The renewables driven revolution in electricity pricing

Away from the public eyes, one of the most radical transformations of wholesale electricity markets in the last 100 years is occurring. Since the time of Thomas Edison, almost all the electricity that we use has come from the combustion of fuels. By releasing the latent energy in coal, gas, wood or oil, we convert latent energy into heat, and use that heat to create steam. The steam forces a magnet to spin around a set of wire coils, thus creating a current. It is this innovation in science that created the modern world, but today a growing proportion of the developed (and developing) world’s electricity no longer comes from fuels. I am of course talking about wind and solar.

When power is created from the combustion of fuels it is dispatchable. This means that it can be turned on and off whenever the owner of the power station wishes. While a Nuclear plant will often generate electricity around 92% of the time, making it effectively a constant (hence “base”) generation source, most fuel based generation sources run for much less time. In the USA, coal and gas plants often run less than 60% of the time. By contrast wind and solar are not dispatchable. Rather, their production output is variable. Wind and Solar do not require a fuel to create energy, but they cannot control when they will produce electricity. It is this contrast that is at the crux of the challenge.

To ensure a power grid has sufficient electricity for all consumers, a grid operator such as National Grid, must estimate demand and source that demand on an annual, monthly, daily, hourly and sub-hourly basis. In complex power markets like the UK, the sourcing of electricity supply comes from an auction system. This is why wholesale power prices are in upheaval.

To match supply with demand, national grid asks companies that produce electricity to make offers to supply electricity. Each company states how much electricity it can supply and the price it will accept to supply that level. These prices are then sorted from lowest to highest and national grid will accept all bids necessary until it reaches the supply level it requested. This is called “Merit Order Dispatch”.

To explain this is shown in the table below:

Electricity needed 100MW   
Clearing auction price £30/MWh  
       
Bidder name Bidding price Quantity of power offered Quantity of Power Accepted
Wind 1 £10/MWh 20MW 20MW
Solar 1 £20/MWh 20MW 20MW
Nuclear 1 £25/MWh 30MW 30MW
Gas 1 £30/MWh 30MW 30MW
Coal 1 £40/MWh 30MW 0MW

As wind and solar have no fuel, their cost to run is essentially zero. As such they can bid any price they like. For Nuclear, the cost of fuel is considerably less than building the site, so it also bids a low price. By contrast gas and coal have to buy their fuels to combust them. As shown in the table above, coal can’t compete against wind and solar on cost and so it losses the auction. Everyone else is paid the marginal cost of production, which is the amount that gas receives (£30/MWh) and they supply the grid.

So what does this mean? Essentially as we build more wind and more solar, we will increase the number of electricity supply bids into the market which are below the viable level for any fuel based generation. This is why the USA’s Department of Energy wants to pay a subsidy to coal and nuclear. As wind and solar are not dispatchable, there is a concern that all dispatchable fuel sources will be unable to compete in the price auctions for the majority of the year, except for periods when electricity demand is extremely high. That would make most plants economically unviable, as they would be required to cover all of their capital costs, maintenance and staffing, based on generating electricity for less than 50% of the year. If these plants go, then what will provide the electricity when the sun goes down and the wind doesn’t blow? That is the question that energy market regulators are asking in the UK, USA, Europe and across the developed world.

To many the concept that renewables are cheaper than fuel based sources doesn’t seem correct. Indeed, most renewables remain more expensive than coal (though not in all areas and not by much), when considering the total cost of the system. But it is important to understand that wind and solar are fundamentally different in how they are financially structured and that explains the pricing disruption. Operations and maintenance of renewable power plants are minimal. Building the assets is the expensive part. As a result, Renewables always want to sell their power at any price in order to re-coup the cost of construction. By contrast a coal plant or gas plant will lose money if they try to sell electricity for below the cost of their fuel source. This gives renewables an incentive to bid almost zero, thus guaranteeing that they will be able to sell almost all their electricity they generate at any time.

This is actually worse in countries that have adopted a renewable government subsidy called a Feed-In-Tarriff (FIT). Under a FIT, the government guarantees the owner of a renewable company that they will receive a fixed price for the production of their electricity. However, the electricity has to be generated and supplied to the market in order to claim the subsidy. As a result, renewables have no incentive to put in competitive prices for auctions because they already have a fixed price.

What does all of this mean though for businesses, consumers and investors? Well for now it means that the annual average wholesale cost of electricity has fallen in countries like the UK on a constant basis. That also means that most households and industries have paid less in energy bills than would otherwise have been the case.Wholesale market

But while the costs of electricity have fallen, other costs are occurring across the system. As coal and gas plants cannot compete in the market they are forced to close the plants early and suspend new constructions. A great win for climate change, but an outcome that has cost European utilities half a trillion euros according to the economist. In California, where solar PV deployment is high, prices in the wholesale market now go negative for periods of the day. Yes that is correct. Producers effectively pay other people to take the power that is being produced. In the same is happening in Germany.

The move towards greater renewables in the electricity mix is vital. But like any great transformation there will be unintended and unanticipated consequences. The greater the growth of renewable energy, the more inevitable it will become that wholesale power markets will change. If consumers are focused that could potentially lead to longer term price stability and cost savings. But only if they know where to look.

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UK Climate change – progress report

Ask many British industry experts whether the UK has an energy strategy and you’ll mostly be met with laughs or exasperated expressions. But while the UK may look like a mess to industry insiders, the country has been remarkably successful in de-carbonising its economy.

Let’s start with the big question: is the UK on track to meet its legally binding 2007 target of reducing CO2 emissions by 80% below 1990 standards by 2050? The answer appears to be yes. From 1990 to present the UK has reduced its gross emissions from 800mn tonnes of CO2 per annum to under 500mn tonnes. On a net basis (including emissions captured by newly planted vegetation or offset against renewables/re-forestation in other parts of the world), the UK has also fallen from 600mn tonnes in 1990 to 400mn tonnes by 2015.

UK climate target

But if emissions are falling, the next question is whether this is due to government policy or if this was inevitable. Examples of an inevitable decline would point to aspects like declining economic growth, de-industrialisation, declining population growth and basic energy efficiency gains. Thus, the question is whether any of these features have a role to play in the UK’s declining emissions story.

The answer is a partially. The UK population grew by over eight million people between 1990 and 2017, while the UK economy grew from USD $1trn in 1990 to USD $2.6trn today. These factors should have contributed to increased greenhouse gas emissions, but offsetting some of these rises is the decline in manufacturing from 17% of UK GDP in 1990 to 9.69% in 2016 . Nevertheless, UK CO2 emissions per capita have fallen from 9.7 tons in 1990 to 6.31 tons in 2017 .

As a consequence we can state that the fall in UK emissions seems to be primarily driven by alterations in the UK energy supply.

UK Renewable Generation

As the table above shows, the UK has expanded its share of Renewable Generation from 5GWs to 35GWs in little over 7 years (the equivalent of 10 – 12 Hinkley points). However it is worth noting that a significant proportion of the renewable electricity generated has come from re-converting the Drax power station in Yorkshire, so that 50% of the towers now run on biofuels (aka woodchips). Drax power station was the 2nd largest power plant in Europe when it was built, with ~4GW of coal capacity. Today over 60% of the electricity it generates comes from woodchips, mostly from North Carolina and Canada. Perhaps not (in this authors view) exactly “renewable” but certainly a step up from Coal.

It’s worth pausing to mention coal briefly. In 1990 the UK relied on coal for circa 30% of its electricity needs. Today that figure is below 9%. Moreover no new coal plants will be built in the UK and in April[1], the National Grid reported that the UK had its first day without any coal fired electricity generation in over 200 years. This trend seems set to continue. In 2017 Scotland set a record for 70% of generation coming from renewable resources, while the UK has averaged 50% of electricity from renewable resources for the 2017 period to date.

Bizarrely perhaps for people accustomed to thinking of the UK as wet and windy, the leading source of Renewable generation in the UK is now Solar PV.

UK Renewable Energy techs

The stalling of wind has been largely driven by strong local community resistance and cuts to the UK’s principal subsidy tool, the Feed in Tariff regime. However Solar PV has surged and UK developers now believe that Solar PV can be built without subsidies and will compete at around the £70 – £90 per Megawatt hour. This is comparable to the Levelized Cost of Energy that a new Combined Cycle Gas plant would require. In a further sign of confidence Blackstone (a leading Private Equity fund) and Lightsource (a leading UK developer) approved a £1bn fund to buy already operational UK solar sites in 2017[2]. It is precisely the emergence of a secondary market, through tie-ups between PE firms and Developers, which reflect the maturity of Solar PV in the UK market and should attract further buyers.

Beyond the wholesale market, the most exciting new frontier is on the retail side. The latest papers by the UK energy regulator Ofgem and the UK Department for Business, Energy, Industry & Skills (BEIS) have highlighted sweeping changes to the classification of battery storage and how these assets can earn revenues. Alongside more favourable battery deployment laws, the UK is also introducing TimeOfUse tariffs into the retail sector, allowing savvy energy users the opportunity to reduce their electricity bills through smart meters and smart appliances. In a sign of things to come, Ikea has announced a scheme to sell Solar PV panels and Lithium ion storage batteries to UK home owners. These changes, while still too early to fully assess, indicate a continued progression towards a distributed UK clean energy system.

Of course the UK has much more it can do. At circa 100,000 Electric Vehicles on the road (from over 20mn ICE vehicles), the UK has a long journey to reach a 20% reduction in transportation by 2020. Similarly on the heating side, the UK will be fortunate to reach a 10% reduction, despite a committment to a 20% reduction by 2020. But these failures have to be placed in context.

Improving Energy Efficiency is the key to reducing heating emissions. But replacing/refurbishing existing housing stock is extremely hard. The simple fact is that if the UK built more new homes (the current rate is a pitiful 100-150k per annum) to even moderate specs, the UK would make significant progress in reducing its heating emissions. On the transportation side the UK may be lagging, but with the 3rd largest EV fleet in Europe (Norway is the largest) its hardly a laggard. EV’s remain expensive and at any rate the real emissions in transportation come from freight, rail, aviation and shipping. In all of these regards, the move towards electricification, hydrogen fuel cells and second generation bio-fuels is progressing and the UK remains a leader in funding Hydrogen deployment.

In short the UK probably deserves a 7/10 on its climate change score card. Could it do more? Certainly. But is it behind its targets? The evidence would suggets otherwise.

[1]Real Estate IPE, 2017 https://realestate.ipe.com/news/investment-vehicles/uk-pension-funds-allocate-11bn-to-blackrock-renewables-fund/10019933.article – Blackrock renewable funds

[2] Guardian, 2017, https://www.theguardian.com/environment/2017/apr/21/britain-set-for-first-coal-free-day-since-the-industrial-revolution

Exploring the commercial viability of integrated DER solutions in NY state 2016-17

Over nine months ago, myself and three fantastic colleagues Max Stadler, Fujia Zhang and Xitong (Kathy) Gao began work on researching distributed energy resource solutions for higher education institutions in New York state. The project was a collaboration between Johns Hopkins SAIS ERE department and Power Capital, a UK based Energy Consultancy.

Many wonderful people have supported our efforts and listened to the team drone on about this project. So as a small thank you, I have included a final version of our report here. It is available to be read, but the intellectual property remains with myself, Max, Xitong and Fujia so please contact us if you wish to use the content first.

Our project examined whether a new energy services compnay model was viable for the New York market and what sorts of market/regulatory pressures ar affecting these customers. We believe it is the firts report of its kind on this segment and market.

It has been a pleasure to work with such an exciting group of people on such a wonderful project. I hope others also find it of interest.

Exploring the commercial viability of integrated DER solutions in NY state 2016-17

Thoughts for the year – 2017

While many will have breathed a sigh of relief on the 1st of January that 2016 is over, the consequences of last year will continue to define this one. Firstly, we shall see what effect the far right electoral successes and Russian electoral interference in 2016 will have on European general elections. Alongside these events we will also receive further details on Mrs May’s plan for the Brexit negotiations in March, and by the mid-year, we will know whether the “Trump boost” which has lifted global equity markets and triggered a selloff in fixed income assets, will have been justified.

But 2017 is likely to be a tale of two halves. Political paralysis in the USA and Europe has hindered economic growth and encouraged extremely cautious investment strategies. Thus, the consequences of the political choices which Europe and the incoming Trump administration will have to make in early 2017, will provide markets, businesses and other stakeholders with a clearer sense of travel for the world’s largest consumer economies. The second half of the year will then revolve around how the rest of the world responds to these decisions.

If confidence in the economic growth of the US economy continues to rise, and subsequently leads to the projected three rate hikes by the Fed, then the US dollar will continue to appreciate, causing a flight of capital out of European and Emerging Market asset classes (whether they be equities or fixed income). This will cripple companies in the developing world who have large US dollar denominated debt, even if governments in regions like Asia will be better insulated from the effects this time than during the Asian Financial crisis in 1997. Moreover, if the dollar appreciation leads to a widening of the US trade deficit, as witnessed during the Reagan years in the 1980’s, we would expect to see greater emphasis on an “America First” trade policy. The rhetoric and responses to President Elect Trump’s tweets on Trade, already indicate that this may be the course of action.

Though these comments may seem overly financial, their wider societal implications are enormous. If investors see greater returns in US markets, alongside greater political instability in other global markets, then access to finance will become constrained across the developing (and perhaps even developed) world. This comes at a time when global investment in infrastructure remains well below the estimated requirements by the world’s leading international financial institutions, such as the World Bank, ADB, African Development Bank and Inter-American Development Bank. To put figures to this effect, it is estimated that Asia needs to spend between US $2-3 trillion a year on infrastructure. The figure to date is roughly US $1trn, or 50% of that required. Elsewhere in the world, notable Africa, the figure is even lower. Such infrastructure includes basic goods such as hospitals, schools, roads and power generation assets. Without the ability of governments to finance and provide these goods, then societal frustrations with consistently poor living standards may lead to greater political unrest and support for populist parties. This is especially concerning in countries that are still experiencing large population booms and who have a growing, young population that need economic growth to find jobs.

Moreover, as the value of the US dollar rises, oil producers who have operational costs in domestic currencies, will see increased financial returns. This will help alleviate some pressure on the balance sheets of oil dependant governments, but it will also increase the real cost of oil for citizens and businesses in emerging and developed markets (oil globally is priced in dollars, so a rise in the dollar v.s. other currencies will increase the cost of fuel for consumers).

Looking beyond the potential areas of concern, there are areas where optimism is warranted. In 2016 investment in Renewable Energy overtook investment in fossil fuel based power generation for the first time since the start of the industrial revolution. In 2017 this trend will only accelerate. The UAE has already committed, in the first week of 2017, to spending US $163bn to provide 50% of its power from Renewables by 2050. Others will continue to follow. Moreover, electric car growth will continue to expand, fuelled by government incentive schemes and the launch of several new car models, such as the newest Tesla vehicles, directly targeted at middle income families and competitively priced (though government subsidy support will still remain crucial). In science, we may also see a breakthrough cancer drug brought into final stages by AstraZeneca by the end of 2017, as well as several major space launches and satellite passes of earths neighbours in our solar system.

As a student studying the world from an ivory tower in Washington DC it is easy to get lost in the noise of the world. But the one prediction for 2017 that I can make with certainty is not a macro level prediction, it is a micro one. Despite all the concerns and hysteria that the press will cover in the next year I remain convinced that the vast majority of people in the world will experience few changes to their daily lives as a direct consequence of the headline grabbing events. In fact, the biggest question in 2017 is whether despite all these huge events occurring around us, people will become more engaged politically at all.

In November 2016 I had the privilege to stand outside the White House after the election results had arrived. In a large student city, which voted overwhelmingly Democrat, in an election where Trump was (and is) described as a threat to the very nature of the American political system itself, there were more journalists present than protestors. Nor did DC see many protestors or rallies of significant size in the weeks after the result. In the UK too, after Brexit the protests were few (if any) and the rallies were poorly attended (if held). All this in a country where 1 million people marched to prevent fox hunting from being banned in 2005. Thus one question for 2017, that I hope to see answered, is whether this year of change is also a year of political awakening for the generations of citizens who have been sleeping for the last two decades.

Time will tell!

The Myth of “The United Petrostates of America”

Firstly my apologises for the delay in writing another article. It has been a busy few days, but now back to the title!

On Monday the well-known US publication, Foreign Policy, published an article on how the US would be transformed by the advent of Shale gas and become The United Petrostates of America (for the link click here). Of course this assertion is absolutely laughable.

Firstly the advent of US Shale will not lead to massive exports of Oil and Gas from the US because other domestic US energy sources (Coal, traditional oil + gas wells) are declining and also because other developing nations like China, India and Brazil have a plethora of other less politically sensitive sources of Petroleum products they can access.

Secondly, the US Petroleum industry primarily exists to service the production of US goods for US consumers and whether that is for transport needs (in a vast territory with poor public transport) or heavy industry like Chemical manufacturing, Ship building, Car building, etc. In short the US does not export what it needs at home and so does not get the boost in its trade figures with other states.

The Last error however is the assertion that the export of Shale oil & gas will boost the strength of the dollar. Now assuming the author of Foreign Policy by some miracle is correct, this is not the reason why the US dollar is strong against other currencies, it is because the Dollar is the world’s currency reserve. The value of the US dollar is high because in times of insecurity people put their money in Dollars because of the long held belief that the US will not default on its debts. Excluding those who write about the decline of the US from a position of desire not knowledge, and the mythical “Credit-ratings agencies” (if they even still deserve that name) people trust the US to pay and are almost blind to any other considerations, see the decline in US 10yr bond yields when the US had its Triple A rating cut for the first time.

In addition the US debt (now in excess of USD$14 Trillion) is, contrary to popular belief, largely held by Americans. The citizens of the US and global investors now the US will pay its debts because over $9 Trillion of that debt is owed to fellow Americans. Thus the incentive to default on citizens and institutions of the state itself is, in essence, non-existent.

All of these things combine to a very simple point that seems to be missed in the US discussions of Shale gas, what is the US net increase in Energy supplies? If we look at the historic growth in US natural gas over a 20 year period, we see that consumption of gas in the US rose from 19.17 TcF in 1990 (from all Sources) to 24.09 TcF in 2010. To put it more simply, between 1990 and 2010 US gas demand grew by 25%, yet over the same period the US production of natural gas only grew at 21% (17.81 TcF to 21.58 TcF). To add to this even further, the growth in US gas supply between 2012 and 2032 is predicted to increase at an even slower level of 15% over the whole period.

Thus the key point is that US Shale Gas is not a “Bonus” to US energy supplies, rather it is the critical lifeline preventing them from a huge collapse. According to the EIA the US is expected to increase its supply of gas (as mentioned above) from 23.65 TcF of gas (from all sources) in 2012, to 27.27TcF from all sources by 2032 but if the growth in gas demand increases by the same factor as it did between 1990 and 2010 then there will be a net deficit.

Last thoughts to add here: if the US population grows by 15% between 2015 and 2035 (prediction from US Census) and Obama and Republicans want to see the US boost domestic manufacturing to boost their exports (despite the growth in gas demand occurring during a decline in US industry), will the US still have to import gas even with Shale?

Russia 2020 – Game over Putin?

Since 1990 Russia has experienced something of an escalator ride in the nation’s fortunes. From near bankruptcy the Russian economy has bounced back since the beginning of the Putin years, largely on the back of a vast overhaul of its oil and gas industry which has fuelled the increasing spending demands of Putin’s various administrations. Yet are we about to see the Russian state experiencing another rollercoaster drop in the next decade? Here are a few humble suggestions why Russia is facing a perfect storm in 2020:

“It’s the Economy Stupid” – or more accurately it’s the Oil Price.

For most of Russia’s history its economy has been primarily driven by its primary industries which have exported the vast resources at the states disposal. But in recent years the dependency of the current Russian economy on oil and gas exports has become truly staggering. Not only does Russia’s oil and gas industry now account for 49% of the state’s revenues, but Russia also requires over 2/3rds of its gas production simply to service its own economies internal requirements.

The situation when we start to examine Russia’s much discussed export of oil and gas products gets far worse (if you are Russian). Of Russia’s 600BcM of gas produced every year, around 140BcM is exported to Europe but of that 140 BcM exported to Europe, Germany and Ukraine account for 70BcM of exports combined (at 30BcM and 40BcM respectively. To re-phrase this, Russia relies on Germany and Ukraine for around 34% of its gas sales, whilst Ukraine accounts for nearly 19% of all Russia’s gas exports. Compounding even this terrifying over-reliance, the pipelines that provide Russia’s gas to the rest of its EU markets all currently use Ukraine as a transit nation. Thus for anyone who remembers the 2009 gas crisis in Europe, this is why Russian planners are so concerned about their gas position.

Even if Russia is able to construct its South Stream project to reduce its reliance on Ukraine as a transit hub it is not only competing against the EU machine, which has aggressively tried to challenge Russian gas hegemony, but also the alternative gas pipeline, Nabucco West.

Taking aside the above issues however the baseline concern for the Russian economy is to do with the price of oil. With the US explosion of Shale gas, estimated to increases the US gas production by 25% by 2020, there will be an inevitable decline in demand for oil related products on the international market, especially as other BRIC nations seek their own domestic means of energy production. In addition, the climate change agenda and the effects of air pollution in major cities is leading developing nations like China to increasingly seek gas as an alternative to oil. The problem for Russia however is that, simply put, it gets such a good price from Europe that it won’t accept the terms China and others are offering.

The implication of this fall in the oil price is an inevitable decline in the Russian state revenues. If the price of oil and gas declines then Russia will face a choice: to reduce its current output of oil and gas to maintain the price level (assuming the rest of OPEC will do likewise) or to maintain its output but at a reduced profit (and in some cases certain projects will become close to loss making). All of which is disastrous for the Russian government’s spending pledges, including its $800 billion armed forces modernisation programme….

The energy crisis however is not just linked to the state revenues from oil and gas however. The World Bank’s latest report on the ECA and FSU states has indicated that they will need to invest $1.5 trillion into maintain and modernising its energy infrastructure within the next 20 years, yet to do this will require a large increase in the price of electricity. This then leads to the next problem of the Russian economy: a large proportion of high energy intensity industries whose main advantage is price competitiveness, in no small part due to low energy prices. So the question here is: if faced with a decline in global oil and gas prices will Russia reduce its supply of oil and gas and sell its products purely on the basis of the highest bidder in Europe and at home, or will it maintain its output levels and use its oil and gas industry to subsidize its domestic manufacturing industries?

The net result of any of these variables above will mean less revenue for the Russian state and hence the problems below:

Increasing domestic instability and declining state security resources:

The re-election of Vladimir Putin was considered by many competitors to be an academic exercise. He was too strong, too popular or too well connected to lose so commentators said. And sure enough they were right, except this time Russia’s voters didn’t lie down and play dead. The scale of protests was unprecedented under Putin’s rule and provides a glimmer of the hostility ordinary people feel towards the current government.

It is true that for many Putin is still deeply popular but the same is certainly not true of his lieutenants and it is their increasingly public misdemeanours that are starting to significantly chip-away at the regimes support base. The sense of insecurity felt by Putin was perhaps best displayed by the obscene levels of attention and media coverage that was generated by the Russian punk rock band “Pussy Riot” whose 30 seconds of fame generated world-wide news coverage.

Now whilst Russia has often suppressed riots and domestic violence, it is the impact of declining state revenues that will suddenly start to lead to difficult strategic decisions on where Russia spends its resources. If the state continues to focus its funding on internal suppression then it will inevitably have to reduce its spending on its planned military modernisation programme, something which will surely reduce the global reach of the Russian military and certainly the extent it can intimidate its neighbours.

Furthermore, if Russia does retrench domestically, will this lead to more aggressive actions by those states that have territorial disputes with Russia currently? Any increased belligerence by states like Georgia and Azerbaijan would be increasingly embarrassing for Moscow, whose people would demand a response. Will the Russian state be able to in the future? Even the latest Russian fighter jet project, a symbol of its super-power aspirations, could be threatened if it fails to find suitable export partners and its numbers drop below its already low order number, (expected to be initially 100 or less).

Demographic issues:

Inherently linked in Russia with domestic security concerns is population issues and immigration. The Russian state has always incorporated a large number of ethnic minorities and different faiths, but notice the word minorities. The modern Russia today is facing a marked decline in the birth rate of European, orthodox Russians, whilst its minority populations, notably those who follow Islam, continue to grow, as does the number of immigrants from central Asian states.

This again will start to stir domestic tensions where the state has historically under invested in the East and often concentrated its investments into a few key cities like Moscow. Furthermore, regional hot-spots like Chechnya may become emboldened to push for further regional autonomy if the region’s population continues to grow whilst the typically more Slavic and European population of western Russia declines.

Linking this all back in again. Under-investment in regions with high birth rates which will require greater state resources for health care and education as well as state and/or private investment to create job opportunities for a rapidly increasing young workforce will create a policy headache for a state with limited alternatives than state spending or careers in the oil and gas sector. Both of which seem certain to decline.

Squaring the Circle – concluding remarks:

So what does all this mean? In effect Russia is facing a perfect storm by the end of this decade and the only possible solutions to its problems still look as distant as ever.

The Russian state cannot generate internal investment without an end to the rampant corruption that eats away at public confidence in the state bureaucracy and decimates the ability of financial institutions to invest sensibly into growth prospects. But more fundamentally what Russia really lacks is a functioning rule of law.

No company today can invest in Russia without the concern of expropriation or state interference and those that have tried have often been burnt badly in the process, whether BNP-TNK or Shell and its development of Sakhalin island. This hampers any serious private sector investment and again places the onus of investment squarely on the Russian state.

With declining state revenues and increasing demands on its budget, does Russia have many options left open? Can it cut spending and if so what? Can it increase its level of government debt and if so for how long and at what cost? All of these questions leave Russian policy planners feeling uneasy and with Putin’s grand ambitions so publically stated what would be the political damage if the policies failed or perhaps even worse, they were cancelled?

So while for now Russia may be having its moment in the spotlight as a super-power in Syria, it’s worth waiting to see what happens next. My suspicion? Russia may just start getting that bit quieter and quieter as this decade progresses.

So keep an eye on Russia and 2020. The Russian roller coaster may just be about to drop.

The Southern Gas Corridor

The end of Russian Hegemony or an expensive distraction?

In 1990 the Cold War ended, the Iron Curtain fell and former Soviet satellites dashed towards Europe and the US to learn from them and emulate their apparent success. Nearing the end of 2012 and things look slightly different. Russia is re-emerging as an economic and political power, bolstered by its vast energy reserves and the high global price of oil and gas, whilst the EU remains in the doldrums of economic stagnation and the US recovery teeters on the edge of its self-created “Fiscal cliff”.

But despite this current state of affairs, many former Soviet Satellites have boomed since the end of the cold war and with their ascension into the EU, particular states like Poland whose growth rates have remained high and its political clout has grown have boomed. Romania, Hungary, Bulgaria are also former Russian satellites that are on the ascendance too, with an increasingly educated populace, strong national work ethics and cost competitive environments for manufacturing. Yet despite weaknesses in governance and the power of organised crimes in many of these states, it is Energy security, or perhaps more appropriately, independence from Russian gas that garners the greatest concern in these states about their future prospects.

For the last decade Russia has utilised its gas hegemony in Europe to economically pressure and cajole its former satellites and when that has failed, such as the deployment of US missile defence systems in Romania, Russia has punished these states with crippling energy prices. Little wonder therefore why the dream of the “Southern Gas Corridor”, to break Russia’s seeming stranglehold over the regions gas supplies, has such a strong appeal.

The Shah Deniz Stage II Consortium

The Southern Gas corridor plan that exists today began life as a plan by a consortium of Eastern European nations, with EU and US endorsement, to bring gas from Azerbaijan’s largest gas field, Shah Deniz Stage II, to Europe via Turkey. This idea, originally conceptualised in the planned “Nabucco Project” has subsequently faced several alterations and has now broken up into 3 pipeline projects.

The main pipeline route from Shah Deniz to Europe will be provided by the Trans-Anatolian-Pipeline or TANAP that will bring the gas from Turkey’s border with Georgia through to Turkey’s European border. From there the Shah Deniz consortium, led by BP, will decide in spring 2013 whether to award the next stage to Nabucco West or its rival the Trans-Adriatic-Pipeline (TAP).

 Nabucco West

Nabucco West planned route.

 TAP

 

 

 

 

 

Trans-Adriatic-Pipeline planned route.

South Stream and regional politicking:

Of course Russia has not exactly been blind to these plans and has been developing its own pipeline route called “South Stream” which aims to undermine those states that currently provide the transit point for Russian gas into Europe, most notably Ukraine. For Russia the southern gas route provides an opportunity for diversifying its supplies into Europe, thus weakening the transit states it has been traditionally forced to negotiate with whilst also increasing Russia’s hegemony of gas supplies into the region.

The existence therefore of two fundamentally competing visions for the Southern Gas Corridor, one Russian, one European, has inevitably stimulated intense political manoeuvring by the transit states, perhaps most notably Bulgaria. For those states within Eastern Europe both projects represent inherent risks and potential pitfalls which has required careful consideration. To ignore or refuse to cooperate with Gaprom on the Russian South Stream project may leave states in Eastern Europe facing potential price hikes in their gas imports, which for many states may be as much as 80% of their total gas which is sourced from Russia. Yet to endorse South Stream at the expense of Nabucco West (and to a significantly smaller extent TAP), will continue to leave Russia in control of Eastern Europe’s energy supplies.

Thus the planned transit states of Eastern Europe are all seemingly playing a double game. They have mostly endorsed both South Steam and its rival Nabucco West and have made public statements in support of both projects.

What happens next and why is the Southern Gas Corridor a “Distraction”?

The title of this post alluded to the author’s personal belief that the Southern Gas Corridor is a distraction and indeed this author does believe that the Southern Gas Corridor is a distraction from the more effective options available to provide Eastern Europe with the Energy security it craves.

The flaws of Shah Deniz:

Most significantly in the mythology that surrounds TANAP, TAP and Nabucco West is the unspoken acceptance that Shah Deniz Stage II can supply meaningful levels of gas to Europe at a cost efficient level for the medium to long term. This would seem not only an absurd assumption when we consider that the Nabucco West pipeline combined with TANAP would require in excess of 3,500km’s of pipeline to be laid (which appears the most logical choice by the Shah Deniz Consortium), which in turn requires this vast pipeline to be secure from attacks over 2,000km’s of mountainous Turkish hinterland as well as the security of the pipelines within Georgia and Azerbajan.

Furthermore, the real gas providers in the region, namely northern Iraq and Turkmenistan (and realistically Iran), are all unfeasible in the current geo-political environment, yet offer the only real long term gas reserves at a price competitive level to make the European Southern Gas corridor viable.

The Russian bluff – sourcing South Stream:

Whilst I have criticized the viability of the EU endorsed TANAP –TAP-Nabucco West vision, the Russian South Stream project is even more questionable. Whilst the old adage of beware a Greek bearing gifts is an old cliché, the idea that Russia is able to source 63 billion cubic meters of gas to Europe via South Stream by 2018, after completing the pipeline (4 pipes together) under the Black sea and across over 3,000km’s of territory by 2015 seems very much like an empty present.

Not only has Gazprom not yet identified where it will source this vast quantity of gas that it intends to supply, it also has stated that it will personally cover the cost of creating the vast majority of the pipeline. Again it seems questionable that Gazprom would invest such a vast sum into a project with so many as yet unresolved variables.

The fundamental issue – the myth of $100 a barrel:

Perhaps the single greatest flaw that underpins the Southern Gas Corridor is the belief that the oil price will remain above $100 per barrel and with it, the price of natural gas will remain high too. To maintain oil at $100 a barrel or greater will require some very intense discussions and negotiations between OPEC and other oil and gas hubs in the future as Europe increases its usage of Renewable energy, the US moves towards Shale gas.

At its heart the dilemma is that many oil sources are only viable at $100 per barrel to develop at a profitable level, yet if demand falls then either the price must decline or the supply must decline, both factors which will reduce the state revenues that OPEC members have traditionally relied above in order to suppress internal dissent and exert political power on the international stage.

With the global shipping industry moving towards eco-ship designs, “cold ironing” and gas driven designs, the airline industry actively pursuing reduced fuel sources and the increasing use of alternative fuel sources in automobiles, cane sugar in Brazil, a core market for oil products has a clearly declining demand trajectory.

Thus it seems unlikely in the medium to long term that either pipeline project, whether Russian or EU backed will live up it its much hyped expectations. Rather, the Southern gas corridor will become just another small part of the European energy supply network. Not insignificant, but perhaps not the anticipated game changer.

If the Southern Gas Corridor is a distraction, then what?

The key issue that the EU seems consistently unable to address is that of a European wide energy grid. For Europe, a totally integrated Energy grid would be able to deliver multiple immediate benefits with relatively few drawbacks:

  1. The construction of the infrastructure needed for a European energy grid would help to stimulate economic growth.
  2. A Europe wide grid would reduce wastage within national grid systems by allowing surplus energy from one state to be moved to another.
  3. Greater regional integration and cooperation as all states become more closely intertwined.
  4. A more consistent energy prize for all European citizens and states.
  5. A significant reduction in the dependency of any European energy state on one energy source.
  6. Greater political independence from Russia.

Whether people like the idea of greater European integration or not, it is inevitable that the future energy security of Europe will not be secured by grand visions like the Southern Gas Corridor but rather by integrating those networks that are already in place. That is the true answer and path to Europe’s energy security.