A Land Too Cold for a Free Market in Energy

At an otherwise unremarkable meeting last week between Vladimir Putin, Gerhard Schroder, Germany’s chancellor, and Russian and German businessmen in the Urals region, Mr Putin made a remarkable admission. In reference to the European Union’s demand that Russia should raise its low domestic gas and electricity prices to world levels if it wants to join the World Trade Organisation, the Russian president retorted: “That is impossible. We would cause the whole Russian economy to collapse.”

Most observers shrugged this off as another example of defensive Russian overstatement. But Mr Putin is absolutely right. It would be impossible for Russia to allow free-market domestic energy prices. Its economy is almost entirely dependent on the provision of low-cost oil, gas and electricity. It is equally dependent on budget revenues generated by energy sales abroad at high world prices. Russia is in fact trapped by the imperatives of a two-tier energy pricing system.

Energy is the big issue in Russia’s domestic and foreign policy. Oil and gas account for nearly a quarter of Russian gross domestic product, about half its export earnings, and about a third of government tax revenues. Every $1 increase in the world market price of a barrel of petroleum translates into as much as $1.5 billion of yearly federal budget revenues. Aside from nuclear weapons, oil and gas are Russia’s greatest strategic assets. It has the world’s third largest oil reserves, while in natural gas it is unsurpassed.

But, as Mr Putin is acutely aware, there are many conflicting demands on energy in Russia. Energy must fuel the country’s economic development, increase its influence overseas and satisfy Russian companies’ aspirations to compete with the world’s oil majors. Most important, Russia’s resources must maintain cities and industries in some of the coldest places on the planet. Bluntly speaking, it is cheap oil, gas and electricity that keep people alive through the Russian winter.

Today, people and factories in Russia still languish in the places where communist planners put them—not where common sense or market forces would have attracted them. From the 1930s to the 1980s, the Soviet Union defied nature and the market to launch huge industrial and urbanisation projects in Siberia. The costs are now apparent. The mass settlement of this vast, resource-rich but inhospitably cold territory means that almost 40 million people live and work in cities where the average January temperatures range from minus 15degrees C to minus 45degrees C. Of the world’s coldest cities with more than 1m people, the first nine are in Russia.

In other northern countries, people have moved out of the coldest regions for warmer climes over the past decade, but Russians have been frozen in place. Migration to European Russia, to warmer areas where there is most potential for economic growth, is constrained by restrictions on settlement in Moscow, and by the absence of new jobs and housing elsewhere.

Siberia is a burden on the Russian economy. Costs of living are four times higher than elsewhere in Russia; costs of industrial production are higher still. Residents of Siberian cities earn less than a twelfth of the wages of counterparts in Moscow. Local industries (with the exception of oil and gas) teeter on the verge of bankruptcy. The majority of people and industries cannot afford their utility bills. Even with low domestic prices, the Russian government must pay for winter fuel deliveries for the coldest regions, at an annual cost of about $700 million.

So Mr Putin is right. Deregulating domestic energy prices and raising the cost of utilities would prove catastrophic. In Siberia, heat is literally a life-or-death issue. No Russian government could let utility companies punish millions of non-payers by turning off the heat. As it is, most municipalities and many industries fall short on utility payments.

This state of affairs is not sustainable. As Mr Putin also noted last week, sooner or later Russia will have to contemplate switching its domestic market to international energy prices. The state cannot afford to subsidise Siberia. The dilemma is how to downsize Siberia’s cities and industries and move people and economic activity back in from the cold. This will be a far greater challenge for Russia than any other structural reform of the past decade.