#16 - JRL 7168
Carnegie Endowment for International Peace
www.ceip.org
meeting summary
Reforming the Gas Sector in Russia: Myths versus Reality
April 29, 2003
A presentation by William F. Browder on the effects of reforming the Russian gas industry.

On April 29, 2003, the Carnegie Endowment for International Peace hosted a presentation by William F. Browder entitled, "Reforming the Gas Sector in Russia: Myths versus Reality." Browder is CEO of Hermitage Capital Management, the leading public equity fund dedicated to Russia. Following a January 2003 meeting about the effects of reforming the Russian gas industry with Igor Yusufov, Russian Minister of Fuel and Energy, Hermitage Capital Management engaged the Boston Consulting Group (BCG) to analyze the myths of the Russian gas market and to better understand its reality. The final report that Browder presented today was given to the Minister of Fuel and Energy on March 31, 2003. The meeting was chaired by Rose Gottemoeller, Senior Associate at the Carnegie Endowment. William Browder opened his presentation by noting that his views on Gazprom and the Russian gas sector in general are controversial, in large part because of the major presence of Gazprom holdings in the portfolio he manages. Still, he maintained, major reforms in the Russian gas sector would benefit not only investors, but also the Russian public and the Russian economy.

For the past decade the Russian government has struggled to determine which commodity sectors should be deregulated, when this reform should take place, and at what pace. During the Soviet era all of the major commodity markets (oil, oil products, coal, metals, pulp and paper, gas, and electricity) were regulated by the government. Over the course of the 1990s, most sectors were liberalized, leaving only gas and electricity-in short, the commodities about which voters care most-regulated. The continued subsidization of these two sectors have now become the primary issue blocking Russia's accession to the World Trade Organization. Yet Russian officials have been hesitant to proceed with the deregulation of these industries because they fear that an increase in gas and electricity prices will lead to runaway inflation. Russian politicians feel that they are in a real quandary: they believe that the political costs resulting from high inflation will be high, but they also realize that the economic costs of not joining the world economy are incalculable.

However, the Hermitage-BCG study reveals that the dilemma facing Russian policy makers is not as intractable as it may appear. The Russian gas and electricity sectors can indeed be deregulated with few adverse consequences. Browder's research shows that the first myth of the Russian gas sector-that raising gas prices will create runaway inflation-is unfounded. Raising gas prices 138%, from $21 per 1,000 cubic meters to $50, would have only a marginal impact on consumer price inflation, increasing total Russian consumer spending by 2.35%. This increase would become even less significant if Russia installed valves or metering devices in residences-a step which reduced heating consumption by 20% in Eastern Europe. If Russian homes were as efficiently heated as Eastern European homes, a 138% increase in gas prices would result in an inflation rate of only 1.75%.

Next, Browder addressed the second myth of the Russian gas sector: that raising gas prices will destroy Russian industry. Assuming, once again, a 138% increase in gas prices, Browder's data indicates that only a few sectors-including the chemical, construction, and electricity industries-would be feel the effects of a price hike. The latter would the be most affected, but its long-term existence would not be jeopardized, as it would pass its increased operating costs on to consumers and other industries. The chemical and construction industries, which comprise relatively small portions of the Russian economy, have enjoyed the highest profit margins to date precisely because of massive gas subsidies; deregulation of the gas industry would lead to increased austerity and efficiency rather than a major industrial breakdown. In addition, other sectors-particularly the coal industry-would benefit from increased gas prices to the tune of more than one billion dollars per year.

The third myth, famously propagated by Chubais, is the idea that an increase in gas prices would mandate a commensurate increase in electricity prices. In fact, gas comprises only 21% of the total electricity cost structure, so a 138% increase in gas prices would result in a relatively modest (32%) increase in electricity costs. Browder debunked the fourth myth-that low Russian gas prices are necessary because of high transportation costs to Europe-by showing that even after adding $60 per 1000 cubic meters for transportation costs, Russian gas prices would have to increase fivefold to match European prices. The Hermitage-BCG data also questions the conventional wisdom that European distributors like Ruhrgas are good partners because they allow Russia to make a large profit on its exports. Although it is true that Ruhrgas pays Russia $103 per 1,000 cubic meters-five times what gas is sold for in Russia-Browder pointed out that Rurhgas marks the Russian gas up to $352 for its German consumers. Finally, Browder attacked the notion that cheap gas is Russia's national advantage, arguing instead that cheap gas is Russia's national opportunity to waste a valuable resource. In terms of gas usage and electricity consumption per capita as well as electricity consumption per ton of steel produced, Russia is far more wasteful of resources than any other country in the world. So long as gas and electricity remain virtually free in Russia, they will not be used prudently.

Browder concluded his presentation by noting that Russia has resolved most of the problems that once seemed poised to block its entry into the WTO, leaving the domestic prices of gas and electricity among the few major issues that remain to be resolved. Although the benefits associated with Russia's accession to the WTO provide reason enough to reform the Russian gas and electricity sectors, Browder pointed out that there are many other incentives to begin deregulation. Increasing gas prices would slash households' energy consumption by 30%; create growth of $1 billion per year in the coal industry; free up an additional $3 billion worth of gas available for export; increase Gazprom's profits by $7 billion, which would allow increased investment in the gas industry; and raise an additional $2.2 billion in tax revenue, a sum equal to 3% of the Russian federal budget. Deregulation of the gas and electricity sectors offers Russia unprecedented opportunities for growth and reform, with virtually no economic drawbacks.

The question and answer session opened with one meeting participant inquiring about the official Russian response to the Hermitage/BCG study. Browder responded that Yusufov concurred with the findings and encouraged him to release his data to the Russian press. In general, administrators-that is, ministry officials-see the benefits of deregulation; politicians, on the other hand, have proven more hesitant to make major changes. In the short term, Putin may manage to take some steps on the path to deregulation. For example, in order to situate himself on the side of reform without taking political risks, Putin recently supported an electricity reform bill that provides for price increases only after 2005. Similarly, the administration may choose to raise gas prices for industrial-but not domestic-consumption. Due to continuing misperceptions about the effects of gas and electricity deregulation, however, voters have not yet rallied behind the liberalization of this sector as they have behind eliminating corruption and improving the judicial system. It is therefore unlikely that politicians will assent to these changes before the upcoming legislative and presidential elections, or that gas and electricity prices will be raised across the board before 2006 or 2007.

Another meeting participant noted that the economic principles favoring deregulation are relatively simple, but that the patronage and kickback structures linking the Kremlin and the gas and electricity sectors might discourage reform. Browder reiterated that liberalization would serve politicians' domestic and foreign policy interests no less than their economic interests. Russian politicians will ultimately assent to the foreign pressure encouraging deregulation, because they understand that it is in their long-term interest to export as much gas as possible at costs as high as possible to Europe. Furthermore, should an OPEC-like gas cartel be formed, Russia would find itself in a crucial leadership position; although it can no longer maintain its superpower ambitions, it has the real potential to be a gas superpower. In the end, Browder believes that the confluence of these factors will lead Putin, risk adverse as he is, to realize that there is virtually no risk in gas and electricity deregulation.

Finally, an attendee asked Browder to reflect more generally on business trends in Russia and the long-term outlook for the Russian economy. Browder believes that Russia is currently in a transitional moment. For ten years, the best way to make money in Russia was to steal. Now that the most valuable assets of Russian corporations have been stripped, would-be tycoons will have to earn their keep the old-fashioned way: by building businesses. If entrepreneurship will prove the engine of the Russian economy over the next decade, Browder fears that currency overvaluation may become a major stumbling block. Although the ruble is currently undervalued-according to the "Big Mac Index," Russia has the fourth lowest prices in the world-Browder projects that the value of Russian currency rapidly will increase. In three years' time, the ruble will be fairly valued; in six years, it will be overvalued. If the Russian government does not take steps to reverse this trend, overvaluation may become Russia's newest economic nightmare.

Summary prepared by Faith Hillis, Junior Fellow with the Russia and Eurasia Program at the Carnegie Endowment.