Russia

Two important publications on fossil fuel subsidies were released last week, though covering quite different aspects of the problem.  The first, by Oil Change International in Washington, DC, updated information on US subsidies to fossil fuels to 2013.  Their work captures the subsidy escalation that has occurred following surging domestic production of oil and gas in recent years.  The second, produced for the Global Subsidies Initiative in Geneva and WWF Russia, provides two case studies of Russian gas projects in the Arctic Circle.  This is an environmentally sensitive region of the world that, ironically, is facing greatly increased pressure for hydrocarbon extraction as the climate warms.

Cashing in on All of the Above: 
U.S. Fossil Fuel Production Subsidies Under Obama
by Shakuntala Makhijani (Oil Change International)

Report Highlights

• Growth in domestic production has resulted in sharp (up 45% since 2009) growth in federal subsidies to oil and gas as well.
• Subsidies to fossil fuel exploration and production in 2013 were $21.6 billion.  Of this, state-level subsidies comprised $3.1 billion -- though not every state has been analyzed yet.
• Subsidies to fossil fuel consumption exceeded $11.2 billion for 2013, of which $2.2 billion was at the state level.
• The study provides an updated literature review of subsidy values related to oil defense and fossil fuel-related externalities, though does not include these large values in its reported totals.
• A tally of fossil-fuel-related project finance through US export credit agencies (ECAs) also highlights that even in a world of increased concern over global warming, the ECAs continue to provide subsidized credit and insurance to the fossil fuel sector.

Government Support to Upstream Oil & Gas in Russia: 
How Subsidies Influence the Yamal LNG and Prirazlomnoe Projects
by Lars Petter Lunden and Daniel Fjaertoft

I wrote about the rush to develop Arctic oil and gas reserves back in October 2012 (Russian Yamal Peninsula LNG Project:  Tracking subsidies to Arctic destruction), and unfortunately the situation does not seem to have improved in the years since. 

Not surprisingly, I was delighted when the Global Subsidies Initiative, in conjunction with WWF Russia, decided to fund some detailed work on the issue -- including the Yamal LNG project.  Their analysis is a first step in calling attention to some very complicated market dynamics associated with government-led regional development of natural resources in environmentally-sensitive regions. 

For these types of projects, individual subsidy line items are but a starting point.  It is vitally important as well to look at the broad set of policies, including less direct ones such as roadbuilding or transport links, and assess the degree to they shift so many of the development risks from the private to the public sector that they "tame" the high risk regions for profitable development.  This shift is relevant not only for this project, but for many others that follow.  It is the full number of projects, after all, that convert pristine ecosystems into industrial waste lands. 

Often, this "taming" actually requires enormous public financial support per benefit created -- though the costs are masked, hidden, and shifted in all sorts of clever ways.  When this dynamic of public intervention occurs in areas of poverty or urban blight, we normally applaud the efforts as necessary and important development that are critical to "turn an area around."  When the behavior occurs in environmentally sensitive regions such as the Arctic, the trade-offs and reactions are (indeed, must be) quite different. 

Even if there are poverty-elements to these regional support strategies (as there often are with developing world mining projects, for example), the risk shifting remains problematic.  The environmental damage is often irreversible, and the selection of a natural resource-intensive pathway can represent a false choice.  Quite often there are multiple development path options for job creation or regional improvement -- some of which can offer similar social gains at a much lower environmental cost.

Report Highlights

• Viability dependent on government support.  Both the Yamal and the Prirazlomnoe projects would not have been viable without some of the government support analyzed.  This conclusion was reached even with some important gaps in the types of subsidies the research team was able to quantify.  For example, they were not able to assess preferential credit terms for some important financing agreements, or evaluate the level to which insurance and indemnification requirements were adequate and privately funded.  Inclusion of missing subsidies would have further worsened the returns.
  The authors frame this issue as follows in relation to the Yamal project:

The Yamal LNG project seems marginal from an economical point of view, i.e., the project shows small positive economic returns pre-tax, and marginally negative economics pre-tax if the project would have to pay all infrastructure investments. By paying for a large share of infrastructure investments, the government has
granted the owners of Yamal LNG a considerable subsidy.

In the meantime, proponents of Yamal LNG would claim there are strategic reasons for developing this project. Yamal LNG will be Russia’s first LNG project for west and east-facing markets as well as Russia’s first non-Gazprom gas export project. Moreover, it will generate traffic for the Northern Sea Route and pay for and utilize icebreaker services. In addition, Yamal LNG will contribute to the development of the Arctic region,which some regard as a benefit per se (p. 34).

• Viability sensitive to discount rate assumptions; these may be even higher than assumed.  The profitability of the projects is sensitive to which rate of return is assumed appropriate for investment in the projects.[fn]In the paper, the authors assumed a 10% real discount rate for the oil industry, with an additional 2% added to reflect country risk in Russia (page 8). However, the fields examined were not just in Russia, but in the Arctic -- so an even larger rate adjustment might be warranted.[/fn]  It is notable (though not explicitly stated) that the appropriate rate of return is, in itself, influenced by the degree and type of government involvement with the projects. 
• Pattern of regional support evaluated at a first level; further analysis would be quite useful.  As noted above, a critical aspect of reviewing subsidies to “remote” resources (either geographically or technologically) is how a pattern of government support alters not only a single project, but the development trends in an entire regions.  Canadian subsidies to the tar sands in Alberta is a good example of this; or US hydro dams and the expansion of agriculture in parts of the US West.  To the extent that Russian infrastructure, services, and subsidies are not only supporting Yamal, but also derisking other investments in fossil fuel development in the Arctic that would previously have been unprofitable, the subsidies both reduce the breakeven rate of return needed for Yamal and Prirazlomnoe to go forward, and accelerate development of other fields in the area. The GSI/WWF paper, by looking at subsidies to infrastructure to the fields, opens debate on this critical issue.  Much more research is needed.
• Tax breaks seem to lack an underlying strategy.  Tax breaks to the oil and gas developments evaluated seemed to be granted ad hoc, in some cases apparently to bolster demand at military shipyards, rather than per an underlying set of rules.  This approach normally increases the latitude for more political deals.
• Employment gains do not look large.  Job creation and development benefits to the local population appears to be fairly limited, given their existing skills and industries, and substantial tenders already underway to foreign firms. 
• Environmental risks inadequately assessed.  The returns on the projects (even with subsidies) remain moderate, and environmental damages from dredging, spills, or other activities would likely turn those negative.  The authors note that the environmental reviews conducted thus far do not appear to be robust, and that independent reviews anticipate significantly larger environmental risks than have been reflected in the official documents.

In the movie Field of Dreams, actor Kevin Costner hears a voice in his head telling him "If you build it, he will come."  The "it" is a baseball diamond in the middle of his corn field; the "he" is his dead father.  Onlookers, of course, think he is crazy, which perhaps he is.  But at least in the movie the costs to build and maintain the diamond were not paid by the government.  If the idea was a bust, it was Costner's character, not taxpayers, footing the bill.  And the environmental impacts?  Immaterial.

Oil and gas extraction from the Arctic seems to be following the same "build it and they will come" playbook.  The scale of this game, however, is very big.  It is so big that I'm reminded of the push for massive, heavily subsidized, irrigation projects throughout the US west -- engrossingly documented by Marc Reisner in Cadillac Desert.   High risk capital infrastructure is being paid for by the state.  Returns are irrelevant so long as the infrastructure paves the way for investment in the region's energy resources.  Assume capital costs will eventually be written off and the services from the capital look cheap.  Environmental risks?  Perhaps the dam model applies here as well:  promise you'll be careful when you can't ignore the issue, but ignore it whenever you can.

Arctic activities getting attention; associated subsidies not so much

Documentation of the rush for Arctic oil has been growing for some time.  A useful backgrounder on the Russian perspective by Dmitri Trenin and Pavel K. Baev, The Arctic: A View from Moscow, for example, was released by the Carnegie Endowment for International Peace in 2010. But what is still not getting the attention it deserves is the role of subsidies.  It is these government handouts in all their guises that are ultimately making firms invest in a high-cost, high-risk marginal energy resource called the Arctic circle.  Arctic oil and gas, after all, competes with easier supplies around the world.  

These subsidies are driving the construction of infrastructure that will jump-start and greatly expand Arctic oil and gas development well beyond the levels we would see if market forces alone were driving investment.  The pressure to subsidize big is not entirely surprising.  There is substantial overlap between energy, geopolitical designs on the region, and an effort to expand access (and perhaps domination) of newly thawing waterways.  These are powerful drivers for government intervention regardless of economic cost, particularly in Russia. 

But the environmental price is likely to be high.  Those of us who worry about all sorts of damage to the pristine Arctic environmental really ought to be banding together to document the subsidies and demonstrate the economic irrationality of the development.  If this has started to happen, I've not seen it.

The article below, from the Voice of Russia last month, was forwarded to me by Steve Kretzmann of Oil Change International.  It is a useful example of what is going on, though based on past experience my guess is that the article captures but a portion of the many ways the government is providing subsidies to, and shifting risk from, private investors.  The article is reposted below with subsidy-related commentary.  Bold highlights have been added to flag subsidy coverage within the article; the indented text preceded by asterisks is my own.

Yamal LNG: what isn't being subsidized?

Arctic exploration in practice: Yamal LNG

"Practical development of Arctic mineral deposits, which is about to commence in Russia, is not needed by Russia alone. Oil and gas from that region will be supplied to different markets and will help solve energy deficit in various countries. Take, for instance, the Yamal LNG project - gas from the Russian Arctic can be shipped by tankers to practically any market. Thus, gas from the Russian Arctic will be used in Asia, in Europe or, if necessary, in North America. The Yamal LNG project provides for building a gas liquefaction plant near the Sabetta port in the eastern part of the Yamal Peninsula.

For years, the International Energy Agency has been measuring subsidies to consumers by looking at the gap between world reference prices for a particular form of energy and what that energy sells for in a country's domestic market.  The lower the cost to consumers relative to its world value, the higher the subsidy.   Russia has always been among the top of this list: in the IEA's 2010 update, Russia came in third with just under $40 billion in consumer subsidies.

Calculating consumer subsidies is not an easy task -- but it is downright simple compared to trying to figure out the many ways that a country lacking transparent fiscal systems subsidizes producers.  There are assorted tax breaks, but also production-sharing agreements, tremendous government ownership of energy-related assets and infrastructure, and complicated financing schemes by which credit is channeled to those and other projects.  Like China, the energy sector in Russia is very much a strategic asset of the government, and an extremely important one at that.  It is quite difficult to figure out precisely how this relationship plays out in terms of altering market relationships and prices. 

Dr. Ivetta Gerasimchuk, working with WWF-Russia and IISD's Global Subsidies Initiative, has done an admirable and detailed review of this arena in her recent study Fossil Fuels – At What Cost? Government support for upstream oil and
gas activities in Russia.  The analysis touches on a number of critical themes:

• Increasingly large subsidies to Arctic oil and gas production.  She notes that all parties recognize this production would not occur without subsidies.  Given the extremely fragile ecosystems in this part of the world, and the difficulty recovering from spills, subsidizing extraction there seem particularly foolish.  There is, however, lots of money at stake, and it is not just Russia that is rushing in to get in to stake their claims on Arctic resources.
• Sovereign credit, sovereign control.  Federal credit support for a variety of energy projects is quite common, often at very high levels ($3-8 billion per project -- see p. 74).  Sovereign credit is even more common in the thermal power sector than oil and gas due to reduced access to capital markets.  The study notes that there is insufficient data on lending rates and risks to assess the subsidy value of this support.  Since oil and gas firms can borrow on global capital markets, the author believes that a core purpose of subsidized sovereign credits in that sector is to reduce the risk of a foreign takeover of the firms should they hit a period of financial distress.  Working through the role of federal credit on this infrastructure in more detail would be a very useful piece of follow-on research.
• Lax enforcement of environmental regulations.  Even when there are statutes in place, they are rarely enforced.  Russia is not alone in this regard; however, it is nice to see the issue picked up explicitly in a subsidy review.  Unlike tracking environmental externalities, these are situations where existing law already assigns responsibility to the producing or transporting firm.  Lax enforcement means that the cost of paying for damages ends borne by taxpayers or the parties affected by the pollution, rather than in the delivered price of the fossil fuel.
• Property tax exemptions and below-market tariffs for pipelines.  With a capital cost in the billions, it is hard to argue that pipelines are not valuable property.  Clearly they should pay property taxes where such charges are levied on other industries.  Exemptions in Russia are widespread at both the federal and municipal levels, according to Gerasimchuk's review, with a subsidy value of about $2 billion per year.  This is more evidence that the subsidies particular industries get are fairly consistent across the world.  The controversial Keystone XL pipeline in the US, slated to move tar sands from Canada to Texas, is also receiving significant property tax abatements from the states it crosses.  Another interesting element of Russian policy is the decision to subsidize oil exports to China by instituting artificially low tariffs on shipments through the East Siberia - Pacific Ocean pipeline (p. 103).  The subsidy was worth an estimated $1.1 billion in 2010.
• Tax evasion through the use of transfer pricing.  Multinational firms can buy and sell goods and services to particular divisions at prices set to transfer the accounting profits to low-tax regions or to eliminate taxable income entirely.  Past efforts to curb the practice through legislation were of limited success.  An additional tightening of regulations is set to occur in 2012, but its success is also not yet proven.  The subsidies to the oil and gas sector in Russia are estimated in the billions of dollars per year.  My expectation is that better data would find tax avoidance significantly higher than people had expected.
• Special terms in production sharing agreements and widespread municipal tax breaks for, and ownership of, energy-related enterprises.  These two important areas are discussed as well, with estimates where possible.  Additional research to quantify what are likely widespread subsidies at the municipal levels would be extremely useful.

The chart below links many of the core subsidies identified to stated objectives of the policies, and compares support for extending production from mature fields versus subsidizing new ones.  The objectives (shown in blue in the center) should be taken as directional rather than definitive.  Politics and money are both at play as well, and often tip policies towards those with power rather than towards those most likely to achieve stated social policy goals.