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In an environment of state capitalism in Russia, regulation is defined as tools and procedures for government control and management. However, in light of the specifics of the industry, in this study we discuss regulation in a broader sense. We analyze business standards, procedures and customs accepted both among entities in the industry — gas producers and consumers and gas transport, sales and other organizations — and those used with respect to other industries by the government and on the intergovernmental level. In this sense we will refer to everyone involved in the industry as industry participants.

The evolution of regulation in the gas industry is primarily associated with two participants: the RF Government and OJSC Gazprom. Historically regulation evolved along two major lines — from the top down, when relationships were based on federal laws, and from the bottom up, when the existing system of industry relationships was codified formally and informally.

The outside observer might identify three key concepts around which the regulation evolved: «prices and tariffs,» «access» and «investments.» This triad represents a simplified regulatory arrangement and relatively accurately replicates the industry’s key problems.

A more detailed analysis of the situation reveals a far more differentiated distribution of industry problems and options for their solution by regulatory decisions made today. These detailed arrangements might be structured both using the mechanism for describing the industry supply and using more complex models with a greater number of measurements — complexity, the urgency of the problem, the method of codifying regulation, the level to which the procedure is formalized, economic importance, etc.

Nevertheless, any attempt to describe the structure of gas industry regulation visually demonstrates the absence of a strategic idea for the development of this regulation. So far regulatory standards have been developed exclusively as a response to industry problems. Depending on the level of the problem, the participants and available resources, these responses have been more or less adequate to the challenges that engendered them. As a result, regulation in the industry is fairly disjointed, inconsistent, often contradictory, discriminatory and unenforceable.

OJSC Gazprom has played a major role in this:

? As a for-profit company dominating the market and earning profit from this domination,

? As the heir to the government ministry, continuing to concentrate within itself specific government functions,

? As a political player with a formidable set of tools to impact society.

This study breaks down the trends in various areas of industry regulation and attempts to predict these areas and the local vectors of interest among its participants on the basis of an overview of the current situation.

Specifically, decisions by the RF Government in the spring of 2007 concerning wholesale gas prices ended the «political battle» on that field, but initiated long and laborious efforts to develop and approve the details of the new relationships among industry participants. The risk of a shortage of investments in the industry remains a key threat in the various scenarios for the development of this work.

The reform in the electric power industry remains a major factor in the development of relationships in the gas industry. Largely thanks to the efforts of the electric power industry, active price differentiation will begin in the near future and will make both the seasonal gas sales and gas storage businesses more transparent.

Regulation of a consistent tariff for gas transmission is the nucleus of the specific model for government regulation in the industry. The emerging trend in the transmission tariff now is not so much a reflection of the rise in actual costs in this sector as a consequence of the paradigm shift in the gas transmission system operator. Previously, gas transmission was mainly a service ancillary to gas sales, but in the future it will increasingly begin to look more like a separate business, which will promote the need for more transparency and adequacy in cost allocation. The curve reflecting the rise in tariffs must therefore be economically justified and possibly at some point start to decline under pressure from the antitrust mechanisms of government regulation.

In public opinion the monopoly has a positive image that enables it to discriminate against other participants. One of the more significant problems in this respect is the efficiency of gas distribution projects. The official public significance of these projects enables their organizers to largely ignore the economic basis for their further operation, which will inevitably result in financial conflicts in the future.

Tax differentiation as a function of business conditions has recently become a popular topic. Specifically, the opinion that the tax on mineral production should be differentiated according to the geological characteristics of the gas occurrence has become fairly widespread. By virtue of the specific structure of the industry and mechanisms for regulating OJSC Gazprom, these suggestions do not promote industry development and in the near term will increase the tax burden for independent producers through an increase in the absolute tax rate.

OJSC Gazprom artificially created the access problem to exploit the resources of independent producers and control its own traditional sales markets. Under these conditions the problem cannot be solved through additional investments or by establishing fair quotas. The real solution to this problem lies in the legitimization of the existing gray market for capacity.

The administrative spinoff of business within the OJSC Gazprom holding company creates an opportunity for targeted privatization of producing, distribution and sales companies. Undoubtedly the transmission and balancing gas storage infrastructure will remain under central control.

The enactment of the prohibitive Law «On Gas Export» left no prospects for the regulation of natural gas export. The theoretical possibility of developing regulatory mechanisms for «fair» export conflicts with OJSC Gazprom’s unwillingness to share its export earnings. The monopoly now has sufficient tools to interpret the law as an exclusive right, not as a duty.

If we interpret the term «market» as a consumer’s right to change suppliers, today it is exclusively the consumers who need market rules, and exclusive as a tool to protect themselves from the possible whims of OJSC Gazprom. The real reasons why other participants are involved in the development of these rules are different from what they claim. Consumers don’t need the market, but they do need reliable deliveries at predictable prices. Producers’ market initiatives represent their struggle for their own interests: Gazprom fights for an increase in prices; the independents for access. Government regulation of the «gas market» is exclusively an administrative bargain between officials and the industry and among themselves. The future trend in «market» regulation depends on the balance among the real reasons. The most likely trends will reflect the interests of the strongest players — an increase in prices and redistribution of administrative authority.

On the other hand, market rules are the price of liberalization. In other words liberalization will not be possible until the government is provided with transparent and nondiscriminatory trading rules. It is this facet that might arouse interest in rewriting the current «Gas Delivery Rules» both within OJSC Gazprom and not-for-profit organizations that unite gas market participants (KRG, RGO) and within federal executive branch agencies (Russian Ministry of Industry and Energy).

In the near term the structure of the market will undergo significant changes. The regulated and unregulated sectors will be transformed into «long-term,» «public» and «others.» The size of the gray market will diminish slightly, but will remain relevant because of the existence of different markets for one commodity without the legal possibility of crossflow. The surpluses in the long-term sector will significantly increase the volume of spot trading.

A unique opportunity for establishing new industry rules on the level of law — the opportunity afforded by the Law «On Technical Regulation» — has still not been tapped. OJSC Gazprom is clumsily trying to monopolize the development of technical procedures, but the shortage of skilled personnel and the absence of significant threats «enable» the monopoly to avoid forcing these issues.

The lack of a strategy for developing regulation is seen in an analysis of the Government’s «framework» documents — the Energy Strategy, the Conceptual Plan for Development of the Industry, etc. The documents contain disparate sets of forecasts with a wide range of feasibility. The likely change in Government after the presidential elections may prompt a review of the strategic documents with a slant toward administration, coordination and encouragement of development.

There is already a significant change in consumer attitude toward the industry. The electric power industry, as a major consumer, intends to participate in changing the structure of industry relations — a change in planning horizons, the concept of delivery reliability and principles of government regulation. Along with the reform of regulation in the electric power industry, new approaches to regulating gas industry are coming. The formation of a single gas energy regulator that might become an independent center of gravity is a promising trend.

The interests of industry participants lie in a single plane, but have different focuses. While OJSC Gazprom is actively trying to boost wholesale prices for gas while preserving the sales market, the Government is trying to preserve retail prices for gas and the products of its use, independent producers are trying to obtain access to gas transmission infrastructure, while consumers’ interests lie primarily in the area of reliable deliveries to meet effective demand. In this situation the critical forecasting factor is the size of the effective demand for gas. Today the industry is not ready to satisfy a significant rise in demand. The best-case scenario in this situation is «moderate depression» («Inertia» in the terminology of the Ministry for the Economic Development and Trade). When there is a slight rise in demand accompanied by approved limits for a rise in prices, the industry will be able to expand under «black box» conditions, meeting outside requirements. A profound economic decline will result in a shortage of financing and a crisis in the industry. An abrupt economic spurt will lead to the same consequences, but through a sharp rise in demand for gas and the need to develop the expensive deposits at Yamal and Russia’s northern shelf.

In this forecasting environment, the key driver for the development of the sector is the personage of V. Putin and his team. The hypothesis is that Putin does not intend to let the industry out from under his control even after the presidential elections, regardless of the result. A new model for managing the industry will inevitably evolve — the old existing model is not adequate to the economic realities or the current management goals.

Preparation of the regulatory framework for the transition to the new model is now being completed. Specifically, any significant threats to the status of OJSC Gazprom are being suppressed through laws, orders and other government documents. The remaining documents should be approved shortly before the elections. This will be the next-to-last spurt in industry regulation. The last, most dynamic spurt can be expected right after the election.

Recommendations on future behavior for industry participants are highly dependent on their long-term strategies, assessments of acceptable risks and the degree of «immersion» into industry businesses. Nevertheless, there are a number of universal recommendations:

1. An active «name» position in the regulatory playing field in the near term will be risky. The increased threat will be seen as a challenge requiring an immediate response. The use of high-level tools (draft laws, intergovernmental negotiations, etc.) will result in an unnecessarily harsh response to inoffensive suggestions.
2. The process of preparing for a change in the industry management model has begun at many levels. The changes are frequently not managerial, but intuitive — those implementing them try to guess the will of the managers. This situation requires careful monitoring of the industry environment to regularly forecast the immediate future and lower the risk of inadequate business decisions.
3. If we assume that the format of the new industry management model has not yet been cast in stone, the opportunity exists to introduce meaningful elements into it. The shortage of regulatory skills in the initial stage allows for the option of using plans, structures and methodologies, the ideology of which does not conflict with the goals for changing the management model. There is merit in starting to draft new regulatory documents on the level of anonymous «participant opinions.»

I. OJSC GAZPROM’S CURRENT REGULATORY AGENDA

Subject of the Study and Historical Patterns

Regulation as business standards, procedures and customs. The regulators and the regulated. The role of the government in regulation.

Russia’s current economic order is characterized by a separation between the government and other participants in decision-making — particularly decisions pertaining to the procedure for production and for satisfaction of needs. Currently, given official approval of the development of a market system, the emphasis is on central planning. In this situation it is hard to quantify the Government’s economic role. A very crude indicator of the relative importance of the market and the government in the economy is the fact that currently about 4/5 of national product is supplied by the market system, while the rest is produced under Government auspices. Statistics also show that taxes and total government expenditures — to buy goods and on social programs — represent approximately 1/3 of the national product.

Given the development of state capitalism in Russia, we can define regulation as the tools and procedures for government control and management. But given the specific nature of the industry, in this study we discuss regulation in a broader sense. This study analyzes the consequences of the use of business standards, procedures and customs both accepted among industry entities — gas producers and consumers, gas transmission, sales and other organizations — and used in relationships with other industries, the government and on the intergovernmental level. In this sense we will refer to everyone involved in the industry as industry participants. Without downplaying the Government’s role, one must note that most regulation in the gas industry in the broad sense is by the participants themselves, one of the participants — OJSC Gazprom — to be precise.

Evolution of regulation as the process of responding to challenges. The industry’s historical challenges. Responders and respondees. Gazprom’s role.

Regulation has historically evolved along two key lines — from the top down, when relationships are based on federal laws, and from the bottom up, when the existing system of industry relationships has been officially and unofficially codified. The process of the privatization of the assets of RAO Gazprom included the denationalization of the Soviet system of industry management. Some of the government management bodies were abolished, but most continued to function under the new joint stock company. In this way, the initiative in the industry’s regulation passed from the government to one of the participants in this industry.

The privatization of most of the gas industry in the form of a unified system was no accident. That is how the management of RAO Gazprom responded to the Government’s failure to make the decision to privatize and how it reduced the risks of this process. In the early 1990s the key standards for the industry were introduced in the form of Order No. 1333 of the President of the RF, dated November 5, 1992, «On Conversion of the State Concern Gazprom into RAO Gazprom.» The order was not a step in the strategy for expanding government regulation — it only blocked possible industry challenges and guaranteed the monopoly’s subsequent conservative development, given the Government’s attempts to formulate the basis of market principles in the country’s economy.

Table 1. Chronology of «Threat-Response» Events

Period	Event	Gazprom’s position	OpPosition
1992-93	Privatization	Unified system	—
1994-95	Inflation	Inflation-based rise in prices	—
1995-96	Economic disintegration	Gas industry fund	—
1997	Price limit achieved	—	Order № 426
1996-97	Disregard for the state	—	Commission of government representatives in Gazprom
1996-97	Establishment of independent companies	—	Regulation on access
1997	Defaults	Establishment of Mezhregiongaz	—
1998	Rise in consumer competence	Gas delivery rules	—
1999	Risk of loss of control of the pipeline	Las on Gas Supply	—
1998-03	Shortage of resources	Revision of the Regulation on Access	Conceptual Plan for Industry Reform
2006	Plans for independent gas export	Law on Gas Export	—

Similar responses to upheavals were the Decision on Simplified Regulation of the Gas Industry (essentially the right to change gas prices in accordance with the industrial price index), the formation of a Unified Fund for Stabilization and Development to Maintain and Expand Gas and Condensate Production Capacities and other regulatory decisions in 1996.

Then the Government seized the regulatory initiative. In 1997 a psychological and, in some sense, economic limit on prices was reached. As part of the general conceptual plan for structural reform of natural monopolies, structural reform of the gas industry began. Subsequent disregard of Government decisions led to the assignment of exclusive powers to a board of government representatives to OJSC Gazprom and the introduction of requirements to publish the results of mandatory audits of RAO Gazprom according to international auditing standards to allocate industry costs. Then the Government adopted Resolution No. 858, dated July 14, 1997, «On Providing Independent Organizations Access to the OJSC Gazprom Gas Transmission System.» A little later, Resolution No. 843, dated November 2, 2000, formed the Government Commission on the Use of Oil and Gas Export Pipeline Systems.

For its part RAO Gazprom continued to fight for its understanding of «stable industry growth.» Confronting the problem of defaults, which was aggravated by the lack of experience with contractual relationships concerning natural gas deliveries, the monopoly spun off a sales division (Mezhregiongaz Ltd.) and developed its own version of the Gas Delivery Rules, which were approved by Government Resolution No. 162, dated February 5, 1998. In response to the Government’s efforts to apply costs within the industry, which led to the requirement to spin off the gas transmission system, RAO Gazprom developed the «Law on Gas Supply,» which gives it exclusive rights as the owner of the Unified Gas Supply System.

Since then history has been regularly repeating itself. In response to a predicted shortage of gas and of investments in its production, the Government develops all new plans to reform the industry. And OJSC Gazprom revises the Regulation on Access in response to ever more frequent complaints by the independent producers. The adoption of the Law «On Gas Export» in response to the risk of loss of the monopoly on foreign markets is an example from recent history.

In this way, regulatory standards have so far been established exclusively as a response to industry problems. Depending on the level of the problems, the participants, and the available resources, these responses have been more or less adequate to the challenges that engendered them. As a result, the industry has regulation that is disjointed, inconsistent, often contradictory, discriminatory and unenforceable.

OJSC Gazprom played a major role in this as a for-profit company dominating the market and earning profit from this dominance, as heir to the government ministry that continues to concentrate within itself specific government functions and as a political player with a formidable set of tools for exerting pressure on society.

We can identify typical negative features of OJSC Gazprom’s regulatory activities:

§ Its corporate nature — regulation as designed «by Gazprom» is aimed primarily at the company’s stability, not the growth of the industry

§ Multiple levels — the holding company’s subsidiaries often do not share the interests of parent company. The goals of regional business often conflict with the company’s strategic goals. The result is a constant conflict of interests that spills over into a regulatory conflict.

§ Tactics alone — Planning involves the rules for the annual «deal’ with the Government (prices, tariffs, investment program). The company has no significant long-term strategy whatsoever.

§ Inertness — Broad administration requires consistent coordination of ideas (upward) at each stage in the hierarchy and reciprocal transfer of responsibility (downward). The high level of bureaucracy in the process is disastrous to decision-making and sometimes renders decisions irrelevant to the changing situation.

Given the attempt to structure the results of this regulatory activity — the regulatory model — the outside observer might identify three key concepts around which industry regulation is evolving: «prices and tariffs,» «access» and «investments.» This triad constitutes a simplified regulatory structure and replicates the industry’s key problems fairly accurately.

A more detailed analysis of the situation reveals a more differentiated distribution of problems and options for regulatory decisions made today. These detailed structures may be based both on the mechanism for describing the industry supply chain and on more complex models using a large number of measurements — complexity, the urgency of the problem, the method for codifying regulation, the level of which the procedure is formalized, economic importance, etc.

 

1. Individual Components of the Regulatory System

1.1. Price Regulation

Prices and tariffs are the main regulatory tools «confronting» the interests of the parties:

? For the state — a crude, obsolete and inadequate tool for managing a situation (more often a curb);

? For customers (industrial) — the basis for product profitability;

? For Gazprom — an excuse to bargain with the state;

? For the independent gas producers — a business benchmark.

As a result of RAO UES’s demand for firm gas delivery guarantees in the form of long-term contracts and OJSC Gazprom’s intention to repeal government regulation of gas prices, the Government adopted Resolution No. 333, dated May 28, 2007, «On Improvement of Government Regulation of Gas Prices.» This document establishes the principles for government regulation of gas prices until 2011 based on ensuring an equal rate of return on deliveries to the domestic and foreign markets. In particular, gas delivery contracts in this period may contain a price ranging from the minimum set by the Government to the maximum, which is 60% higher than the minimum in 2007 and gradually reaches the minimum by 2011. It also establishes the right and the principles for price differentiation for different kinds of consumers and consumption conditions.

This pivotal decision, officially cleared with the relevant Government ministries, met an ambiguous response. There are still objections to certain relatively anti-market provisions of the Resolution by the Ministry of Finance and the Ministry for Economic Development and Trade.

RF Government Resolution No. 333, dated May 28, 2007, «On Improvement of Government Regulation of Gas Prices» establishes that:

? Before January 1, 2011, to inform gas market participants of the principles for the formation of wholesale gas prices to be used starting in 2001, the wholesale price of gas produced by OJSC Gazprom and its affiliates subject to government price regulation is set by the federal executive branch agency for government price (tariff) regulation according to the formula established by that agency to ensure an equal return on gas deliveries to the foreign and domestic market (gas price formula). Information on the price of gas is posted on the official website of that agency on the Internet;

? As of January 1, 2011 the delivery of gas produced by OJSC Gazprom and its affiliates under contracts (including long-term) to all consumers (except the public) will be at the wholesale prices set by the gas price formula.

A new price category has been introduced — the «wholesale gas price» which is calculated in a range between the «maximum and minimum wholesale price levels.» Most likely it is not called regulated because it is determined independently by the parties within the limits of the range set by the Federal Tariff Service of Russia. This price is determined as follows: the wholesale price of gas calculated at exit from the gas transmission system by the agreement of the parties on execution of contracts for gas delivery (including long-term) to end users in the relevant groups.

The following terms have also been introduced:

? Maximum wholesale gas price level — the wholesale price level that cannot be exceeded in gas delivery contracts;

? Minimum wholesale gas price level — the wholesale price level below which the cost of gas in gas delivery contracts cannot be set.

Note that that prices cannot be in any case set either below the minimum or above the maximum.

The wholesale gas price, which is calculated in a range between the maximum and minimum wholesale price levels is tied directly to the named categories of consumers.

The resolution establishes 3 groups of end users (except the public) to which OJSC Gazprom and its affiliates deliver gas under the new kind of wholesale prices:

? End users executing contracts for gas delivery starting after July 1, 2007 (except organizations established as a result of the reorganization of organizations that previously purchased gas produced by OJSC Gazprom and its affiliates or organizations that acquired (including by way of succession) gas-consuming equipment previously supplied with gas produced by OJSC Gazprom and its affiliates);

? End users acquiring gas above the amounts fixed in 2007 gas delivery contracts (not counting quantities of gas specified by supplemental agreements to those contracts);

? End users to which gas is delivered in connection with work to expand the Unified Gas Supply System.

The Resolution (para. 15.2.) codifies the levels of increase in minimum and maximum prices:

? The minimum level of wholesale gas prices are the regulated wholesale gas prices based on the average rate of growth in wholesale prices determined by the Russian Federation Government.

? The maximum wholesale gas prices are the regulated wholesale gas prices based on the average rate of growth in wholesale prices determined by the Russian Federation Government and raised in 2007 by 60 percent; in 2008 by 50 percent, as of January 1, 2009 by 40 percent, as of July 1, 2009 by 30 percent, as of January 1, 2010 by 20 percent and as of July 1, 2010 by 10 percent.

However, it does not follow from this resolution that the new kind of wholesale price does not apply to organization not affiliated with OJSC Gazprom.

Only in the systemic interpretation, together with the standard of law (article 21 of the Law on Gas Supply), and the official position of the Supreme Court (Decision KAS 02-381, dated July 30, 2002), which clearly states that price regulation applies only to natural monopolies and only to organizations owning gas supply systems, can one conclude that Resolution 1021 in principle does not apply to organizations not affiliated with OJSC Gazprom.

But the problem is that in this situation organizations not affiliated with OJSC Gazprom might prefer not to exercise their right to unregulated prices.

Wholesale Prices

Nevertheless, the boundaries of the price increase have become objective factors and the basis for making predictions. After all, if prices are only a fairly crude economic management tool for the Government, for OJSC Gazprom they are an excuse for the annual deal with the Government over its earnings, for gas consumers they are primarily the basis for product profitability, and for independent gas producers they are a key business benchmark.

One can identify the following among the potential consequences of the government’s decision:

? The independents’ gas might officially become regulated. According to the revised Delivery Rules, the contract price cannot trespass price boundaries. However, officials unofficially affirm that this is only a flaw in the working, according to them, and the document does not deal with the interpretation of this idea.

? The fee for sales and supply services (SSSF) applies to «gas within regulated boundaries.» This means that independent gas producers and other sellers have the opportunity to set the SSSF through the Federal Tariff Service and collect it from consumers.

? OJSC Gazprom begins to sell extra gas with a multiplier of 1.6 and steadily reduces the quantity of «limit» gas. The monopoly’s unregulated ability to differentiate prices aggravates the «market» battle to win consumers.

? There is a genuine risk that the «equal return» price will fall below OJSC Gazprom’s incremental costs, specifically below the cost of gas production at the Yamal field. This will necessitate covering the shortage of financing for new production projects by raising domestic prices above export prices.

Wholesale Prices

OJSC Gazprom is in favor of prices calculated by the net-back formula; the dispute is over maximum prices. The point of dispute is the introduction of a maximum price.

Reasons for the equal return:

? RAO UES’s desire to have gas delivery guarantees — to interest Gazprom in the domestic market;

? RAO UES’s desire to have an electricity market that is honest with respect to fuel;

The result: long-term contracts will be more expensive than «traditional» deliveries.

With respect to regulation of prices for industrial consumers OJSC Gazprom is for immediate liberalization.

Overall, OJSC Gazprom will adhere to the scenario for price increases until 2011 incorporated into RF Government Resolution N 333, dated May 28, 2007, «On Improving Government Regulation of Gas Prices.»

After 2011 there are plans to transition from government price regulation to regulation of tariffs for gas transmission.

The reason for the change in wholesale price regulation should be sought, among other things, in the reform of the electric power industry. Prospects for the liquidation of RAO UES as an agency focusing power-generating demand on natural gas and negotiating terms for its delivery threatens the stability of fuel supplies to power plants. As a result, RAO UES has traded OJSC Gazprom’s long-term guarantees of gas delivery quantities for price increases accepted by the parties. Further, the problem of creating a fair market for electrical energy produced with gas is not being solved. The authors of the electrical industry reform dread OJSC Gazprom’s monopoly pressure on the market through the power plants that the company plans to buy as part of the reform. In addition to the Government Resolution, the result of these negotiations will be the resegmentation of the gas market, where the long-term contracts segment will actually see higher prices than the traditional annual deliveries segment. In addition, overestimates of demand on the part of power plants will necessitate the sale of some long-term contract gas on the spot market.

APG and LPG Prices

OJSC Gazprom is in favor of abolishing APG price regulation.

It is in favor of abolishing the regulation of prices and balance targets for NGL, although theoretically they are of no concern to it.

Overall, the LPG and APG market is the sphere of interest of OJSC Gazprom subsidiaries (Sibur). LNG is the primary interest for the Gazprom parent company. The LPG market (domestic and export) is supposed to be entirely controlled by OJSC Gazprom.

1.2. Tariffs for Gas Transmission for Independent Gas Producers

OJSC Gazprom is in favor of a dual-rate tariff with mandatory payment for capacity.

The declared increase in gross collection to 40-50 rubles ($2) per 1000 m³ per 100 km is so far merely talking.

However, within OJSC Gazprom it is understood that the tariff for gas transmission cannot rise at the same pace as the price for gas, since the cost of transmission services in the third countries is rising with domestic Russian prices.

OJSC Gazprom is therefore planning to bring the tariff up to the Central European tariff and stop there.

The Federal Tariff Service plans to increase tariffs by 13-13.1%.

1.3. Access

OJSC Gazprom is in favor of retaining the existing system: the declarative «Regulation on Providing Independent Organizations Access to the OJSC Gazprom Gas Transmission System,» approved by RF Government Resolution No. 858, dated July 14, 1998, and actual contractual access conditions. Any initiatives to change this situation will be harshly curtailed.

Investment access is also without guarantees.

The OJSC Gazprom Conceptual Design provides for the following plans for expansion, reconstruction and modernization of the gas transmission system:

? Implementation of the investment project without independent gas producers with OJSC Gazprom’s own funds;

? An independent gas producer loans Gazprom money to expand the gas transmission system (the «Loan» financial/legal arrangement).

1.4. Structure of the Gas Market

OJSC Gazprom generally plans to replicate the model of a unified export channel on the domestic market — all gas is purchased at the well and then sold centrally by Gazprom.

The establishment of a new gas sales entity, among other things, demonstrates this[1].

1.5. Export

Natural Gas

OJSC Gazprom’s current position is clearly stated and codified in regulations: export is closed to all organizations except OJSC Gazprom and its affiliates. Theoretically, the playing field for regulation-writing is open, but in reality it is closed. OJSC Gazprom will not share export earnings with anyone.

There is a myth that «a significant drop in export prices will turn the right into a duty.» But the legitimate and flexible procedures for reviewing contract terms and amending laws are a counterweight to this myth .

Monopolization of the LNG market is also anticipated.

2. Components of the Added-Value Generation Chain

2.1. Production

Strategic Fields

OJSC Gazprom is in favor of blocking the access of foreign companies and any Russian companies except Gazprom itself to strategic fields.

Continental Shelf

OJSC Gazprom continues to be in favor of independent development of the continental shelf

However, because Russian companies, including OJSC Gazprom, in reality lack the technologies, the engagement of foreign companies to develop the shelf in some capacity is inevitable.

PSAs

OJSC Gazprom is in favor of expanding PSAs: applying them to the continental shelf (Shtokman and Prirazlomnoye).

Overall Subsoil Use Strategy

OJSC Gazprom currently exercizes full control over when and which fields are put into development and still controls the gas section of the Central Subsoil Exploration Committee.

This situation will persist into the future.

The RF’s Energy Strategy and General Plan for Gas Industry Development

No one but OJSC Gazprom can develop a General Plan for Gas Sector Development, because only it has the relevant information.

Under Government order N 975-r, dated July 16, 2002, OJSC Gazprom is the «coordinator» of the Eastern Gas Program.

OJSC Gazprom in fact approves where and in what sequence fields are developed (by using connection to the UGSS and approval of the UGSS transmission balances).

The lack of a strategy for regulation development is also seen in an analysis of Government framework documents — the Energy Strategy, the Conceptual Plan for Sector Development, etc. The «old» documents are already largely inadequate for the situation. The Ministry of Industry and Energy has already formed a working group to prepare a new Energy Strategy. But its efforts will not be productive because of the lack of the relevant political push — the transformation of the fuel and energy industry is still incomplete and officials have not yet declared the new strategic goals. The «new» documents are having a hard time making their way through the approval procedures. The position of government officials toward the Strategy for Gas Industry Development is contradictory and reflects a battle of bulldogs under the carpet.

The documents contain disparate sets of forecasts varying widely in feasibility. One of the stabilizing factors is the introduction of the national fuel and energy balance. Key topic for discussion is the requirement that sector participants adhere to this balance and their rights and duties in preparing and implementing it. The country has no experience in classic prediction of energy product supply and demand. There is a tendency toward creating demand for those tools for which there is the corresponding supply. Commercial forecasts play a stabilizing role in market formation in addition to their direct function of satisfying curiosity.

Strategy documents evidence a lack of incentives and constraints. The change in Government after the presidential elections might prompt a review of the strategy documents with a slant toward administration, coordination and encouragement of development.

Mineral Extraction Tax

Taxation remains one of the indirect tools of government regulation of the industry. The rise or fall of the overall tax burden promotes the industry’s development or stagnation. But the differentiation of taxes depending on business levels has recently become popular. Specifically, the opinion is fairly common that the mineral extraction tax should be differentiated as a function of the geological characteristics of the gas occurrence and the stage of project development.

Taxes in general are classified as economic standards; they are formed according to the principles inherent to standards. Taxes are economic standards for payments to the budget, but they are authentically uniform and stable and independent of the will of certain individuals. In the spirit of the principles of tax replenishment of the budget, the individualization of tax rates, concessions and penalties is prohibited. They can be differentiated by sector, production operation or region, but not by individual company.

Because of the specifics of the industry and methods for regulating OJSC Gazprom, proposals concerning differentiation of the mineral extraction tax are targeted and may lead only to an increase in the overall tax burden or a change in the budgetary classification of income that the government receives from the gas industry. In general they do not encourage industry development and in the near future will increase the tax burden for independent gas producers through an increase in the absolute tax rate.

A normally functioning tax system is one of the tools for fighting the shadow economy: after all, paying a tax on some activity implies that it is legal and legitimate, while the existence of income, for example, hidden from taxation because it is illegal is prosecuted by the government. The differentiation of the mineral extraction tax therefore legitimizes the differentiation of the government’s attitude toward various production projects.

OJSC Gazprom is categorically opposed to the Ministry of Finance’s position concerning an increase in the mineral production tax.

There are several reasons for indignation:

1. OJSC Gazprom must now pay $7.5 billion for Sakhalin 2, which it is acquiring solely out of political considerations (on the other hand the economic benefits are quite obvious, and no one would reject them);

2. If the mineral extraction tax is increased, it will be impossible to equalize domestic market and export market returns (a very debatable assertion having nothing directly to do with the economics of sales).

The reasons for increasing the mineral extraction tax — in the Ministry of Finance’s version — are:

? Budgetary funds are insufficient;

? The mineral extraction tax has not been reviewed since 2005.

It proposes: raising the mineral extraction tax on gas as of 2008 to 315 rubles (it is now 147 rubles); as of January 1, 2009 raise the rate to 480 rubles, and in 2010 to 735 rubles. But there are fields (worked out cenomanian, valanzhin deposits, etc.) where the cost of production is 500 — 1500 rubles/1000 m³. As the mineral extraction tax rate for gas increases, therefore, it will be differentiated according to geological and other parameters.

Estimates show that about 80% of the money earned from the increase in gas prices on the domestic market will be recovered from Gazprom.

2.2. Seasonality and Storage

Seasonality and Storage

Gas prices may be differentiated by consumer groups depending on

? Connection to systems having different pressures;

? Price ranges;

? Seasonality;

? The time of execution and duration of gas delivery contracts;

? Gas withdrawal conditions;

? Quantities consumed and other factors.

OJSC Gazprom has taken the next step in forming a gas storage business: one may assume with a high degree of probability that the establishment of Gazprom-UGS will result in the long run in the introduction of fairly high gas storage rates.

This kind of business may be regulated.

The topic of cancelable contracts may become relevant, but this kind of business remains dependent on access to the transmission system.

2.3. Access to End Users

OJSC Gazprom plans to divest some of its terminal gas lines having the status of main transmission lines and collect an extra fee for gas distribution services.

OJSC Gazprom has no stake in the existence of a regulation governing the procedure for connecting to gas distribution systems (this is still a gap in the law); the owner (the relevant OJSC Gazprom regional affiliate) handles this.

OJSC Gazprom has a consistent policy toward eliminating middlemen and entering into direct negotiations with consumers (the public and housing management agencies). It has actually eliminated other middlemen (management companies) from the market for retail sales by gas distribution organizations).

It is in favor of codifying consumption standards for all consumers. With respect to the public, the relevant Government resolution already exists (N 273, dated June 13, 2006).

OJSC Gazprom intends to continue consolidation of gas distribution organization blocks (using OJSC Gazpromregiongaz) — to buy out strategic companies and take them off the list.

Gas Distribution

Uncontrolled increased in gas consumption by the public and housing management agencies as a result of unbridled gasification.

The inefficiency of gasification projects and low utilization result in a high specific operating cost. Tariffs for new gas distribution systems are reaching 1000-1200 rubles/1000 m³.

The rise in gas distribution tariffs is accelerated by the exodus of major consumers. A proprietary tap lowers a company’s tariff by a factor of 10-100 (to 1-10 rubles/1000 m³):

? In 2003 the decline in gas volume among major consumers was 3 billion m³;

? In 2004, 7 billion m³;

? In 2005, 4 billion m³.

Example: Sochi — Krasnaya Polyana. The largest consumer: Gazprom Recreation Center — 4 million m³. Tariff — 1219 rubles/1000 m³ for industrial consumers up to 10 million; 1524 rubles/1000 m³ for the public. Cost to build 63 km of pipe: 2.3 billion rubles, which means 37 million rubles/km (at an average of 1-3 million rubles). Utilization 6 million m³ at a capacity of 51 million m³. The tariff requested by Gazprom: 25,000 rubles/1000 m³ . Of 145 million rubles in costs, 118 million are for leasing the pipe from Gazprom.

3. Other Issues

OJSC Gazprom Reform (Restructuring)

OJSC Gazprom has been restructuring for several years already. During this time specialized entities have been spun off from subsidiaries and assets transferred to them. Gazpromregiongaz, Gazprom-UGS, «Gazprompererabotka» and others have already been formed. The stated goal of this restructuring is an attempt to separate and cover costs on the level of commercial agreements. Officially, the second phase of the announced reform is supposed to be completed in 2008. But the current transformations are not solving the key problem of transparency of the OJSC Gazprom cost structure, either for the government regulator or for industry participants.

Administrative spinoff of businesses within OJSC Gazprom provides an opportunity for targeted privatization of producing, distribution and sales companies. Without a doubt the transmission and balanced gas storage infrastructure will remain under central control.

II. ANALYSIS OF ELEMENTS OF THE REGULATORY SYSTEM DIRECTLY IMPACTING THE BUSINESS OF INDEPENDENT GAS PRODUCERS (REGULATION STANDARDS, THE ROLE OF REGULATORY AGENCIES AND THE EFFECT OF OJSC GAZPROM, INCLUDING INTERNAL PROCEDURES)

The regulatory system in the gas industry can generally be represented as a matrix:

1. Functions Formalized in Regulations

Connection to Unified Gas Supply System [UGSS] gas transmission capacities

Connection is regulated by local OJSC Gazprom regulations: Order N 200, dated September 3, 2003 «On the Procedure for Issuing Technical Specifications.»

As of July 2002 the rules of the game changed — specifications are issued not by the gas transmission companies, but directly by OJSC Gazprom.

In reality OJSC Gazprom regulates the process.

The Federal Antitrust Service of Russia, however, is the agency authorized to review complaints of abuse of a dominant position. But the antitrust procedures it uses are not effective.

The main problems are:

? The time it takes to review and make a decision to issue a technical specification;

? Frequent change of corporate procedure for reviewing and issuing technical specifications;

? The possibility of amendments and additions to technical specifications already issued;

? A complex decision making procedure to implement approved connections to the gas transmission system.

Connection is a tool of non-tariff regulation «on entry» (before the field is connected to the gas transmission system).

With this tool OJSC Gazprom can influence the business of an independent gas producer, limiting its expansion and influencing total quantities delivered.

Access to Gas Transmission Capacities

Access to gas transmission capacities is governed by federal law N 147-FZ, dated August 17, 1995 «On Natural Monopolies,» the «Regulation on Providing Independent Organizations Access to the OJSC Gazprom Gas Transmission System (adopted by RF Government Resolution N 858, dated July 14, 1998) and local OJSC Gazprom regulations: the Regulation on the Procedure for Preparing and Issuing Permits for Independent Organizations to Access the ОАО Gazprom Gas Transmission System (approved by the Chair of the Management Board on February 15, 1998, as amended in 2001), which also approved the form for applying for access.

The Federal Antitrust Service of Russia monitors and regulates ex post on the basis of general antitrust procedures (para. 5.3.1.3. of the regulation on the Federal Antitrust Service of Russia). There are, however, no procedures for regulating access ex ante and/or detailed, transparent access rules.

In reality OJSC Gazprom regulates access by determining available capacity and establishing internal procedures and schedules for obtaining access.

Despite the regulations, therefore, in practice access is contractual, not regulated.

Access is a key tool for non-tariff regulation and for influencing an independent gas producer’s business «in process» (fields connected to the gas transmission system).

OJSC Gazprom artificially created the access problem to exploit the resources of independent gas producers and control its traditional sales markets. The company’s monopoly position enables it not only to earn additional income (even with government regulation of the transmission tariff), but also to control the industry’s entire development — from field exploration and development to expansion of gas distribution systems and gas supply companies. Moreover, the monopoly on access enables OJSC Gazprom to acquire assets and dominate the markets for heat and electricity produced with natural gas.

Gas Export Pipeline Transportation Tariffs

Gas transmission tariffs are regulated pursuant to Federal Law N 147-FZ, dated August 17, 1995 «On Natural Monopolies,» Resolution N 1012, dated December 29, 2000 «On Government Regulation of Prices for Gas and Tariffs for Gas Transmission Services in the Russian Federation,» the Regulation on the Federal Tariff Service of Russia (approved by RF Government Resolution N 332, dated June 30, 2004), Methodology for Calculating Tariffs for Gas Transmission through Main Gas Lines (approved by RF Federal Tariff Service order No. 388-e/1, dated August 23, 2003).

The regulatory agency is the Federal Tariff Service of Russia, but when it comes to decision making, it is largely dependent on information provided by OJSC Gazprom.

In general, at this stage, the system for regulating tariffs is more transparent and adequate than it was before.

Tariffs for gas transmission through main gas lines are a component of the cost of gas sold by independent gas producers during deliveries using the UGSS.

They are a price constraint on delivery quantities and areas. But the new tariff system enables independent gas producers to deliver gas to more Russian regions than before, i.e., to make deliveries to economically beneficial regions.

Wholesale Gas Price Regulation

Wholesale gas prices are regulated in accordance with Russian Federation law N 69-FZ, dated March 31, 1999 «On Gas Supply in the Russian Federation,» Resolution N 1021, dated December 29, 2000, «On Government Regulation of Gas Price and Tariffs for Gas Transmission in the Russian Federation,» the Regulation on the RF Federal Tariff Service (adopted by RF Government Resolution N 332, dated June 30, 2004) and RF Government Resolution No 239, dated March 7, 1995, «On Measures to Regularize Government Regulation of Prices (Tariffs).»

The regulatory agency is the Federal Tariff Service of Russia (largely on paper) since in practice, the establishment of the wholesale gas prices is a political decision on the highest level with considerable pressure from OJSC Gazprom.

The wholesale gas price is a benchmark for independent gas producers, since they reference the regulate price when they set prices for gas.

Regulation of APG Prices

APG prices are regulated pursuant to RF Government Resolution No 239, dated March 7, 1995 «On Measures to Regularize Government Regulation of Prices (Tariffs).» RF Government Resolution N 332, dated April 15, 1995, «On Measures to Regularize Government Regulation of Gas and Feedstock for Its Production,» and the, Regulation on the RF Federal Tariff Service (adopted by RF Government Resolution N 332, dated June 30, 2004).

The regulatory agency is the Federal Tariff Service of Russia. In reality the RF Federal Tariff Service is an arbitrator: the situation is balanced by the monopolistic-monopsonic structure of the market — market participants prefer to reach agreement on their own.

The Federal Tariff Service of Russia has not yet developed a methodology for regulating CHG prices.

This area is of interest not to Gazprom headquarters, but to its affiliates that are directly involved in this business (Sibur, etc.).

Prices for APG affect refining efficiency and the quantities of APG that are recovered.

Gas Export

Gas export is regulated by Federal Law N 164-FZ, dated December 8, 2004 «On the Foundations of Government Regulation of Foreign Trade» and Federal Law N 117-FZ, dated July 18, 2006, «On Gas Export».

The RF Ministry for Economic Development issues exclusive gas export licenses. The RF Federal Tariff Services is the agency that issues explanations on the basis of Foreign Trade Commodity Codes and directly «releases» gas across the border.

OJSC Gazprom and its affiliates are the exclusive exporters of gas with a stake in the absence of regulations that support nondiscriminatory participate of other suppliers in gas exports (as part of the «unified export channel»).

The prohibitive standards of the law impede the expansion of the independent gas producer’s business (including construction of infrastructure) and indirectly affect the amount of super profits not received from exports.

Restriction and Cutoff of Consumers during Cold Weather Periods (Chart № 1) and in Emergencies

Users are restricted and cut off during cold weather periods and in emergencies in accordance with the «Rules for Gas Delivery in the Russian Federation» (adopted by RF Government Resolution N 162, dated February 5, 1998,), «Rules for the Use of Gas and Provision of Gas Supply Services in the Russian Federation» (adopted by RF Government Resolution N 317, dated May 17, 2002) and the «Procedure for Supplying Consumers with Gas During Cold Weather Periods and in Emergencies at Gas Transportation Systems» (adopted by RF Ministry of Energy Order N 448, dated December 16, 2002).

OJSC Gazprom defines both «cold weather periods» and «emergency.»

Neither gas suppliers nor consumers participate in the development of schedules for switching to backup fuels. As a result purchasers of gas supplied by independent gas producers may suffer.

The restriction and cutoff of consumers during a cold weather period and in emergencies is therefore one more tool for OJSC Gazprom to use in influencing the interests of independent gas producers in performing their obligations to purchasers.

Permission to Use Gas as Fuel

Permission to use gas as fuel is governed by Russian Federation Federal Law No. 60-FZ, dated March 31, 1999 «On Gas Supply in the Russian Federation,» RF Government Resolution N 832, dated October 29, 1992, «On Establishment of the Kind of Fuel for Enterprises and Fuel-Consuming Installations,» «Rules for Use of Gas and Providing Gas Supply Services in the Russian Federation» (adopted by RF Government Resolution N 317, dated May 31, 2002), «Procedure for Making Decisions on Establishing Kinds of Fuel and Fuel-consuming Installations) (adopted by joint order N 333/359/101 of the RF Ministry for Economic Development and Trade, the RF Ministry of Energy and OJSC Gazprom, dated October 15, 2002).

Technical specifications for connection to the gas transportation system are issued by the gas transportation or gas distribution organization if permission has been obtained.

A requirement for obtaining permission to use gas as fuel is the approval of gas resources by local gas supply organizations.

Regulations do not cover the sequence and procedure for obtaining technical specifications for connection and for completing the connection in sufficient detail.

The fact that technical specifications have been issued and/or permission to use gas as fuel has been given is no guarantee of obtaining access to the gas transportation/gas distribution system.

OJSC Gazprom’s approval of the use of gas as fuel determines entities’ access to the design and construction of gas-fired equipment and (or) installations and ultimately access of gas suppliers and consumers to the market for gas delivered using the Unified Gas Supply System.

2. Functions Not Codified in Regulations

UGSS Transportation Balance

OJSC Gazprom approves UGSS transportation balance pursuant to its internal procedures. OJSC Gazprom has this right because it owns the UGSS.

The UGSS transportation balance is a non-tariff regulatory tool. It affects the quantities delivered by independent gas producers (the possibility of restrictions), the determination of the gas delivery area and the expansion of business in general.

«Limits» on Gas Delivery

«Limits» theoretically are not codified in regulations, since the government regulates only price, not quantities. OJSC Gazprom determines the quantities delivered at regulated prices on its own.

According to the OJSC Gazprom order «On Distribution of Gas Resources to RF Consumers…»: «to accelerate coordination of efforts to distribute gas resources,» the functions with respect to allocating additional quantities of gas are assigned to the Marketing Department (K. G. Seleznev). That order instructs this department to purchase gas from independent organizations and develop (before October 20) a procedure for distributing gas resource.

Through limits OJSC Gazprom determines delivery quantities in the regulated and unregulated segments of the gas market on its own.

Limits indirectly have an effect on independent gas producers that may be positive if consumers pushed onto the unregulated market turn to the independent products to acquire gas.

Gas Storage

Gas storage is not yet regulated by the government, because the regulator is OJSC Gazprom.

The agency to which complaints about abuse of a dominant position can be sent is the Federal Antitrust Service of Russia. But Federal Antitrust Service of Russia reviews complaints and makes decisions on the basis of general antitrust procedures.

The government may regulate the storage price, but it is equally likely that regulation will remain unregulated.

In the near term a fairly significant influence on the price of gas sold by independent producers is expected: storage expenses will be an additional component of the price of gas that is sold.

III. ANALYSIS OF MAJOR PREREQUISITES FOR CHANGING THE REGULATORY SYSTEM

1. Domestic

It seems that the relevant internal prerequisites that might have a genuine impact on changing the system of gas regulation in the gas industry are:

? Reform of the electric power industry;

? Reform of the system for regulating infrastructure sectors;

? Public opinion in general.

Reform of the electric power industry

Reform of the electric power industry is a powerful generator of new regulatory forms (co-regulation and self-regulation) and the real driver of changes in the gas industry (the relationship between the electric power industry and gas).

The reform of the electric power industry calls for new planning horizons. Long-term forecasts are relevant: the gas balance, fuel and energy balance, regional balances.

Their place in the regulatory system must be defined and how to create them must be learned.

There is already a significant change in consumers’ attitude toward the industry. Electric companies as major consumers intend to participate in changing the structure of industry relationships — in changing the planning horizons, the concept of delivery reliability and the principles of government regulation. Reform of regulation in the electric power industry is bringing new approaches to gas industry regulation. A promising trend is the creation of a single gas energy regulator, which might become an independent center of gravity and escape OJSC Gazprom’s pressure by consolidating the significant weight of the electric companies. Ideologists promoting the creation of a new regulator see the merits of a fundamental change in the regulatory paradigm in the sense of transitioning from a set of tariff methods to a more modern set of indirect tools — service quality standards, information disclosure, mandatory risk insurance, etc.

Reform of the System for Infrastructure Industry Regulation

Since June 2005 the Federal Tariff Service of Russia has been working on developing a conceptual plan for improving the system for regulating infrastructure sectors. At present the Federal Tariff Service of Russia is essentially the only federal executive branch agency trying to implement a conceptual approach to the regulatory system.

The major proposed innovations are:

? Establishment of professional market regulators;

? Co-regulation;

? Institutionalization of consumer participation in the regulatory process (support «from below»);

? Horizontal inter-industry consolidation (not oil, gas and communications, but production, transportation, wholesale markets, retail markets).

The following positions have now been developed:

? Professional market regulators must be created (primarily in the energy industry — electricity, gas, oil):

? The creation of single-industry regulators during industry reform has been complicated by their self interest in their industry;

? A mandatory aspect of full-fledged industry reform is the reform of the industry regulatory system;

? The time has come to truly involve consumers in regulator processes (e.g., through consumer associations);

? Co-regulation mechanisms are not just desirable, but mandatory in the current economic environment given existing business traditions;

? The Federal Tariff Service of Russia is the natural base for creating full-fledged integrated industry regulators, but one might assume that the formats for creating regulators for specific industries will have their own distinct features.

Public Opinion

Public opinion plays a significant role in gas industry regulation. It is this factor that makes it possible to form and maintain a positive image of the monopoly, legitimizing its discriminatory behavior toward other participants. OJSC Gazprom’s PR budget is about US$150 million a year, which is strange for a company whose product is used by consumers who cannot change their supplier. The answer is that this money is spent to form an opinion of OJSC Gazprom in the minds of government officials as a National Treasure that is allowed more than the others.

The bargaining chip in OJSC Gazprom’s civic activities until recently has been «traditionally free» gas for the public. This enabled the company to demand concessions and compensations in all areas of regulation from the Government. But even the public knows that the monopoly’s export earnings make up for its losses on the domestic market.

One of the more significant problems in this respect is the efficiency of gas distribution projects. The formal public relevance of the projects enables organizers to largely ignore the economic basis for their future operation, which will inevitably lead to financial conflicts in the future. Investments in gasification are made without assessing the rate of return. Some $2.3 billion dollars have already been allocated to gasification projects. The average distribution tariff to cover planned costs should be more than double what they are now.

2. Foreign

Gas is a powerful foreign policy tool, and economics must often be the handmaiden to politics.

Russians gas foreign policy consists of:

• Large-scale projects must remain Russian: the objective lack of technologies is compensated by an administrative resource, of which there is no shortage.

• Gas enables Russia to dictate, not reach agreement: WTO, the Russia — EU energy dialogue, ECT (Transit Protocol);

• As a result a number of illogical premises acceptable only for the current situation have developed in the industry’s decision making process. The inevitable change in the situation will result in a significant increase in risks — new challenges.

Trends and processes in the EU and USA generally have an indirect influence on the changes in the regulatory system in Russia: it is this experience that the Federal Tariff Service of Russia relied on in starting work to develop a conceptual plan for improving the system of infrastructure regulation.

In the current situation, therefore, external factors cannot have a direct effect on domestic Russian processes. Their influence can be only direct and intermediary: given the positive perception of foreign experience, it may be incorporated into the Russian regulatory system.

IV. CONCLUSIONS: PROSPECTS FOR THE EVOLUTION OF THE GAS INDUSTRY REGULATORY SYSTEM: KEY FACTORS AND RISKS FOR INDEPENDENT GAS PRODUCERS

1. Tactical Forecasts and Scenarios Following Gazprom’s Traditional Logic:

Since, as already stated and justified in the previous sections of this report, OJSC Gazprom’s regulatory agency is based on the tactical model «Threat — Response,» we can imagine the following tactical scenarios:

? Exxon plans to start exporting gas to China under the PSA: the Law on Export Pipeline Transportation is revived to prevent construction of the export gas line;

? Liberalization of the electricity market; execution of long-term gas contracts; approval of the general structures of the gas and energy industries, forecasts for growth in demand and mechanisms for «winter» coordination: codification of the fuel/energy balance; an increase in requirements for a backup fuel;

? Shortage of technologies to develop the Shtokman field and the shelf and to build the Northern European gas line, transit problems, etc.: the regulatory structure to regulate the access of foreign companies to Russian resources.

2. Strategic Scenarios:

Strategy 1

Participate in the development of the Energy Regulator through the electricity market:

? Formulate consistent principles for market operation;

? Transfer the principles to the gas industry through the Energy Regulator.

Strategy 2

Focus on tomorrow’s business. For example, develop depleted fields, recover APG:

? Formulate regulatory standards in an environment of the indulgent attitude toward Gazprom;

? Introduce «pre-emptive» regulation — before Gazprom takes an interest.

Strategy 3

? Carefully monitor regulatory processes to prevent risks to existing business;

? Diligently introduce market principles in Government documents under development (Trading Rules, Accounting Rules, etc.).

These strategies can be implemented both in succession and in parallel, depending on priority goals and resources.

3. Detailed Forecasts

Configuration of Regulatory Agencies

With respect to the configuration of regulatory agencies, events may unfold in two ways:

? Creation of an energy ministry (and possibly a regulator);

? Creation of an energy regulator at the Federal Tariff Service (electricity, gas and oil).

RAO UES is promoting the first option and opposing the creation of a regulator, since it plans to establish a powerful wholesale market self-regulator — a Market Board — which will «oppose the functionally atomized, weak regulatory agencies (Russian Ministry of Energy, Federal Tariff Service of Russia, Federal Antitrust Service of Russia, Rostekhnadzor of Russia)»[2].

The second option is harder to implement, but possible. But except for the Federal Tariff Service of Russia, no one really has a stake in this process.

Methods of Regulation:

The plans are to transition from obsolete methods of regulation to more advanced ones (electricity, communications, etc.). This may also affect the gas industry.

Wholesale Prices:

Access

As stated earlier, OJSC Gazprom artificially created the access problem.

In this environment the problem cannot be solved through additional investments or the establishment of fair quotes. The scale of the advantages offered by the initiators of the «investment access» paradigm is incomparable to the actual additional income that the company will receive from its monopoly position in this area.

An academic solution to the access problem lies in strict and public procedures of antitrust regulation — oversight and prosecution. But at present the government is currently dominated by the concept of centralized management, under which the strategic goals of introducing marketing procedures are sacrificed to the tactical manageability of the industry to obtain immediate results.

The real solution to this problem lies in legitimizing the existing gray market for capacity. The independent producers and resellers of gas (more than 30 companies) obtain access to the transmission infrastructure each year through an opaque system of agreements. Legitimizing the capacity market and raising the cost of access services to the level of effective demand will shift the problem from an environment of bribery and corruption to a transparent and predictable business.

Access to export capacities is a special adjunct to the access problem. After all, this involves not just selling gas abroad, but also transmission to the point of sale. The adoption of the prohibitive Law «On Gas Export» left no prospects for regulation of natural gas export. The theoretical possibility of developing regulatory mechanisms for «fair» export conflicts with OJSC Gazprom’s unwillingness to share its export earnings. The opinion that «a steep fall in export prices will turn a right into a duty» is popular among industry participants. But in reality the monopoly now has sufficient tools to interpret the Law as an exclusive right, not as a duty. Current contracts and laws may be legitimately reviewed if there is enough incentive, which a steep drop in prices on the domestic market might turn out to be. It is still generally believed that a rise in domestic prices above export prices is politically intolerable. But this is a matter of habit.

In 2-3 years the situation will change fundamentally and in the worst case scenario OJSC Gazprom will easily prove to the Government the need to seek significant major investments, including at the expense of the domestic market.

Tariff Trends

The core of the targeted model of government regulation in the industry is regulation of a unified tariff for gas transmission — this is the tool that the government will use after 2011. The growth trend of the transmission tariff does not reflect a rise in actual costs in this industry as much as it is a consequence of the paradigm shift in the operator of the gas transmission system. Previously, gas transmission was a service ancillary to gas sales, but in the future it will begin to look more like an independent business, which will encourage an increase in the transparency and adequacy of cost allocation.

Transmission tariff

One step in this process is the adoption of a methodology for calculating the gas transmission tariff. The new methodology introduced a basis for objective calculation, but still cannot eliminate a myriad of problems related both to the adequacy of the data and to principles of cost allocation used in this field.^[3] As a result there is reason to expect a rise in the tariff from $1.50 to $2 per 1000 m² per 100 km.

The uncontrollable increase in the costs of natural monopolies, which exceeds the inflation trend, creates a situation in which the Government will be forced to stop recognizing declared costs. The curve representing the rise in tariffs should reach an economically valid plateau, and possible at some point start to decline under the pressure of market factors and antitrust mechanisms. The Government’s strategy will be aimed at encouraging long-term tariff agreements among industry participants.

End Users

Retail Prices to the Public

 

Ratio of gas sent through systems to their length

Market Sectors

The market structure will undergo significant changes in the near future. Unregulated and regulated sectors will be converted to «long-term,» «public» and «others.» The gray market will shrink slightly, but will remain relevant because of the existence of different markets for the same commodity without a legal possibility of crossover. Surpluses in the long-term sector will significantly increase spot trading volumes.

The new owners of power plants will understand that the profitability of the power generating business depends on the price of fuel. A sensitive electricity market will force energy company management to find opportunities to optimize deliveries, such as seasonal price differentiation and active transactions on the gas spot market. These changes in the strategy and tactics of a key consumer on the fuel market will necessitate a qualitative increase in delivery contract flexibility, the spinoff of the natural gas storage business and the introduction to the market of hedging derivatives linking the prices of gas and electricity and other factors, e.g., weather. The next step might be the implementation of cancelable contracts as a form of mutual beneficial relations between the producer and consumer in an environment of mutual uncertainty. In any case, solving the problem of delivery contract flexibility will require that the problem of access to the gas transmission system be solved.

4. Recommendations

Participants’ interests. Scenarios for the industry’s development and their consequences. Putin as key factor in the industry’s future. Forecast of challenges and responses. Options for businesses and regulatory strategies.

The critical forecasting factor in this situation is the size of effective demand for gas. Today the industry is not ready to satisfy a significant increase in demand. The best case scenario therefore is the «moderate depression» scenario («Inertia» in the terminology of the Ministry for Economic Development and Trade), when a slight increase in demand accompanied by approved limits for a price rise enables the industry to further develop in a «black box» environment, meeting external requirements. A profound economic decline will result in a shortage of financing and a crisis in the industry. A sharp economic spurt will lead to the same consequences, but through an abrupt increase in the demand for gas and the need to develop the expensive deposits of Yamal and Russia’s Northern Shelf.

In this forecasting environment, the key driver of the industry’s development will be the personage of V. Putin and his team. The hypothesis is that Putin does not intend to let go of control over the industry even after the presidential elections, regardless of their result. A new model of industry management will inevitably develop — the old, existing model is inadequate to the economic realities and the current management goals.

Preparation of the regulatory framework for the transition to the new model is now being completed. Specifically, any significant threats to OJSC Gazprom’s position are cut off on the level of laws, decrees and other government documents. The remaining documents should be approved shortly before the elections. This will be the «next-to-last» spurt in industry regulation. The last, more dynamic spurt can be expected right after the elections.

Recommendations for the behavior of industry participants depend heavily on their long-term strategies and the degree of their immersion in the industry businesses. Nevertheless, there are a number of universal recommendations.

1. An active position on the regulatory playing field in the near term will be risky. An increase in danger will be perceived as a challenge requiring an immediate response. The use of high-level tools may result in an unnecessarily harsh response to inoffensive suggestions.
2. The process of preparing for a change in the industry management model has begun on many levels. The changes are often not managerial, but intuitive — the people implementing them try to guess the will of the «managers.» This situation requires especially careful monitoring of the industry environment to regularly forecast the immediate future and lower the risk of inadequate business decisions.
3. If one assumes that the format of the new management model has not yet been cast in stone, there is a possibility of introducing meaningful elements into it. In the early stage the lack of competence in regulation allows using such plans, structures and techniques where the ideology does not conflict with the main goal, i.e. the change of the management model. There is merit in starting to develop new drafts of regulatory documents on the level of anonymous «participant opinions.»

Related Trends

«There has been a super-transaction in the interests of our global competitors, and we have to figure out who led us into this abyss with such incompetence. By 2010, when some technical procedures have been developed, our competitors with their standards will be on the Moon,» said Mikhail Fradkov at the April 13, 2006 meeting of the RF Government on implementation of the Law «On Technical Regulation.» Nevertheless, Shell Oil Company spends about US$8 million a year on international standardization, BP, US$6 million. This is beneficial, since foreign companies receive 20-40 units of profit for each unit of these costs. In Germany from 1960 through 1990 the use of effective standards accounted for one-third of the country’s annual economic growth. In European countries the effect of standardization is about 1% of national GDPs.

Russia still has not tapped the opportunity to establish new industry rules through law — the opportunity afforded by the Law «On Technical Regulation.» OJSC Gazprom is clumsily trying to monopolize the development of technical procedures, but the shortage of qualified personnel and the lack of significant threats keep the monopoly from forcing these issues. The following procedures are already being directly discussed: «On Safe Production, Transport and Storage of Oil and Gas,» «On Safety in Gas Production Processes and Supply Systems» and «On Safety in Long-distance Pipeline Transport, Intrafield and Local Distribution Pipelines.» The last procedure directly pertains to the following aspects of standardization:

? Pipeline calculation and classification;

? Rules for access to construction;

? Requirements for materials and structures;

? «Other forms of safety» as a cost element;

? Environmental requirements.

Appendix 1: Current regulatory agenda of OAO Gazprom and the positions of federal executive agencies

#	1. Regulatory system
1.1. Price regulation	Wholesale price	OAO Gazprom	FTS[4]	Min. Economic Dev.	Minpromenergo
		§ Backs net-back pricing; arguing for maximum prices. The point of contention is whether to introduce maximum prices for «new» customers;§ Fastest liberalization of gas prices for industrial consumers;§ Raising gas prices according to the «schedule» laid out in the Government resolution until 2011;§ After 2011 moves from government regulation of prices to regulation of tariffs for gas transport.	§ Supports the position on maximum prices for new customers: prices above regulation, net-back calculation.	§ Opposes higher prices for new customers;§ Previously held a different position, changed after a personal directive from G. Gref.	§ Agrees with Gazprom and FTS on certain conditions:More lenient regulation methods with respect to «new» gas consumers must be a component part of the bundle of regulatory acts for supplying the national economy with electrical power and gas. Therefore no negotiations of any edict proposed by the Government’s that includes standards for softer regulation methods for «new» customers can take place outside the framework of the entire bundle of regulatory acts concerning long-term contracts for supply and transport of natural gas, taking into consideration Minpormenergo’s suggestions toward improving the methodology of determining free capacity of the gas transport system.

#	1. Regulatory system
1.1. Price regulation	Associated petroleum gas prices	OAO Gazprom	FTS	Min. Economic Dev. Minpromenergo	President’s Administration	Ministry of Natural Resources
		§ Backs the abolishment of price regulations on associated petroleum gas (APG) (Sibur and OAO Gazprom)	§ Plans price increase on APG. The decision had to be carried out before April 2007. By that time FTS also intended to make amendments to the Government’s regulatory acts, which would allow FTS tp determine proce levels on Associated petroleum gas (according to a Methodology that is also yet to be confirmed). Previously this fell under the jurisdiction of the Ministry of Economic Development’§ Understands that even if regulation is abolished it will not solve all the problems in this sector, and companies will still seek their services.	§ Planning operations for recycling of APG (Min. Econ. Dev. with the support of Minpromenergo);§ Presently Min. of Economic Dev. is drafting proposals for: implementing obligatory recycling of APG, setting an extraction tax on APG (currently APG is not taxed on this account), and providing support for capacity development of APG refining (including gas-chemistry). These proposals will be sent to the Government within the next few days.	§ Drafting a commission for M. Fradkov on the need for a unified system of measures, with the aim of raising the effectiveness of APG use; for determining a concrete timeframe for their implementation (up to three years), as well as for facilitating a public discussion of the proposed complex of measures	§ Charged by the President’s Administration with preparing materials on the issue of recycling APG. Carried out the charge, with appropriate materials sent to the President’s Administration. Currently drafting the President’s commission to the Government on the same issue.

#	1. Regulatory system
1.1. Price regulation	Liquefied hydrocarbon gas prices	OAO Gazprom and Independent producers of natural gas	FTS	FAS	Min Econ Dev Minpromenergo
		§ Supports the abolishment of price regulations on liquefied petroleum gases (LPG) and the so-called «balance targets»; however, at this stage (especially considering the gradual increase of regulated prices on LPG) these issues do not really «trouble» Gazprom too much.§ Support for the abolishment of «balance targets» from some of the independent producers;§ Other market players: regulation of LPG must be preserved	§ The abolishment of price regulation of LPG and «balance targets» is outside FTS jurisdiction;§ Raising the regulated price on LPG is a possibility: this will bring it even closer to the unregulated market price;§ Plans to review LPG regulated price in 2008.	§ Preparing arguments for the abolishment of balance targets on LPG (with active participation of SIBUR and Gazenergoset: i.e. the monopoly holders in the sector);§ The arguments are pretty old: any one of the previously concocted (toward «projects» for the abolishment of balance targets, which continually popped up among various agencies some time ago) will do just fine;§ There is no guarantee that the balance tasks will be abolished in the election year;§ An «evolutionary» development (where the FTS gradually raises the regulated wholesale prices of LPG) may be more effective than any overt declaration of the need for the abolishment of balance targets (whatever arguments are adduced in its favor)	§ Wait-and-see position.

	#	1. Regulatory system
1.2. Regulation of tariffs on mainline transportation for independent producers		OAO Gazprom	FTS	Min Econ Dev Minpromenergo
		§ Dual-rate tariff with obligatory payment for capacity;§ Declared increase in gross yield up to 40-50 rub ($2) for 1000 cub. per 100 km (expressed verbally only);§ An unwillingness to raise gas transport tariff at the same rate as the gas prices. This is also unattractive for Gazprom, since it makes use of transportation services in other countries and in setting tariffs there takes its cue from the cost of transport in Russia. Therefore, the plan is to raise the tariff to average European rates and stop there.	§ Plans to raise the tariff to 13-13.1%;§ A three-year plan on raising gas prices is possible (this is a political issue), but setting a tariff for mainline gas transportation for a similar period does not appear justified without substantiating documentation.[5]§ OAO Gazprom must furnish all appropriate information necessary for carrying out regulation decisions.	§ No clearly defined position;§ The rate of tariff increase should not exceed the rate of regulated wholesale price increase on natural gas.

№	1. Regulatory system
1.3. Access to distribution networks	OAO Gazprom	FAS	Min Econ Dev	Minpromenergo
	§ Preservation of the existing system, which contains the declarative «Disposition on access of independent companies to the Gazprom distribution network,» what amounts to a contractual access mode, and investment access without guarantees;§ Categorically opposes any initiative that runs contrary to this position.	§ Formulation of transparent and detailed «rules of access». A resolution has been drafted, titled «Concerning the procedure for non-discriminating access to distribution networks»; this document contained new concepts and categories along as well as detailed accounts of existing rules. This concerns especially:1.Definition of «available capacity»;2. Procedure for «balancing distribution networks»;3. Rules for physical connection to distribution network;4. Standards for disclosing information to owners/operators of distribution networks.§ Participation of independent companies (producers, distributors) in the development of gas distribution systems, which requires detailed and transparent guidelines.	§ Endorses the draft of the Government resolution «Concerning the procedure for non-discriminatory access to distribution networks» drafted by the FAS	§ Endorses the draft of the Government resolution «Concerning the procedure for non-discriminatory access to distribution networks» drafted by the FAS, but «in exchange» for the endorsement of the Government resolution «5+5»;§ Possible blocking of the said resolution at the stage of ratification by Minpromenergo in case «secondary ratification is required from other ministries.

#	1. Regulatory system
1.4. Structure of the natural gas market	General conceptual approach	OAO Gazprom	FAS	Minpromenergo	Min Econ Dev
		§ Generally plans to imitate the model of a single transport route on the domestic market: all gas is purchased at the well, then sold by various entities within OAO Gazprom	§ «Concerning the development of the natural gas market in the Russian Federation, stating the general position on the following issue: the two-sector market model: regulated and non-regulated (direct agreements, gas trading on an exchange board and stock trading) segments. The regulated segment is being gradually diminished, according to the «program,» sponsored by the Government	§ A three-segment market model was proposed in October 2006, which includes a regulated segment, a free trade segment (spot market) and a supply segment based on long-term contracts; the size of the latter is correlated with the size of the free trade segment (where it concerns electrical power) and with the excess of the volume of potential demand for gas over predicted volumes within the limits of supply (where it concerns production)	§ Does not support the strategy of dividing the domestic market; Supports a single market with equal rules for all participants.

#	1. Regulatory system
1.4. Structure of the natural gas market	Long-term contracts	OAO Gazprom	Min Econ Dev	Minpromenergo
		§ In favor of the framework regulation of this issue: all major positions may be deliberated in a bilateral agreement mode;§ Position on specific agreement conditions formulated as follows:§ timeframe: three years and up with possible extension. The minimum term equals the period for which the following are constructed: projected gas balances, financial plans and investment programs, as well as predictions of the nation’s socio-economic development (main indicators of activity in the energy sector, government financial plans), as well as the parameters of change in regulated wholesale prices on natural gas;§ annual supply volume may not exceed the volume licensed to be used for fuel;§ take-or-pay condition: full payment on declared volume even if not actually consumed§ annual, quarterly, monthly, daily (and possibly hourly) «limits» on gas offtake. Higher rates must be imposed on gas consumed «over the limit» in fall-winter; these rates depend on reserve fuel prices: 10% above reserve fuel prices; § reserve fuel component in the daily fuel balance of energy at power stations depends on outside temperature in the region	§ A resolution was drafted, concerning the issue of long-term contracts;§ Priority of access to pipelines should be given to long-term contracts (synchronizing supply term with access and physical connection) and institution of mutual financial guarantees between transport company and gas supplier.§ The following should be stipulated in contracts between consumers, independent producers and owners of transport infrastructure: Term of the agreements: 3 yrs.; Schedule of supply and withdrawal (volumes per units of time, with what accuracy; or contractual pressure at the gas metering station in time Mutual financial guarantees between supplier and consumer; Conditions of interruption/non-interruption of gas supply (coordinated with the transportation agreement); Gas metering mechanism; § A special series of obligations must be evolved within the framework of gas balance, and their special role in gas balances determined.	§ Ceased blocking the resolution concerning long-term contracts, drafted by the Min Econ Dev, on the condition of introducing into it paragraphs charging ministries and agencies with working out specific issues related to long-term contracts..

#	1. Regulatory system
1.4. Structure of the natural gas parket	Development of the non-regulated sector (trading floor)	OAO Gazprom	Minpromenergo	FAS	FTS
		§ In favor of increasing gas volumes traded on the Mezhregiongaz trading floor; also in favor of allowing companies affiliated with Gazprom to trade on this floor as independent players (specifically because independent participants do not have enough gas to fulfill established parity for trade volumes)§ In favor of passing a resolution to continue trading on the Mezhregiongaz board in 2008, and scrapping parity volumes set for independent producers and Gazprom (50/50); also in favor of granting the government (or an authorized government agency) the right to set traded volume ratios between Gazprom and independent producers on electronic trading sites.	§ In favor of increasing gas volumes traded on the Mezhregiongaz board of trade as early as 2007 (no fewer than 15 billion cubic m for 2007, earlier figure was 10 billion cubic m);§ Wait to evaluate the question of continued trading on the Mezhregiongaz board till late 2007;§ Proposing to include gas traded by companies in which Gazprom has a less than 50% stake in a «quota» set for independent suppliers (Gazprom agrees)§ In general, using its authority as a mechanism of «trade-off» (e.g in approving the investment program for Gazprom) and for «political points.»	§ In late 2005 drafted a resolution «Concerning the development of the natural gas market in the Russian Federation,» which stipulated the following conditions in relation to the trading floor:§ A trading floor is set up by a all participants of the non-regulated natural gas market; is equally dependent on all participants and government agencies evolving the conditions of its operations based on the principle of consensus.§ Companies affiliated with Gazprom are prohibited from acting as independent traders;§ Economic entities in the role of a guaranteeing supplier are prohibited from participating in organized gas trading;§ The share of gas traded by various entities within Gazprom depends on the conditions for maintaining competition between suppliers and preventing the possibility for abusing a dominant situation in this sector of the market.	§ Predicts gas trading to reach 30-40 bil cubic m in 2011. Talks of changing the principle of parity are premature: there is not enough information to make concrete decisions. The main purpose of the Mezhregiongaz trading floor is to ensure the execution of contracts already made between Gazprom and independent contractors. The trading system may be developed by virtue of increasing balance points, where gas is sold (by adding outlets for underground storage tanks to the list of said points — for the winter months).

#	1. Regulatory system
1.4. Structure of the gas market	Retail market	OAO Gazprom	FAS	FTS	RF Ministry of Regional Development
		§ In favor of direct contracts with residential consumers without any sort of middlemen. Systematically pushed out of the retail market by distribution companies and other middlemen (management companies).§ In favor of setting regulated consumption levels (for all consumers). A corresponding resolution is already in place, as of 2006 (drafted by Gosstroi, currently in the RF Ministry of Regional Development system);Continuing to further consolidate LDC assets (under the auspice of Gazpromregiongaz).	§ Repeated attempts to defend LDCs that were effectively barred from trading by Gazprom and its regional affiliates. Corresponding cases «made it» as far as the Supreme Arbitration Court, which finally refused to re-open the case;§ In the course of the consolidation of gas distribution assets of Gazpromregiongaz handed down an order for the separation of types of activity. But the order was contested in court and eventually found unlawful;§ In the course of the transaction§ During the acquisition of Nortgaz assets handed down an order prohibiting Gazprom from acquiring gas-extracting assets. This order, however, was found unlawful in court	§ Regulation of fees for supply-sales services, which is set by gas suppliers only;§ Systematic implementation of regulatory requirements for separate accounting of different activities (sales, transportation, etc.)	§ Supports the position of Gazprom on regulated consumption levels. Resolution 373, passed on 6/13/2006, establishes regulated levels of consumption for residential consumers where gas meters are not available. The resolution was drafted by Gosstroi (currently in the system of the RF Ministry of Regional Development

#	1. Regulatory system
1.5. Natural gas export	OAO Gazprom	FAS	Min Econ Dev	Minpromenergo
	§ Not interested in any sort of detailed rules for gas export within the framework of a «single export channel»§ LPG is not of critical importance. Therefore, Gazprom has very little interest in it; however, entities within Gazprom are interested in it;§ The goal of «greater» Gazprom is monopolization of LNG supplies	§ LPG must be delivered to the market otherwise than through the «single export channel.»

#	2. Individual components of the added value chain generation
2.1. Extraction of natural gas	Strategic deposits	OAO Gazprom	Minpromenergo & RF Ministry of Natural Resources			General liberal stance
		In favor of restricting access to all foreign companies and all domestic companies with the exception of Gazprom itself.	§ In favor of restricting access to all foreign companies and all domestic companies with the exception of Gazprom and Rosneft.			§ Minority share of foreign companies is acceptable.
	Continental shelf	OAO Gazprom	RF Ministry of Natural Resources	General liberal stance
		§ In favor of independent exploration: contention with RF Ministry of Natural Resources.	§ Exploration to be conducted by «special» government company.	§ Russian companies lack necessary technology: outsourcing to foreign companies is inevitable.
	PSA	OAO Gazprom	RF Ministry of Natural Resources	Minpromenergo	RF Ministry of Finance		Min Econ Dev
		§ In favor of expanding PSA model: extending it to the continental shelf (Shtokman and Prirazlom deposits)	§ No clear position, since the authority to set compensation sums paid by investors to the government in connection with prospecting and exploration of natural resources within PSA framework has only recently passed to the RF Ministry of Natural Resources.	§ Supports Gazprom and Rosneft positions.	Opposes PSAs (as least effective for the budget). There is, however, an understanding of the difficulty to determine the advantages or disadvantages of PSAs for the government budget.		§ Against new PSAs (in general), judging them economically not viable for the government.
	General strategy for Extraction	OAO Gazprom	Minpromenergo	RF Ministry of Natural Resources
		§ Actual control over the sequence of developing deposits§ Control over the gas segment of the Central Development Commission; would like to continue exercising this control	§ Formal endorsement of the strategy for industry development, including production.	§ Wants to control regulated losses, APG§ Due to current lack of funds there are plans to hand over the operations on regulated losses to NP NAEN (an organization of extractors, based on principles of self-regulation)

#	2. Individual components of the added-value generation chain
2.1. Extraction of natural gas	Energy strategy of the RF and the master plan for the development of the gas industry	OAO Gazprom	Minpromenergo[6]
		§ No one except for Gazprom is capable of developing a full-fledged Master plan for industry development (partly for the lack of all relevant information)§ Is the «coordinator» of the Program of development of Eastern Siberia (by Order 975-r, of 7/06/2002);§ Essentially dictates where and in what order fields are developed (by virtue of EGSS connection and transport balances through the UGSS).	§ Possess formal authority in this sector;;§ There are regular conflicts with Gazprom over failure to hand over appropriate documentation;§ A new nuance has been to the conflicts: the Ministry was harshly rebuffed when it offered to act as coordinator of master plans for the energy sector.

#	2. Individual components of the added-value production chain
2.1. Extraction	Taxation: Extraction tax	OAO Gazprom	RF Ministry of Finance	Min Econ Dev
		§ Opposes RF Ministry of Finance’s proposal to raise extraction tax on gas;§ There are several reasons for this disagreement:1. At his stage Gazprom has to pay $7.5 billion for Sakhalin-2, which was acquired strictly for political reasons;[7]2. With Extraction tax raise it is impossible to arrive at «equal profitability» of the domestic and export markets.[8]	§ In favor of raising the Extraction tax for the following reasons:1. Budget deficit;2. Extraction tax has not been revised since 2005.	§ In favor of raising the Extraction tax for the following reasons:1. OAO Gazprom spends its surplus profits ineffectively. The government, excising them as taxes, could spend them more effectively;2. The current rate does not take into account equal profitability with export.§ Proposed: raising Extraction tax on gas to 315 rub in 2008 (currently 147 rub); to 480 rub in 2009; to 735 rub. in 2010. There are, however, deposits (depleted cenomanian, valanginian), where the net cost of extraction amounts to 500 (500 rub/1000 cub m). It is, therefore, proposed to differentiate the higher Extraction tax according to geological and other factors;§ Assessments show that money appropriated from Gazprom could amount to 80% of revenue generated by raising tax prises on the domestic market.

#	2. Separate components of the the chain of added-value production
2.1. Extraction	Taxation: export duty	OAO Gazprom	RF Ministry of Finance	FAS
		§ Actively participated in the changes implemented by RF Ministry of Finance in the «Rules for determining customs value of products, moved outside the customs territory of the Russian Federation» (confirmed by Order 500, 8/13/2006);§ Supported the position that allowed for subtracting internal transportation costs from customs duty (including that on gas). The specified norm was later repealed.	§ For some time entertained the possibility of lifting regulation of export duty for the general basket of petroleum products, leaving only the basic products (fuel oil, diesel fuel and gasolines);[9]§ Reviewed the «Rules for determining customs value of products, moved outside the customs territory of the Russian Federation» in accordance with the admission requirements of the WTO in August of 2006;§ The passage, following deliberation, of Government Order 500, 8/13/2006, which dictated standards for subtracting internal transportation costs from customs duty for all products (including gas);§ Subsequent amendment, exempting the products transported by pipeline or electric networks from article 16 of the said Order (step back from general unification and resumption of the «old system» of regulation. The changes were retained for other products since they did not play as significant a role as gas in filling the budget.	§ The main opponent of customs duty regulations. Insists on:- establishing seasonal customs duties for LPG export;- lifting the regulation on remaining petroleum products should be coordinated with FAS, since it would otherwise upset the balance of interests (unclear whose).

#	2. Individual components of the added value chain generation
2.2. Mainline transportation of natural gas	OAO Gazprom	Federal executive agencies
	§ Tacit declaration: mainlines must remain in possession of state companies. This position is maintained in the Law «On Gas Export Pipelines.»	§ Federal executive agencies have no expressed positions: everyone is «buddies» with Yazev;§ Minprom, Ministry of Economic development, FAS are not happy with the definition of available capacity. The resolution on non-discriminatory access drafted by the FAS contains a definition of available capacity, based on a different principle.

#	2. Individual components of the added value chain generation
2.3. Storage of natural gas	OAO Gazprom	FAS	Min Econ Dev
	§ Recent emergence of the company Gazprom-UGS is likely to result in a set rate for gas storage in the near future;§ It may be assumed that this type of activity will be state regulated.	§ Statements about the need for state regulation of storage activity and non-discriminatory access to UGS. However, such statements have substance behind them so far (in terms of examined cases of anti-monopoly violations and subsequent decisions).	§ This issue is not thought to be sufficiently relevant as of this time.

#	2. Separate components of the the chain of added-value production
2.4. Access to mainlines	OAO Gazprom	FAS
	§ Gazprom’s objections to the resolution drafted by FAS «Concerning non-discriminatory access to gas transport systems»;§ Accommodating the objections would mean a radical reworking of the document and retention of existing principles: FAS is not ready to accept this;§ All manner of opposition from Gazprom to the passage of this document, at least until long-term agreements are formulated and made in the natural gas market;	§ The draft of the resolution «Concerning non-discriminatory access to gas transport systems» was sent back by the Government Office (despite its being coordinated with interested agencies) with instructions to revise, accommodating Gazprom’s objections and suggestions;§ Preparation of a protocol of differences with Gazprom, which FAS (I. Artemiev) offered to Gazprom (A. Miller) at the bilateral talks. Gazprom refused to sign the protocol; at least not until long-term agreements are formulated and made in the natural gas market;§ Evidently, the resolution will not be passed in the near future.

#	2. Individual components of the added value chain generation
2.5. Access to end-user	OAO Gazprom	FAS	FTS
	§ Plans to make available a number of terminal pipelines with mainline status and charge additional fees for distribution services;§ Not interested in the passage of a regulatory act, regulating the order and procedure of connecting to distribution networks (so far this is a blank spot in legislature and the decision rests with the owner, i.e. the appropriate regional affiliate of Gazprom).	§ It was previously supposed that the prepared draft of the resolution on access to mainlines will also extend to distribution networks;§ However this idea had to be scrapped in the planning stages of the resolution;§ At this stage the FAS still speaks of the initiative of developing a new resolution on non-discriminatory access to distribution networks (with similar expansive content as in the resolution on non-discriminatory access to export gas pipelines); however, a more realistic conclusion is likely to be a series of amendments to the current position, dealing with establishing the order of physical connection to distribution networks (analogous to the one in existence for electrical power)	§ Sets the fee for physical connection to electrical power networks (since the investment program was designed with this fee in mind); however, an analogous fee was not included in the design of the investment program for gas as a source of funding;§ An initiative in this respect is so far lacking;§ View negatively LDC initiatives toward differentiation of distribution networks into high-, middle-, and low-.

Appendix 2. Analysis of elements of a regulatory system having a direct effect on independent producers of natural gas (regulation norms, role of regulatory agencies, Gazprom’s influences, including bylaws)

#	Function name	Reasons for regulation, regulating agency	Specific features of actual regulation		Effect on independent gas producers
Functions formalized within the regulatory sphere
1.	Physical connection to UGSS transporting capabilities	§ Gazprom’s local regulatory acts. Resolution 200, 9/03/2003 «On Issuing of Technical Specifications»;§ The «rules of the game» have changed since July 2002: technical specifications are no longer supplied by transportation networks, but by Gazprom;§ Gazprom is the regulating agency for the entire process; FAS accepts complaints about abuse of dominant position. Measures taken by the agency, however, amount to general anti-monopoly procedures.		§ The time required to process a request for technical specifications; and§ Frequent changes in the corporate procedures for processing requests for technical specifications;§ Changes and additions may be made to technical specifications already supplied;§ Complex procedure for implementing coordinated projects of connecting to the UGSS.	§ A means of non-tariff regulation and exertion of influence;§ Limitation on volumes of supplied gas and control over business expansion.
2.	Access to gas transportation networks	§ Law 147-FL of 08/17/1995 «Concerning natural monopolies.»§ Resolution on providing independent companies with access to gas transportation networks Gazprom» (Order 858 of 07/14/1998)§ Gazprom’s local regulatory acts: resolution on the procedure for drafting and issuing access licenses to Gasprom transportation system to independent companies (confirmed by the Chairman of the Board on 02/15/1998; amended in 2001); the application procedures are also specified in this act;§ FAS provides control and oversight ex post based on general anti-monopoly laws (par 5.3.1.3. Resolution concerning the FAS)§ there is no regulator for access-gaining procedure ex ante, or detailed and/or transparent rules of gaining access.		§ Gazprom is the effective regulator, determining available capacity and establishing internal procedures;§ Negotiated, rather than regulated, access.	§ A means of non-tariff regulation and exertion of influence;§ Limitation on volumes of supplied gas and control over business expansion;§ Determining the «area» of supplies;
3.	Tariffs on mainline transportation	§ Law 147-FL of 08/17/1995 «On Natural Monopolies.»§ Resolution concerning the FTS (ratified by government order 332 on 6/30/2004);§ «Method for calculating tariffs on mainline transportation services» (ratified by Order 388-e/1 of the FTS on 8/23/2003);§ Regulated by the FTS.		§ The regulatory agency depends to a large extent on information supplied by Gazprom in its assessments;§ Overall, the current system of tariff regulation is far more transparent and adequate than the preceding one.	§ Component of the gas price realized through the use of UGSS;§ Price limiter of volumes and «area» of supply. The new system of tariffs, however, allows independent companies to deliver gas to more localities throughout Russia than before, making deliveries to new localities economically profitable.
4.	Regulation of wholesale prices	§ Federal Law of the RF 69-FL «Concerning natural gas supplies in the RF» of 03/31/1999;§ Resolution concerning the FTS (ratified by government order 332 on 06/30/2004);§ Government Order 239 «Concerning the measures for ordering government regulation of prices (tariffs)» of 3/07/1995;§ Regulated by the FTS (to a large extent only formally).		§ in practice this amounts to a political decision at the highest level under considerable pressure from Gazprom.	§ A benchmark for the non-regulated sector.
5.	Regulation of prices on Liquefied Petroleum Gas	§ Government Order 239 «Concerning the measures for ordering government regulation of prices (tariffs)» of 3/07/1995§ Government Order 332 «Concerning the measures for ordering government regulation of prices on gas and raw material for its production», of 04/15/1995;§ Resolution concerning the FTS (ratified by government order 332 on 06/30/2004);§ Regulated by the FTS.		§ The situation is balanced by the monopoly-monopsony structure of the market;§ Interests of Gazprom affiliate structure;§ There is no methodology in place for formulating prices on liquefied petroleum gas;§ FTS acts essentially as arbiter; the sides negotiate independently.	§ General conditions of supply and processing§ Effectiveness of processing; having an effect on the volumes of recycled gas.
6.	Export of natural gas	§ Federal law 164-FL «Concerning government regulation of external trade activity»’ of 12/08/2003;§ Federal law 117-FL «Concerning the export of natural gas» of 07/18/2006;§ Ministry of Economic Development is the agency charged with issuing licenses for the exclusive right to export naturals;§ FTS is the agency that interprets the Code of the Classification of Goods and essentially «lets the gas through» the border.		§ Gazprom and its affiliated structures are exclusive exporters;§ There are no bylaws ensuring non-discrimination of other suppliers in participating in gas export (within the framework of a «single export channel.»).	§ Control of business expansion (including developing infrastructure) and of «unobtainable» surplus profits from export.
7.	Limiting and interruption of service during periods of cold weather (Timetable 1) and emergency situations	§ «Guidelines for supplying gas in the Russian Federation» (ratified by government Order 162 of 02/05/1998;§ «Guidelines for gas use and offering gas service in the Russian Federation (ratified by government Order 317, of 05/17/2002);§ «Procedures for supplying gas to consumers during periods of cold weather and emergency situations on transportation networks» (ratified by Order 448 of the MinEnergo on 12/16/2002.		§ What constitutes «cold weather» and «emergency situation» is determined by Gazprom.§ Neither gas suppliers nor consumers are involved in setting schedules for switching to reserve fuels.	§ As a result, the consumer of natural gas, supplied by, among other, independent companies, may suffer.
8.	License to use gas as fuel	§ Federal Law of the RF 69-FL «Concerning natural gas supplies in the RF» of 03/31/1999;§ Government Order 832 «Concerning the procedure for determining fuel type for businesses and fuel-consuming installations» of 10/29/1992§ «Guidelines for gas use and offering gas service in the Russian Federation (ratified by government Order 317, of 05/17/2002);§ «Procedures for preparing the decisions on setting determining fuel types and fuel-consuming installations» (ratified by joint Order of Ministry of Economic Development, MinEnergo and Gazprom on 10/15/2002, 338/358/101).		§ Technical specifications for connection are issued by transportation or distribution organization when the said license is tendered;§ A necessary condition for receiving the license for the use of gas a fuel is the coordination of gas resources with local gas suppliers;§ The procedures for procuring the technical specification for connection, or for actual physical work involved in the connection, is not made sufficiently clear in the legal framework;§ Procuring technical specification and/or receipt of license for using gas as fuel does not guarantee subsequent access to gas transport or distribution networks.	§ The access of economic entities to various activity involving planning and construction of gas-driven equipment — and, in the final analysis, the access of suppliers and consumers to the network gas market — depends on Gazprom’s approval of its use of gas as fuel.

#	Function name	Reasons for regulation, regulating agency	Specific features of actual regulation	Effect on independent gas producers
Functions not codified within the regulatory sphere
1.	Transportation balance on the UGSS	§ OAO Gazprom	_	§ A means of non-tariff regulation and exertion of influence;§ Limitation on volumes of supplied gas and control over business expansion;§ Determining the «area» of supplies;
2.	Limits on gas supplies	§ OAO Gazprom;§ Gazprom’s Order «Concerning the distribution of gas resources to Russian consumers…»: «in order to enhance efforts of coordinating the distribution of gas resources» the task of rationing additional gas volumes is handed over to the Marketing department (K.G. Seleznev). The same order entrusts the said department with purchasing gas from independent producers and developing the procedures for distributing gas resources.	_	§ Division of supply volumes into regulated and unregulated;§ Indirect influence, potentially positive, in case consumers forced into the unregulated market will turn to independent producers for their gas.
3.	Gas storage	§ OAO Gazprom »;§ OOO Gazprom — UGS;§ FAS accepts complaints about abuse of dominant position. Measures taken by the agency, however, amount to general anti-monopoly procedures.	§ Perhaps the state will control the price for gas storage; but it is just as likely that it will remain outside the regulatory sphere.	§ Significant long-range effect on prices of gas, realized by independent producers;§ Limitation on volumes of supplied gas and control over business expansion.

 

 

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[1] An old idea has been implemented:- using A. A. Petrov’s management, to establish, within Mezhregiongaz Ltd,. a separate legal entity — a bid manager (like the trading system administrator) with a permanent staff of about 40 people (actually about 8). However, A. A. Petrov is a temporary head of that entity.[2] A Quiet Reshuffling. The Ministry of Energy Has Reorganized its Fuel and Energy Sector, Aleksei Grivach, VN, 09 June 07Behind a veil of secrecy the Ministry of Energy has carried out an internal reorganization of its energy arm and a minor adjustment of its industry unit. According to information from Vremeni Novostei, on Thursday Viktor Khristenko signed and order replacing the Fuel and Energy Industry Department and the Department for Structural and Tariff Policy in Natural Monopolies with three new divisions. As a ministry representative explained, the conversions are related to the forthcoming completion of electric industry reforms and the intensification of discussions as part of the global energy dialogue.To create a center of administrative responsibility for regulation of the electric power industry after the liquidation of RAO UES of Russia, a special department with the appropriate functions will be established. Vyacheslav Kravchenko, who up to now has been the director of the Department for Structural and Tariff Policy in Natural Monopolies, heads it. A new department for government energy policy will be responsible for the energy dialogue with consumers and suppliers. Anatoli Yanovsky, previously responsible for the entire fuel and energy industry is its director. He will also have to handle the «updating» of Russia’s energy strategy until 2030, which the Ministry of Industry and Energy announced in the fall of last year. The order also set up a department for oil and gas policy, which will work on hydrocarbon production. A ministry source confirms that someone from the current team will head this department, most likely from the Federal Energy Agency.[3] For more detail on this topic see «Introduction of a New Methodology for Calculating Tariffs for Gas Transmission Services,» April 2006.[4] The Federal executive agency with the authority to implement regulations in a given sector is highlighted in black

[5] On Feb 11-12, 2007 the following information appeared in the media: «Transport tariffs for independent producers must increase by 20% per year, since anything lower will not yield a return on investments. These conclusions were given in the letter addressed by the Federal Tariffs Service to appropriate agencies along with predictions for tariffs increases for 2008-2010. Taking into account the cost-effectiveness of capital investment the tariff rate should increase by 20% in 2008, by 19% in 2009 and by nearly the same amount in 2010. The increase would be 14% without taking into account profit on invested capital, said a source in one of the agencies citing the letter.» No such official letter was ever sent out by the FTS. This notice appeared following a conversation between a journalist and an FTS official, who had mentioned, in the course of the conversation, some approximate figures on tariff increases for mainline gas transport which were being calculated in the course of work on long-term contracts and their pricing.

[6] Order 88-r of the Russian Federation of Jan 29, 2007 establishes the plan of action of the Russian Government in implementing the main positions of the Program for short-term socio-economic development of the Russian Federation (2006-2008). Specifically, this document charges Minpromenergo, together with interested agencies, with developing a fine draft of the Energy Strategy of the RF for the period up to 2020. The document was expected to be introduced in March and passed in April of 2007.

Moreover, there has been considerable talk recently of the need to begin work on the Energy Strategy up to 2030 (according to some sources it should be developed by 2030). According to some sources V. KHIRSTENKO is urgently trying to assemble a «special team» to work on these strategies. Moreover, a special department has been assigned to work on developing energy strategies in the Ministry’s Energy department headed by A. Yanovsky. Money is being allocated in expedited fashion (the work is said to take place in an R&D framework). Many in the Ministry believe that Energy department must put all its energies into revising the Energy Strategy.

The Government will consider the Master plan in June (pushed up from February). As far as we know Minpromenergo had approached V. RUSAKOVA offering to help with coordinating the gas and electric master plans, and to fine tune the gas plan in accordance with the resolutions of the Government of Nov 30, 2006. RUSAKOVA responded with a harsh No (As in: We’ll deal without you!)

V. KHRISTENKO continues in his opposition to the Eastern Gas Program. There have been attempts to exert some influence on him, notable through M. FRADKOV. (FRADKOV was appraized of the situation during his last trip to the East, and had subsequently questioned KHRISTENKO). KHRISTENKO replied: «I have some differences… and the Min Econ Dev is opposed. We’ll submit a document to the government, with some differences.» Even Gazprom is expecting the Program to finally be introduced in the summer… albeit with some differences.

[7] On the other hand the economic benefits are obvious, and no one would refuse them by them just like that.

[8] A fairly contestable statement that has no direct relation to the economics of sales.

[9] According to Ministry of Finance officials, expert duty is not levied in Europe: it is a regulatory instrument native to Russia. Moreover, Ministry of
Finance had always held the position that customs duty is an instrument, regulating averagee profitability of an industry in export operations. For this reason they calculated the amount of customs duty based on the cost of exported gas minus transportation costs outside the customs territory of the Russian Federation.