution in the two-player senario, kraine maximizes profits: Π MonopolyB = ( t ) x from where we obtain its best-response funtion 1 t = x σ The solution for this ase is similar to the non-ooperative solution for two players (Setion 3.2). But kraine now reeives a lower profit sine x in equation (16) dereases in B x (that is with additional transit apaity at lower ost) and t dereases with a smaller amount of x. 3.5 Cooperative Strategy Extended Nash Produt Solution (Three Players) We now onsider the Nash produt solution in the three-player senario: NP 3 = ( Π Π )( Π Π ) (17) oop T oop Monopoly B oop Monopoly B ussia and kraine negotiate a fixed amount T oop for kraine as the global transit fee for the residual quantity. In the ooperative Nash produt solution, this orresponds again to half of the profit-maximizing surplus in the Nash produt solution, similar to (11). The Nash produt an then be alulated as follows: NP 3 = ( ax + b )x x( ( ax + b )x x( + ) Π 2 + ) Π 2 Monopoly Monopoly Π Π Monopoly Monopoly and we obtain the transit quantity through kraine by maximizing w.r.t. x * + b 2ax x = 2a B (18) 17

20 Note that as for (14) the optimal export quantity x * does not depend on the marginal impat of kraine's transit fee and thus exeeds the optimal level in the non-ooperative solution (16). Furthermore, note that the volume x that is transported through kraine is dereasing in B the apaity on the Northern route through Belarus. x, 4 Data and esults 4.1 Demand Funtion and Data The import demand funtion x ( p) that orresponds to equation (3) an be derived from a nested utility funtion in whih a given onsumption level of gas is met by domesti and imported gas and where expenditure minimization at given pries determines the ombination of both. However, sine gas imports of Western Europe do not originate from ussia alone, the orret linear speifiation must be x ( p,x others ) where x denotes imports from ussia while x others are imports from all other origins and p is the average prie for imported gas in Western Europe (assuming that gas of different importers is suffiiently homogenous, suh that imports are solely determined by supply osts and apaity restritions of the respetive pipelines). Consequently, the orresponding form for (3) is ( x + x ) β α + p (19) = others where p is the average prie for imported gas in Western Europe, and α and β are exogenous parameters. Then, if we take hanges of other importers to be exogenous in order to fous exlusively on the relation between ussia and kraine, this speifiation oinides with (3) for a = α and b α x + β. To estimate parameter α and β from (19) we use = others annual time-series data from 1981 to 2001 for gas imports (soures: BP Statistial eview of World Energy, Eurostat, national statistis) as well as average E gas import pries 18

21 (IEA/OECD, various issues). For the base senario, the parameters are =, S $ a 9 tm10 m and = ). S$ b tm With regard to osts, we use estimates by OME (2002) for all European gas suppliers. Variable transportation osts are taken as 15% of total long-run inremental ost. Thus, ussian prodution and transit osts to its Western border are 12.3 S $, and marginal transit osts tm from the ussian border to the E through kraine and Belarus are S $ S $ 5.14 and.77 tm tm 4, respetively. This onfirms that it will be preferable to use the Belarus apaity fully before swithing to kraine as transit ountry. The krainian transit apaities (pipelines alled Central, Progress, and Soyuz) total approximately 130 bm per year. In 1999 some 60 bm of gas were transported to Western Europe, and some 40 bm to Central Europe. Together with exports to ountries in the South- East of Europe, the utilization rate of these pipelines was near 100%. The apaity of the Yamal Pipeline via Belarus and Poland is taken as 18 bm per year during the first stage, and raised to 28 bm and 56 bm, respetively, in the senarios. 4.2 esults: Non-Cooperative Strategy vs. Cooperative Strategy Tables 1 and 2 provide results of our simulations based on the models developed in the previous setion. Both tables inlude simulations for the non-ooperative and ooperative strategies under various assumptions on the apaity of the Belarus transit pipeline (18 bm, 28 bm, and 56 bm, respetively). Column (1) in Table 1 (base senario) shows the results for the point of ineption, i.e. the period before 1999, with kraine as a non-ooperative transit ountry. For this benhmark, we alibrate the unobservable parameter σ suh that our model repliates a quantity of gas exports to Western Europe of 70 bm as observed in the data, and an initial transit fee harged by kraine of t = S $ tm as derived from OME (2002). Note that under this speifiation, profits of kraine (600 mn. S$) orrespond quite losely to independent earlier estimates (see Opitz and Hirshhausen, 2001). 19

22 In ontrast, olumn (5) shows the results for the ooperative Nash produt solution between ussia and kraine (two-player game). Note that the profit-maximizing quantity in the ooperative Nash produt ase has inreased to 81 bm. The differene results from the eliminated mark-up of transit fees by kraine, leading to lower pries and therefore inreased demand. 14 Both ators, ussia and kraine, benefit from the ooperation, though the inrease in profits is modest. The joint profit Π + Π is 5.16 bn. S$ (olumn (5)), as ompared to joint profits of 5.07 bn. S$ in the non-ooperative senario. The additional profit is shared equally between the two ountries, suh that both ussia and kraine are better off by 47 mn. S$ ompared to the non-ooperative senario. A omparison between olumns (1) and (5) of Table 1 also shows that the West European gas importers benefit from the agreement between ussia and kraine. While the atual prie for S$ gas at the European border amounted to 85.9 tm in the transit monopoly onstellation, it falls S to 77.3 $ tm in the Nash produt solution. As a onsequene of the ooperation, ussian gas will beome more ompetitive in Western Europe and will therefore - eteris paribus - obtain a higher market share in Europe. We now turn to the omparison of strategies in the three- player environment, i.e. by taking into aount alternative routes from ussia to Western Europe through Belarus. Columns (2)- (4) of Table 1 show the results of the non-ooperative strategy between ussia and kraine for different apaities on the Northern route through Belarus (18 bm, 28 bm, 56 bm, respetively). Total gas sales to Western Europe inrease (to 72 bm, 74 bm, and 78 bm, respetively). ussian profits rise with inreasing apaity through Belarus, a logial result of the lower osts along the Northern route. kraine learly loses transit volumes and profits. Note that the weaker position of kraine also leads to a lower mark-up on the transit fee, whih falls from 13.7 S$ tm (olumn (1)) to 7.8 S$ tm (olumn (4)). 14 The parameter σ was alibrated for the year 1998 as

23 Columns (6)-(8) show the results of the three-player ooperative solution. The assumption here is that the krainian transit harge is redued to the marginal osts, so that the export quantity is maximized. As ould be expeted, ussia's export quantities remain the same as in the two player ooperative senario (81 bm); as long as the low ost apaities through Belarus are limited, the export quantity is determined by the marginal osts of kraine (whih are higher than those in Belarus). Note that with inreasing apaity through Belarus, the additional profit for kraine from pursuing a ooperative strategy diminishes; if Belarus apaity is 56 bm, kraine gets a mere 4 mn. S$ from joining the onsortium. We an onlude that ooperation is the first-best solution for both ussia and kraine. Table 1: esult of the data analysis: Base demand senario about here 4.3 Simulations with Demand Expansion We now analyze a senario where West European demand for ussian gas inreases signifiantly. This senario is important for two reasons: first, all foreasts point to inreased gas demand in Western Europe, whih will in turn lead to higher demand for ussian gas (see IEA, 2002, European Commission, 2000). This is due to inreased energy demand in Europe, and a fuel swith, away from oal and nulear power towards natural gas. Seond, should this our, then we are interested in the effet on pries and, eventually, the effet on ompetition with other gas exporters to Europe (suh as Norway and North Afria). We therefore run senarios on our base model: inreased demand for ussian gas in Europe is taken into aount by shifting the estimated demand urve upwards: parameter b is set suh that total ussian gas S exports orrespond to the inrease of demand (220 $ tm ). 15 Table 2 presents the results of the 15 Note that we do not take into aount strategi behavior by the other gas exporting ountries, suh as Algeria and Norway. For suh models see Golombek, et al. (1995, 1998), and Perner and Seeliger (2004). 21

24 demand expansion senario for the non-ooperative and the ooperative solutions, respetively, in the three-player onstellation. Starting with the non-ooperative senario, and assuming Belarus transit apaity of 18 bm (olumn (1)), total ussian sales to Western Europe will inrease signifiantly, to 121 bm. Of this, kraine will transport 103 bm to Western Europe, the transit fee would be 17.8 S$ tm, and S the ussian gas prie in Western Europe would be $ tm, a signifiant prie inrease. 16 This senario onfirms that as Belarussian apaity is expanded, kraine loses additional transit business. For the senario of 56 bm apaity available on the Northern route (olumn S (3)), kraine's transit harge dereases to 13.8 $ tm, and the prie for Western Europe falls to S $ tm. Columns (4)-(6) of Table 2 show that in the ooperative strategy, total exports to Western Europe inrease to 137 bm, almost double the 1999 quantity. The total additional surplus arising from the ooperation between produer and transit ountries amounts to 204 mn. S$. Extending the Belarussian pipeline system to 56 bm will inrease total profits to 14,977 mn. S$. It learly follows that under demand expansion, as well, the ooperative solution is advantageous to both self-ontained partiipants. Table 2: esult of the data analysis: Demand expansion about here 5 Conlusion In this paper we analyze different options for transporting ussian gas to Western Europe. The issue is inreasingly gaining in importane with the opening of a parallel trunk pipeline from 16 Note that we use nominal pries throughout. 22

25 ussia to Western Europe through Belarus, and ussian plans to push the diversifiation of transit routes even further, e.g. with the bypass around kraine through Slovakia, or the North Transgas Pipeline. The topi is also of high relevane in the emerging European disussion on supply seurity and the E-ussian Energy Dialogue. Should ussia ponder higher LNGexports to overseas regions, its pipeline exports to Europe might be adversely affeted. Last but not least, reent politial turmoil in kraine and unertainty onerning the future relations between ussia and kraine highlight the sensitivity of the issue. We use a game theory approah to analyze the situation where the transporting ountry has signifiant bargaining power beause it owns the essential faility, a ommon situation in international pipeline gas trade. We ompare the results of non-ooperative behavior between ussia and kraine with the ooperative behavior modeled as a Nash produt. The analytial solution to the model onfirms the real-world developments observed in the region during reent years: as long as kraine was the exlusive transit ountry, it was unneessary to think about behaving in a more ooperative way. When ussian efforts to diversify transit routes sueeded, kraine hanged its strategy and entered into a ooperative agreement with ussia. It may be asked why kraine did not reah an agreement with ussia earlier in order to prevent the onstrution of the new pipeline. Possible and frequently mentioned explanations are that kraine was too self-onfident in its monopoly position, short-termism of krainian politiians and gas industrialists, or the substantial distrust of many krainian offiials in ussia and the orresponding belief that setting up a ooperative profit sharing sheme is impossible. We also argue that there are problems of orporate governane in both ountries gas industries, leading to resoure misalloation and suboptimal results. It has been amply shown that ussia wins from more ooperative behavior by the transit ountries beause it an raise sales and profits. Note that building up an additional pipeline for exporting gas to Western Europe is a feasible option for ussia only if it an seure long-term ontrats to over the risk of high, sunk investments in the infrastruture. If varying demand and unertainty drive up the apital osts, it may not be in ussia s interest to invest in new pipeline infrastruture. By deploying a more ooperative strategy vis-à-vis its transit partners, 23

26 ussia ould also inrease the feeling of enhaned supply seurity in Western Europe. As Grais and Zheng (1996) have shown, European demand for ussian gas is positively related to the trust that importers plae on the seurity of supply of these deliveries. Politial and eonomi instability in the main transit ountry, kraine, indeed raise doubts as to the reliability of supply, thus ontaining the market share of ussian gas on the West European market. The impliations of the model for the West European gas onsumers are omplex: on the one hand, gas importers learly benefit from lower pries resulting from ooperation and/or from additional transit apaity through Belarus. On the other hand, European import dependene on ussian gas also learly inreases; in the demand expansion senario, European imports from ussia almost double. The overall assessment of these developments will then depend upon a politial weighing of the objetives of the import-dependent region, between low pries and diversity of supply. In this partiular ase, the European Commission Green Paper (2000) seems to suggest a proative strategy of diversifiation to limit import dependene upon one individual ountry. Alternative soures of gas supplies to Europe inlude Norway, the Netherlands, and North Afria (Algeria, Lybia, Egypt), and in the medium term LNG imports from overseas. Most of these alternative ountries have wellhead osts below those of ussia, and shorter transport distanes to Western Europe. Thus, they are potentially more ompetitive than ussian gas supply. However, ussia owns by far the largest gas reserves, and an therefore expet to gain further market power as its ompetitors empty their reserves. Alternatively, one might also think of an OPEC-like artel of the gas exporting ountries. Indeed, a Gas Exporting Countries Forum (GECF) has been established in May 2001 by 11 large gas exporting ountries, with the objetive of establishing a tangible o-operation among gas produing and exporting ountries (see Perner and Seeliger, 2004, for simulations of the effets of a gas artel on Europe). The model presented in this paper ould be extended in various diretions: first, it would be useful to integrate the strategi behavior of other gas exporting ountries suh as Norway, the Netherlands, and Algeria. Seond, a more preise estimation of the European demand funtion for gas might inrease the quality of the empirial results further. Last but not least, more 24

27 omplex transit issues an be treated using the approah outlined here, e.g. Caspian energy supplies to Europe. eferenes Banks, F.E. (1983). European eliane on Soviet Gas Exports. The Energy Journal 4(3): Boots, Maroeska G., Fieke A.M. ijkers, and Benjamin F. Hobbs (2004). Trading in the Downstream European Gas Market: A Suessive Oligopoly Approah. The Energy Journal 25(3): Chollet, Andreas (2001). ussishe Gasexporte für Westeuropa. Berlin: Master Thesis at Free niversity. European Commission (2000). Green Paper - Towards a European Strategy for the Seurity of Energy Supply. Luxembourg: Commission Doument COM (2000) 769 final. Golombek, olf; Gjelsvik, Eystein; osendahl, Knut Einar (1995). Effets of Liberalizing the Natural Gas Markets in Western Europe. The Energy Journal, 16(1): Golombek, olf; Gjelsvik, Eystein; osendahl, Knut Einar (1998). Inreased Competition on the Supply Side of the Western European Natural Gas Market. The Energy Journal 19(3): Grais, Wafik; Zheng, Kangbin (1996). Strategi Interdependane in European East-West Gas Trade: A Hierarhial Stakelberg Game Approah. The Energy Journal 17(3): Greer, B.I.; ussel, J.L. (1982). European eliane on Soviet Gas Exports: The Yamburg- rengoi Natural Gas Projet. The Energy Journal 3(3): Hubert, Franz; Ikonnikova, Svetlana (2004). Strategi Investment and Bargaining Power in Supply Chains: A Shapley Value Analysis of the Eurasian Gas Market. Berlin/Mosow: Disussion Paper. International Energy Ageny (2002). ussia Energy Survey. Paris: OECD. 25

28 Observatoire Méditerranéen de l Energie (2002). Assessment of Internal and External Gas Supply Options for the E, Exeutive Summary. Sophia-Antipolis: Study for the European nion. International Energy Ageny/Organization for Eonomi Co-operation and Development (various issues). Energy Pries and Taxes. Paris: IEA/OECD. Perner, Jens, and Andreas Seeliger (2004). Impat of a Gas Cartel on the European Market Seleted esults from the Supply Model EGAS. tilities Poliy 12(4). Opitz, Petra, von Hirshhausen, Christian (2001). kraine as the Gas Bridge to Europe? Eonomi and Geopolitial Considerations. In: Hoffmann, Lutz; Möllers, Feliitas (eds.): kraine on the oad to Europe. Heidelberg, New York: Springer, Stern, Jonathan P. (1999). Soviet and ussian Gas: The Origins and Evolution of Gazprom s Export Strategy. In: Mabro, obert; Wybrew-Bond, Ian (eds.): Gas to Europe: The Strategies of Four Major Suppliers. Oxford: Oxford niversity Press, Stern, Jonathan P. (2002). Seurity of European Natural Gas Supplies. London: The oyal Institute of International Affairs. 26

29 Table 1 esult of the data analysis: Base demand senario Non-Cooperative Strategy Non-Cooperative Strategy Cooperative Strategy Cooperative Strategy Variables krainian Transit Monopoly Extended krainian Transit Monopoly Nash Produt Extended Nash Produt Two-Player S-K Three-Player S-BEL-K Two-Player S-K Three-Player S-BEL-K (1) (2) (3) (4) (5) (6) (7) (8) exogenous: x B (bm) endogenous: x (bm) x (bm) p (S$/tm) П (mn S$) П (mn S$) П +П (mn S$) t (S$/tm) NP ussia (mn S$) NP kraine (mn S$) Surplus NP (mn S$)

30 Table 2 esult of the data analysis: Demand expansion Non-Cooperative Strategy Cooperative Strategy Variables Extended krainian Transit Monopoly Three-Player S-BEL-K Extended Nash Produt Three-Player S-BEL-K (1) (2) (3) (4) (5) (6) exogenous: x B (bm) endogenous: x (bm) x (bm) p (S$/tm) П (mn S$) П (mn S$) П +П (mn S$) t (S$/tm) NP ussia (mn S$) NP kraine (mn S$) Surplus NP (mn S$)

31 Figure 1 ussian Gas Export oute to Western Europe 29