1.   Concise Description of Reasons and Premises for Altering the Procedure of Access to the Gas Transportation System of JSC Gazprom

1.1         General Issues of Industry Structuring

Description of fundamental methods for structuring the gas industry is not the goal of this report, in which we have tried to describe them in a schematic way. At the same time, it is impossible to completely deny their consideration, because the ways to improving the access to the gas transportation system of JSC Gazprom considered in this report are beyond the scope of the existing system of gas industry operation and, for this reason, require consideration of possible alternative solutions that are outside the framework of the existing system of gas industry regulation.

The models considered here are theoretical models that do not describe any concrete systems of gas industry operation. Real systems of gas industry operation are essentially different from the systems discussed here. Nevertheless, we tried to grasp and convey the nature and most salient features of each considered model.

Particular attention should be paid to the fact that the gas industry is an industry requiring a network infrastructure for delivering its products from producers to consumers. In our analysis of models, we assume that the network infrastructure is furnished with product custody transfer, accounting and technical regulation equipment used for delivering products from specific producers to specific consumers. With this type of network infrastructure, the gas industry market may be constructed as an open market of products. Construction of a market of network infrastructure services is a separate task. Organization of full-fledged market relations in the gas industry requires equipping the network infrastructure with accounting devices and control hardware for connection of producers and products consumers to the distribution network.

If, for technological reasons or inadequate equipment, the network infrastructure does not allow accounting and/or regulation of product flows at domestic nodes of the network, accounting of direct supplier-consumer relations becomes practically impossible. Other models of market organization may be considered and used in this situation administratively or by mutual consent of participants. Use of buying agencies is one of such models.

In terms of competition development on the gas market, there are only four essentially different ways of gas industry structuring, each of which has many possible versions. These ways are characterized by different levels of monopoly and, therefore, different shares of competitive market permitted or required in the industry.

• Model 1. Monopoly at all levels. In this model, there is no competition and choice of supplier in the sphere of gas production. The monopoly produces gas and delivers it through pipelines to companies that sell and/or distribute gas to final consumers.
• Model 2. Buying Agency. This model allows an individual buyer (or the Buying Agency) to choose one of different producers of gas, which promotes development of competition in the sphere of gas production. Final consumers have no access to gas transportation and distribution facilities. The Buying Agency has a monopoly on gas transportation and gas sales to final consumers.
• Model 3. Competition on the wholesale market. In this model, the companies engaged in sales and/or distribution of gas buy gas directly from gas producers and transport it through trunk gas pipelines. The companies selling gas have a monopoly on gas sales to final consumers and/or distribution of gas. Access to trunk gas pipelines is free.
• Model 4. Competition on the retail market. This model permits every individual buyer to choose a gas supplier (producer). Access to all gas-transportation facilities (trunk and gas-distribution pipelines) is free. Distribution of gas is separate from gas sales, and competition is implied in gas sales.

Table 1 reflects the main characteristics of each of these four models.

TABLE 1. Main characteristics of gas industry structuring models

Characteristic	Model 1. Monopoly at all levels	Model 2. Buying Agency	Model 3. Competition on the wholesale market	Model 4. Competition on the retail market
Competing producers	NO	YES	YES	YES
Choice for gas selling companies	NO	NO	YES	YES
Choice for final consumers	NO	NO	NO	YES

Each of these models involves use of various types of contracts and regulation instruments.

The differences between the models are concentrated in the way they answer the question «To whom may independent organizations sell their products?»

In Model 1, nobody can buy gas from independent organizations simply because they do not exist. Gas is supplied to all consumers only by the gas monopoly. The first step to competition development in Model 1 is creation of competing gas producers (creation of independent gas producers). This leads us to Model 2, in which only the Buying Agency is allowed to buy gas from producers, including independent gas producers. This is why this model is sometimes called the single buyer model. Conclusion of gas purchase contracts is the main salient feature of Model 2.

In Model 3, the companies engaged in gas sales have the right to buy gas directly from independent producers and retain the exclusive right to provide services to retail buyers. Thus, both independent gas producers and gas selling companies need access to trunk gas pipelines, which necessitates conclusion of contracts on use of the transportation infrastructure (access to trunk gas pipelines).

In Model 4, final consumers have the right to buy gas from independent gas producers. This extension of the list of companies allowed to choose their suppliers involves use of more complex contract relations and possibly a more complex process for provision of access to trunk gas pipelines and gas-distribution pipelines.

As an alternative, we can look at all this from the consumer standpoint. Fig. 1 shows who is granted the right of choice in each of these models.

FIGURE 1. Choice from the consumer standpoint

Producer (P)	Wholesale buying company (W)	Gas supplying company (S)	Consumer (C)
				Model 1. Monopoly at all levels
				Model 2. Buying Agency
				Model 3. Competition on the wholesale market
				Model 4. Competition on the retail market

Let us consider each of these models in greater detail.

Model 1. Monopoly at All Levels

Model Description

Model 1 is a model of a monopoly usually characterized by a vertically integrated system. A single company owns and operates all gas-production and gas-transportation facilities on a certain territory and sells gas to consumers. The company is a monopoly on this territory.

In return for its monopolistic positions, the company has certain customer service obligations, including the obligation to supply gas to all consumers on the territory at the rate (price) regulated according to the cost of services and calculated in a certain manner. Production monopoly may be stringent when no other company is entitled to produce gas on the territory, or it may involve production of gas by other companies only for their own needs and sales of a limited amount of excess gas by them to the monopoly at regulated prices.

In this model, the monopoly may create a number of subsidiaries and delegate to them the power to execute certain stages of gas production, transportation and sales. Contracts between the monopoly and its subsidiaries will aim to minimize costs and especially taxes. There is no competition in gas production.

Access to Gas-Transportation Facilities

In Model 1, the question of access to gas-transportation facilities is only raised for transit volumes of gas supplied under intergovernmental agreements or contracts with the monopoly. Terms of access to gas-transportation facilities and transportation rates are to be stipulated in this case. In Model 1, there is no transportation to the territory occupied by the monopoly, because consumers have no choice other than using the services of the regional company, and there are no independent producers. This raises the question about the responsibility of the monopoly for tracking the growth of costs and, therefore, the growth of prices for the gas supplied by it throughout its entire territory.

The system of Model 1 is typically characterized by a vertically integrated company. This company owns and manages production facilities and trunk gas-transportation facilities and uses available possibilities for their optimization through what is called economies of scale. The company may gain important advantages owing to efficient coordination of its operations, in particular, through coordination of the activities in its fields, gas-transportation organizations, and gas-selling companies.

Efficiency

In Model 1, the structure of production ensuring minimal expenditures is maintained through planning carried out by the monopoly, whose results, as a rule, should be approved by regulating authorities or the government. The expenses for approved expansion or construction of new production or transportation facilities are levied from final consumers through retail prices.

All risks in Model 1 are usually carried over onto final consumers by including them into the expenses and accordingly regulating the price of services. Final consumers pay for errors in investments, changes in demand, unforeseen obsolescence of technologies, and everything else. This reduces the risks for investors of the monopoly, which, in its turn, may diminish the value of the capital used by the company for investments. At the same time, however, this may also lead to erroneous decisions on development of new fields, construction of new gas-transportation facilities, etc. because of the inconsistency between the resulting low value of all company investments and the actual high value of investments in the specific project.

Collection of all expenses from final consumers, in which case prices grow with increasing expenses, does not stimulate curtailment of costs. Various measures, collectively known as ‘incentive regulation,’ may improve stimulation by transferring a part of risk to the owners or operators of assets. It is common knowledge that prices should be at least partly dissociated from the cost in order to stimulate reduction of costs. Even for regulation methods based on costs, regulation delay may be conducive to considerable detachment of prices from costs.

Social Obligations

One of the most attractive aspects of Model 1, which is preserved in Model 2 and tangibly weakened in Models 3 and 4, is the ability to take social obligations into account. Social obligations are imposed by the government and have no place in markets with full-fledged competition (the latter being a salient feature of Models 3 and 4). Social obligations may be divided into two groups: obligations related to gas production and other obligations. The first group includes gas supply obligations (involving provision of services and/or commitments to construct sufficient and adequate facilities ensuring a certain level of gas supply reliability), rational use of subsoil and resources, efficient development of available reserves, and control and regulation of waste release into the environment. Other obligations include universal price formation on territories with different costs, gasification of the countryside, discounts for consumers of large volumes of gas, reduction of prices for the low-income and disadvantaged population, implementation of environmental protection programs, and high taxes paid into the budget. All these obligations may readily be fulfilled in Model 1, whereas the obligations related to gas production may run into serious problems in subsequent models.

A monopoly is able to fulfill these tasks by carrying over its excess expenses onto its customers. High expenses for production of gas and construction of redundant facilities may be supported only when final consumers have no other choice. Differentiation among consumers is also possible by selling gas to large-scale consumers at prices differing from the prices for small-scale consumers (using what is called cross subsidization).

In Model 1, the monopoly is often performing so many different aspects of the social policy that it practically turns into a state authority of sorts (the monopoly collects «taxes» and redistributes them among various consumers). These social policy aspects are based on extra-market expenses that the monopoly may impose owing to its monopolistic position and the high demand for the product that is practically indispensable.

Possible Changes

Model 1 begins to fall apart if the marginal costs of production in conditions of competition or if the price offered by new market participants is lower than the price set by the monopoly.

The theory and practice of regulation show that the price of the monopoly may be higher than prices formed in conditions of competition.

Conclusions

Model 1 was the main model in the world for a long time for several substantial reasons. This form of vertically integrated organization enabled development of large-scale systems of gas production and transportation. The arguments and reasons in favor of savings based on large scale that have been used for many years in the past and remain to be relevant for certain developing countries now have justified the monopolistic organization of the market.

Complete monopoly is capable of implementing the policy pursued by the state, subsidizing less developed territories, supplying gas to the countryside, etc. Different aspects of this policy may involve monopoly in the sphere of gas production and retail sales even in future.

Model 2. Buying Agency

Model Description

Independent gas producers are allowed in Model 2. Independent gas producers may be established by branching off the existing producing companies (incorporated into the monopoly holding structure) or established as new producing companies entering the market when it requires additional volumes of gas and when it becomes possible to compete with the monopoly. Independent producers compete in gas production and assume the associated risks. This is what differentiates Model 2 from Model 1. Independent producers sell produced gas to the Buying Agency, the role of which is played by the monopoly. In its turn, the buying company sells gas to the companies selling gas to final consumers and having a monopoly on their customers.

Despite the fact that Model 2 allows competition in gas production, all produced gas should be sold to the Buying Agency. Thus, the Buying Agency is a monopoly purchasing all produced gas from producers. Producers compete with each other for the right to sell their gas to the Buying Agency on a contractual basis. This engenders competition at the level of exploration and development of new fields and development of the existing fields.

In principle, the Buying Agency may discriminate against or in favor of individual gas producers. For this reason, it is necessary to work out regulations for making proposals or take other measures for preventing discrimination. In certain cases, however, the Buying Agency is established specially for exercising the power of monopoly and discriminating between producers by offering lower purchase prices to the producers with lower production costs, which makes it possible to redistribute the funds saved by using less expensive sources or the sources already paid for by consumers.

The Buying Agency model is useful when the number of suppliers is relatively small compared to the number of consumers and the structure of transactions is not subject to frequent changes.

Transition to Model 2

In case of transition of an industry monopoly to Model 2, existing fields may be sold to private buyers based on the results of tenders and contracts of gas sales to the Buying Agency. As an alternative, the regulating authority may require that the monopoly from Model 1 should buy gas from independent producers based on their tender proposals.

Contract Relations

In Model 2, producers usually sign contracts with the Buying Agency. As a rule, these contracts involve payments covering capital costs and payments covering operational costs, including dispatching costs.

The set payments for supplied gas at the level of actual costs provide little incentive for curtailing these costs. One of the possible solutions to this problem is thorough cost control.

In Model 2, the Buying Agency sells gas to gas-selling companies at wholesale prices. In terms of efficiency, these prices should correspond to the marginal costs of the system. Apart from that, the price should cover the total gas-purchasing costs and expenditures of the Buying Agency. Mechanisms of multi-component prices (rates) comprising payments for capital costs and different variable costs are used for this purpose.

The gas-purchasing price is not regulated in order to retain the possibility of market-based selection of suppliers. Consumers in the system have to purchase gas from the Buying Agency, for which reason the monopoly-related components of the Buying Agency’s price-the sales markup to the average weighted price of gas purchased from producers-is regulated by the state or local authorities.

Access to Gas-Transportation Facilities

The transportation issue discussed for Model 1 is still present in this model and retains its importance for all other models. Access to trunk gas pipelines in Model 2 brings up another aspect related to the influence of field location on transportation costs. The procedure of filing applications for development and connection of new fields to the system should take into account the actual and potential restrictions and gas transportation losses and ensure the corresponding assessment of proposals.

Terms and rates of access to gas-transportation facilities require clear and unambiguous formulation. These terms will regulate the relations between independent producers if they cannot produce sufficient amounts of gas because of the restrictions in access to gas-transportation facilities. For instance, the Buying Agency may guarantee access to trunk gas pipelines to an independent producer. If subsequently the independent producer was not able to supply the required amount of gas because of transportation restrictions, the Buying Agency should compensate the losses of this independent producer.

Independence of the Buying Agency

The issue of structure in Model 2 consists in the requirements that should be met by a company for becoming the Buying Agency. The Buying Agency have to sign long-term contracts with producing companies, for which reason it should be a solvent company. Thus, the main candidate for the role of Buying Agency is the state or a company with strong standings, both of which are a potential source of conflicts.

In principle, the Buying Agency should be independent from gas producers, otherwise conflicts would be inevitable. It should be clear for everyone that the Buying Agency is not pursuing a discriminatory policy in favor of its own resources in both gas purchasing and transportation.

Another conflict becomes imminent if the Buying Agency is the operator and the dispatcher of the system at the same time. In a mixed system where management of the dispatcher’s own field is more profitable than management of a competitor’s field, these conflicts may run deep and wide. The only proper solution to the problem is signing thoroughly and carefully drawn-up contracts providing the dispatcher of the system with necessary incentives for transporting the least expensive gas regardless of its ownership.

Social Obligations

One of the most attractive features of Model 2, which also characterizes Model 1, is the ability to take social obligations and social policy objectives into account.

According to this structure, the Buying Agency is obliged to ensure an adequate required level of gas production, for which reason it has a direct or indirect monopoly on consumers. To fulfill this obligation, the Buying Agency has to ensure availability of sufficient volumes of gas supplied by independent producers on a contractual basis or per proposals of independent producers for gas transportation.

Monopoly on gas sales on the retail market makes attainment of these goals possible as it allows the Buying Agency to levy excess expenses from consumers. The Buying Agency can stand high production costs and tolerate the existence of redundant facilities if its customers have no other choice.

Possible Changes

The pressure towards transition from Model 2 «Buying Agency» to Model 3 «Competition on the Wholesale Market» comes from different sources. One of such sources is wholesale consumers-companies that sell gas to small-scale consumers or large-scale industrial consumers who prefer purchasing gas on a highly competitive market.

The pressure towards liberalization of access to the gas-transportation infrastructure also comes from independent producers or large-scale consumers. It may also emerge from producers of gas in new fields with lower total costs than the costs reflected in the prices of the Buying Agency. These producers will try to avoid the system and sell gas to local consumers using their own pipeline transportation facilities.

Conclusions

This model introduces competition into the sphere of gas production, which may yield most tangible results in terms of reduction of costs. This model may also be useful for attracting new sources of capital. At the same time, this model makes it possible to avoid certain costs present in subsequent models and related to signing contracts on the existing markets, getting access to gas-transportation facilities, and increased capital costs due to the assumption of process risks by the producers. This model may be instrumental for the state in implementing social policy measures such as gasification of the countryside. By and large, Model 2 is a good transitional model without the necessity of developing a complex contracting system needed for more complex structures of the market and the necessity of implementing it.

At the same time, Model 2 protects independent producers from market risks and facilitates attraction of capitals for them. The revenues of independent producers do not depend on market prices and independent producers do not have to compete with new market participants. For this reason they may be financed with a fairly high share of borrowed capital, which may reduce their prices. The existing risks are transferred to final consumers through the Buying Agency, on which it has a monopoly.

Model 2 isolates producing companies from the influence of market forces, weakens the dynamic advantages of competition, and leaves many aspects of choice as to where to produce gas and how to develop gas-transportation facilities up to centralized planning authorities rather than entrepreneurs and businessmen. Moreover, the structure of prices complicates concealment of excess costs in the gas price for market participants compared to Model 1.

Model 3. Competition on the Wholesale Market

Model Description

Model 3 provides the right to choose the company selling gas to consumers and allows competition in gas production. This model is sometimes called the model of competition on the wholesale market in contrast to the model of competition on the retail market (Model 4) in which final consumers rather than gas-selling companies choose their suppliers. In Model 3, there are several companies selling gas to consumers. They may buy gas for their customers from any independent producer. The companies selling gas to consumers retain their monopoly on gas sales to their consumers (each of them has the right to provide services to a certain set of consumers).

In fact, Model 3 moves the Buying Agency from level of trunk pipeline transportation of gas to the level of gas distribution and stops being a model of a single buyer. Model 3 involves open access to trunk gas pipelines and provides independent producers with alternative buyers. Thus, buyers do not have to assume the market risks, and the form of gas purchase contracts may change from the form of contracts implied in Model 2 to the form of contracts that protects from market risks. However, final consumers still have no right to choose suppliers on their territories. In this structure of the market, the obligation of supplying gas is transferred to the retail company that has a monopoly on final consumers.

Wider competition does not obviate the need of regulation. It is still necessary to regulate monopolistic owners of gas-transportation facilities and control the competing elements of the market.

The market acquires additional functions that should be performed by one of its participants and additional instruments that should be created on the market. One of such functions is the function of a dispatcher that should be independent from traders and ensure stability of gas supplies.

Instruments that should be created in the framework of Model 3 include the following:

• a gas-transportation rate that reflects marginal gas transportation costs, determines transportation priorities, and controls loaded branches in an economic and rational way;
• a gas market or gas exchange where buyers and sellers of gas submit their proposals and determine the prices of gas with a certain periodicity;
• a forward market where parties may get in contact with each other. This market originates in a natural way if ill-considered regulation does not hinder the natural process;
• ensuring the freedom to enter or leave the market and the freedom to increase or decrease gas production in the fields in response to the action of market forces. The market should have the freedom to provide the necessary resources, which may require changes in legislation and the existing practice of relations.

Access to Gas-Transportation Facilities

In Model 3, competing producers may sell gas directly to gas-selling companies. Companies selling their gas to consumers still have the right to their set of consumers and may be associated with distributors if they own gas-distribution systems. This model, however, does not require free access for all market participants to gas-distribution networks. Thus, Model 3 requires only determination of rates for gas transportation through trunk gas pipelines. The location, connection and dispatching of fields should be taken into account in rates for ensuring adequate and sufficient revenues for the owners of trunk gas pipelines.

Gas Transportation

In Model 3, the functions related to gas transportation are defined differently. First, trunk gas pipelines, if there are many of them, may be united under the ownership of one company for economy and saving. Contract relations in Model 3 between the trunk pipeline networks of different owners become far more complicated. The greater the number of trunk pipeline network owners, the more contracts should be signed and executed for operation and calculation of flows at the network junctions. The cost of these procedures demonstrates that merging of networks is the most efficient alternative.

Second, the question about incorporation of gas-transportation functions into separate dedicated companies becomes quite urgent for preventing potential conflicts. New functions related to the use of the gas-transportation system for trade should be identified and entrusted to one of the market participants. We have so far identified at least three new functions: the functions of a dispatcher, a transporter through the gas-transportation system, and a market operator, which may be described as follows:

1. The dispatcher has to maintain stability of gas supplies through trunk gas pipelines and act as an optimizer of gas-transportation system loading. In an ideal case, the dispatcher should be independent from buyers and sellers of gas in order to avoid potential problems related to operations in the dispatcher’s own interests. A model in which an integrated monopoly acts as the dispatcher is also possible though it may require massive universal regulation for preventing operations in own interests and discrimination.
2. The transporter has to set terms and conditions of granting access to users to the available gas-transportation facilities and collect payment for using the gas-transportation system. The transporter is often but not always the owner of trunk gas pipelines.
3. The market operator has to control the difference between the contractual volume of gas and actually supplied volume of gas. In spite of the fact that most transactions are based on contracts, there is always some discrepancy between the contractual volume of gas, actually produced volume of gas, and actually consumed volume of gas. This discrepancy remains even if the buyer and seller coordinate the demand and supply of gas.

These functions should be performed independently from market traders; otherwise massive regulation of their activities may be necessary. It may also be necessary to perform these functions separately and independently of one another due to potential conflicts of interests.

The functions of market operator and dispatcher may be performed by the same entity, because these functions are mutually non-conflicting. These functions are often considered as fairly compatible owing to the common information used by the dispatching and accounting services of the system. However, the skills required for performing dispatching functions are very different from those required for managing and accounting a great number of transactions, which are necessary in banking and trading businesses. For this reason, separation of these functions and appointment of a dedicated market operator is fairly worthwhile.

Efficiency

Field development is started by a gas producer if the market price of gas can cover the costs of field development and operation, as on any other market. In Models 1 and 2, the producer has no access to broader markets. For this reason, the producer needs a contract (implied in Model 1 and explicit in Model 2) before starting actual field development. In Model 3, producers also need contracts. However, the existence of an organized market where they can sell their gas diminishes the importance of contracts. In Model 3 contracts are used for sharing and distribution of price risks, whereas in Model 2 contracts are necessary for ensuring fulfillment of contractual obligations by both parties.

The market price is also a powerful instrument for ensuring high efficiency of gas consumption and utilization. The market price is always used for complete settlements, where there cannot be any discrepancy or deficiency, because the market price is always sufficiently high to bring the demand and supply into correspondence.

Social Policy Obligations

The ability of producers to implement different aspects of the social policy related to gas production is practically irrelevant in Model 3. Purchase of uneconomical resources, too high environmental standards, and technologies preferred only for national security have no place on a competitive market.

However, implementation of other aspects of the social policy unrelated to gas production may continue if the regulating authorities decide that they are necessary in conditions of monopoly on the retail market. For example, discrimination in favor of larger-scale consumers may continue until consumers find a mechanism for reselling their less expensive gas. The same is true for sales of gas to low-income and disadvantaged population strata at prices lower than the net cost of gas. Markets in Model 3 may resell gas, but final consumers in Model 3 cannot resell gas.

For subsidizing, someone has to defray the expenses. Usually, the expenses are defrayed by monopolized consumers, who are utterly inflexible. However, the expenses may be directly paid by taxpayers. In Model 3, consumers are still monopolized and can stand higher local taxes and subsidization of gas supplies to low-income and disadvantaged population strata.

Possible Changes

In Model 3 «Competition on the Wholesale Market,» companies selling gas to consumers may buy gas directly from competing independent producers or from wholesale companies at their own discretion. For this purpose, they need access to the system of trunk gas pipelines. Introduction of Model 3, in which producers may compete for selling their gas to a gas-selling company, brings about a problem of defining the nature and goals of such a company.

Definition of a company selling gas to consumers as a company that owns gas-transportation networks and buys gas for reselling it immediately raises a number of questions such as «May a large industrial company with its own gas-transportation network be considered as a company selling gas to consumers?» «May a group of large-scale consumers declare itself a company selling gas to consumers?» or «May a city be a company selling gas to consumers?»

Model 3 limits the choice of consumers, favoring consumers that can afford to choose. This is why any definition will ineluctably be vague.

These problems urge transition from Model 3 to Model 4.

Conclusions

Model 3 involves broader competition and provides independent producers with more consumers. A larger number of buyers make the market in Model 3 more competitive and dynamic than in Model 2, which involves only one buyer.

The advantages of competition in gas production become even stronger owing to the transfer of market and process risks back to producers. Usually, producers are better in judging the benefits and advantages of new technologies than regulating authorities.

However, the transaction expenses in Model 3 are higher because of the necessity of contracts on the markets and in gas-distribution systems. The gas-distribution monopoly is retained, because consumers have no right to choose their suppliers. This also retains some subsidization and social policy obligations in spite of their limited forms.

Model 3 is definitely a model having all advantages over Models 1 and 2, but still this model is not stable and is only another step on the way to Model 4. Model 3 may be considered a test stage.

Model 4. Competition on the Retail Market

Model Description

Model 4 involves competition on the retail market. In Model 4, all consumers have access to competing producers of gas directly or via a retailer at their discretion. Model 4 differs from Model 3 in that it grants the right of choice to all consumers and not only for companies selling gas to consumers which have a monopoly on their set of final consumers. The main version of Model 4 involves complete separation of gas production and retail sales of gas from gas transportation both at the level of trunk pipeline transportation and the level of distribution. There is no monopoly on retail sales, and competing traders may perform the same functions as on other commodity markets. Model 4 involves free open access to gas-transportation facilities or common transportation as in the case of trunk gas pipelines in Model 3.

This structure provides the freedom of entering or leaving the gas production markets. This means that there is no need for regulation of new field development or development of unprofitable fields. Retail sellers also have the freedom of entering the market. Retail sales constitute a new function in Model 4. This is a commercial function that does not require ownership of gas-transportation facilities even in frequent situations where an owner of gas-transportation facilities competes on the market as a retail seller.

Contract Relations

Model 4 provides free access to all gas-transportation facilities and requires a mechanism of large-scale trade through the gas-transportation system. In Model 4, it is necessary to set rates for using trunk gas pipelines and gas-distribution facilities.

The main problem in Model 4 is measurements in execution of contractual obligations.

Social Policy Obligations

Social policy obligations include different aspects such as indirect control of the industry, regulation of demand, implementation of environmental protection programs, assistance to low-income and disadvantaged population strata, and revision of the fuel and energy balance, which may require subsidies for certain industries, high taxes to the local budget, and economic development. These aspects may be divided into two groups: aspects related to gas production (such as indirect control and regulation of demand, use of different types of fuel, and economic aspects) and aspects not related to gas production (such as assistance to poor population strata and economic development).

Regardless of which model is used for industry operation, the ability to introduce and collect the aforementioned extra-market costs is determined by the ease with which consumers can choose the alternatives that are free of these costs. Thus, competition makes it difficult to cover expenses mentioned above. However, owing to the fact that the regulated sector is a monopoly, there is a simpler and easier way to cover these extra-market expenses by collecting payments for sales services, because consumers usually cannot avoid the system of retail sales.

As one model approaches the next one, the regulated sector dwindles gradually and the competitive sector grows, diminishing the scale of social policy obligations.

Economic development activities constitute a local function that may be paid locally by collecting duties for gas supplies. The same principle is valid for assistance to low-income and disadvantaged population strata. Legislative authorities may entitle the distributing company to collect these duties.

1.2         Existing System of Regulating Access to the Gas-Transportation System of JSC Gazprom

Analyzing the structure of the gas industry in Russia, we came to a conclusion that Model 3 «Competition on the Wholesale Market» is most appropriate. At the same time, there are some essential differences. For example, despite the fact that there are independent producing companies on the gas market, the fundamental issue of access to trunk gas pipelines is not completely settled. Apart from that, the issue of separating gas transportation from gas production and the issue of dispatching are still open. In view of the fact that activities for gas production, transportation, storage, dispatching, commercial balancing, and wholesale and retail sales are concentrated in the same company, it is no wonder that the gas market is characterized by a conflict of interests and discrimination. At the same time, gas distribution and gas sales are separated, which, generally speaking, is not necessary in Model 3.

This situation was generated by the historical development of the gas industry in Russia, which stepped from Model 1 «Monopoly at All Levels» directly into Model 3 «Competition on the Wholesale Market» without creating necessary regulation instruments and without taking necessary measures for structural rearrangement of the industry. Figuratively speaking, the gas industry in Russia is going through a period of «growing pains.» Possible development in this situation is either consolidating all efforts for overcoming the consequences of this problem (that is, creation of a necessary infrastructure and implementation of all required reforms), or making a step backwards (to Model 2) for preparing normal transition to Model 3 (returning to Model 1 is apparently no longer possible now).

Let us consider the existing system of regulation access to the gas-transportation system of JSC Gazprom in greater detail.

Formally, the right of access to the gas-transportation system of JSC Gazprom is guaranteed in a number of legislative and regulatory documents, the most important of which are as follows:

• Antitrust legislation. Federal Law No.135-FZ of July 26, 2006 «On Protection of Competition,» Law No.948-1 of March 22, 1991 «On Competition and Restriction of Monopolist Activities on Commodity Markets,» and Federal Law No.147-FZ of August 17, 1995 «On Natural Monopolies» describe the system of state regulation of gas transportation through pipelines. JSC Gazprom is acknowledged as a natural monopoly and provision of services for transportation of gas through trunk gas pipelines of JSC Gazprom as natural monopolistic activity. Therefore, formally, the Federal Antimonopoly Service of the Russian Federation is entitled to require free access of all participants of the gas market to the gas transportation and supply system.
• Gas supply law. Article 31 of Federal Law No.69-FZ of March 31, 1999 «On Gas Supply in the Russian Federation» requires that the owners of gas transportation and supply systems are obliged to ensure non-discriminatory access to these systems to any organization operating on the territory of Russia.
• Resolutions of the Russian Federation Government on access. The key access-regulating document is Resolution No.858 of July 15, 1997 of the Russian Federation Government «On Granting Access to the Gas-Transportation System of JSC Gazprom to Independent Organizations» (this regulatory document was revised and amended several times, and its last revision was in May 2001), which approved the regulation «On Granting Access to the Gas-Transportation System of JSC Gazprom to Independent Organizations.»

Though the regulations and procedures of granting access to gas-transportation facilities are amended and changed periodically, their key terms and provisions remain the same:

• Free capacities. Access to the gas-transportation facilities of JSC Gazprom is granted only when free capacities are available. Access to gas-transportation facilities may be denied due to the absence of technical possibilities or full load of certain segments of the pipeline system. Information in the current availability of gas-transportation capacities is concentrated only in the Central Production Control Department of JSC Gazprom and is practically never disclosed.
• The Resolution on Granting Access is only valid for gas supplied to Russian consumers. The text of the Resolution on Granting Access contains a provision that this regulatory document is only valid for gas supplies to Russian consumers of gas.

According to the current regulations, any independent gas supplier has the right to file an application for access to the gas-transportation system in the Marketing and Sales Department of JSC Gazprom. The application should provide information required by JSC Gazprom for granting access, including the following:

• Gas quality. It is necessary to provide a detailed description of the chemical composition and physical properties of gas that should meet the requirements set by JSC Gazprom.
• Gas supply contract. The availability of gas and the consumer’s consent to pay for it constitute a formal basis for initiation of the access granting procedure. The suppliers should also prove the ownership of supplied gas by presenting a license for its production or a contract for its purchase.
• Volume and period of supplies. The supplier should specify the volume of gas transportation, the location of connection to the system, and the location of gas consumption (location of the final consumer).
• Technical information. The application should also contain numerous technical details, including a plan for connecting the field to the gas-transportation system.

JSC Gazprom should respond to applications submitted within 15 days if the application involves conclusion of a short-term gas-transportation contract (for a period of up to 1 year), within two months if the application asks for medium-term access to the gas-transportation system (for a period of 1-5 years), and within three months if the application is for getting long-term access to the gas-transportation system (for a period of more than 5 years). After getting access to the gas-transportation system, the independent organization should conclude a gas-transportation contract with JSC Gazprom for the corresponding period of access. The contract should be signed by the parties within one month from the date of getting short-term access, within two months from the date of getting medium-term access, and within three months from the date of getting long-term access to the gas-transportation system of JSC Gazprom.

It is known that, in spite of access regulation, there are serious problems with transportation of gas from independent producers for a number of reasons:

• JSC Gazprom determines free capacities. All rights of access to the gas-transportation system depend, first of all, on the availability of free capacities, which is determined by JSC Gazprom. The availability of free gas-transportation capacities is determined by JSC Gazprom, which tries not to disclose information on the actual load of the gas-transportation system. Nevertheless, all participants of the market do know, to a certain extent, the actual situation and really compete for access with other participants (including JSC Gazprom) in the bottlenecks of the gas-transportation system. However, there is still no transparent mechanism for fairly determining the winner of this competition and no clear and transparent mechanism of investments for de-bottlenecking the gas transportation system.
• There is no real arbitration mechanism. Despite the right of independent producers to require arbitration of issues related to access to the gas transportation system (for example, by the Federal Antimonopoly Service of the Russian Federation), so far solution of these problems never went beyond publications in the press and unfulfilled formal recommendations. The business of independent producers hinges on the decisions of JSC Gazprom, and independent producers are not going to endanger there existence for the abstract triumph of justice.
• JSC Gazprom sets requirements for connection of producers and consumers to the gas-transportation system. There are some formal procedures for connection to the gas-transportation system, but the actual practice of their application (for example, in the case of the Beregovoye field) reveals that they are beyond any control, including state control, and are inadequate and insufficient for ensuring the rights of market participants.
• Non-transparence of determining gas transportation routes. Independent producers are forced to pay for gas transportation along routes whose length is far from optimal. The choice of such routes is often explained by excessive loads of certain segments of the gas transportation network. The actual amount of gas transportation services is almost impossible to estimate correctly, and, as a result, JSC Gazprom is regularly blamed for raising the prices for transportation of gas from independent producers.
• There is no possibility of concluding long-term contracts or take-or-pay contracts. Although the application procedure allows granting access for periods of longer than five years, in actual practice JSC Gazprom never grants such permissions. Moreover, even if a supplier gets access to the gas-transportation system, this does not guarantee that a gas-transportation contract will be signed. Apart from that, there always exists a chance that the customer may be switched over to another supplier (usually affiliated with JSC Gazprom).
• Inflexibility of the gas supply system. Contemporary gas supply systems abroad actively use various technological and financial instruments for maintaining the daily balance of demand and supply. These instruments include high-pressure and low-pressure gas storages, peak fields, etc. that may be used by system operators for physical balancing of the gas stream, take-or-pay contracts with consumers, special systemic rates for over- or under-withdrawal of gas from the system, etc., which  are used for commercial balancing of the system. In Russia, such instruments are usually not used or, when used, are used in a very specific way. The Russian gas supply system is not sufficiently flexible for efficient development and does not provide economic incentives for development of a fair gas market.
• Absence of fair competition. As long as JSC Gazprom combines the functions of natural gas production and its transportation for independent producers, it may always be tempted to use its exclusive position for correcting business results. In cases of failure to fulfill the production plans, the gas monopoly always has an opportunity to sell other producers’ gas, violating the terms of its transportation without any significant sanctions from the owners of the gas.
• Motivation to sell gas at the well. JSC Gazprom is interested in purchasing natural gas from independent producers at the well at minimal prices. Thus, the gas monopoly has the possibility to cover the gas balance deficit without any additional investments. JSC Gazprom has a wide spectrum of methods and implements for forcing independent producers to this form of interaction.

There are several ways used by independent producers for selling their gas:

• Two-sided contracts. Independent producers find customers and have to obtain approval of the deal from JSC Gazprom, which they do not always obtain. The prices of such transactions, which are sometimes reported on by the press, seldom exceed the regulated prices. The reason for this is that the contract is signed for one year only. Gas sold under shorter-term contracts is somewhat more expensive. Nonetheless, there is a tendency towards signing longer-term contracts. For example, the five-year contract between JSC Novatek and Samaraenergo involves supply of 1.1 billion cubic meters of gas per year (provided that Novatek gets access to the gas-transportation system from JSC Gazprom every year).
• Supplies at prices pegged to the prices set by the Federal Rate Service of Russia. The prices set by the Federal Rate Service of Russia are now sufficiently high for covering the expenses of independent producers supplying gas to the domestic market and providing them with profits. This is especially important for regions remote from production areas. Itera sells part of gas supplied to the Sverdlovsk Region at prices that do not exceed the prices set by the Federal Rate Service of Russia, and JSC NOVATEK supplies gas to Tyumen, Kurgan, and the Arkhangelsk Region at prices pegged to the level of regulated prices.
• Sales at the well. JSC Gazprom buys gas from independent producers immediately at the well although this is not very profitable as the prices offered are usually considerably lower than the prices set by the Federal Rate Service of Russia. According to JSC Gazprom, only 400 million cubic meters of gas was sold according to this scheme (by JSC NOVATEK) in Q1-Q2 2003. Other sources report greater volumes (7.5 billion cubic meters of gas a year). The best known deal of this type is the contract signed by JSC Gazprom and JSC LUKOIL for buying 8.75 billion cubic meters of gas in 2005-2006 at $22 per 1000 m³.
• Sales to wholesale resellers. There are a number of wholesale resellers working on the Russian market, the best-known of which is Transneft, whose activities were extensively covered in relation to the crisis of gas supplies to Belarus in 2004, and Tsentrrusgaz. The main task of such companies is getting access to the gas transportation system and finding end users. However, they are related to JSC Gazprom in one way or another.
• Local supplies of gas to isolated territories. In regions unrelated to the gas supply system of JSC Gazprom, such as Norilsk, the Republic of Yakutia, Sakhalin Island, Kamchatka Peninsula, etc., gas is supplied by producers independent from JSC Gazprom directly to consumers. However, the prices in such deals are set by the Federal Rate Service of Russia.
• Sales on the electronic trading site. The first gas trading session based on the electronic trading site of Mezhregiongaz LLC was held in November 2006. Futures gas-supply contracting will also be developed based on the Interregional Exchange of the Oil and Gas Complex.

The logic of JSC Gazprom in the construction of such a scheme is clear. Operational control of access to the gas-transportation infrastructure allows the monopoly to retain its key advantage — the right to choose the sales market.

In the mid-1990s, JSC Gazprom was an absolute monopoly in gas sales (that is, the structure of the gas industry corresponded to Model 1). Thereafter, creation of new independent gas companies stimulated separation of their «habitats»-regions where for a number of reasons the monopoly let these companies organize an independent gas sales market. Apart from full transfer of the gas sales functions to independent organizations (as, for example, in the Sverdlovsk Region), there were cases of mixed schemes where gas is supplied by independent organizations, but distribution and sales of gas are controlled by JSC Gazprom (as, for example, in the Kurgansk Region). The traditional inclination to centralized management failed in gas sales. The large size of the country and the multitude of different interests of local political and business elites made Mezhregiongaz LLC at the turn of the new century fold up the centralization program and delegate serious powers to its regional sales subsidiaries. Implementation of these powers and authorities created different forms of handling the gas of independent producers.

However, the right of preferential choice of sales markets remains valid as long as other parties of the process acknowledge it. Independent producers gained momentum and started establishing direct relations with large-scale consumers of natural gas such as energy-generation enterprises, regional administrations, large chemical holdings, metallurgic enterprises, etc. JSC Gazprom cannot ignore these relations and, in a number of cases under the pressure of consumers, has to issue permissions for supplies of gas from independent producers into the regions of its own influence. At the same time, the limited period of such permissions allows JSC Gazprom to control the situation and keep it on a short leash.

Privatization and the continuing restoration of links and chains in the production industries stimulate appearance of new powerful players on the gas market. New political tasks and the associated powers of local and regional authorities are changing the attitude of politicians to the terms and conditions of gas supply to regions. Considerable changes in the business and political environment make JSC Gazprom change its positions.

The following reforms and transformations are currently underway. In the conditions of continuous rise of the natural gas selling price on the domestic market, JSC Gazprom is carrying out the next round of total centralization of gas sales, now outside the head company. Formally, a separate business of gas sales is being organized. The price of supplied gas now has a component for supply and distribution services, which is used for financing local sales companies. All stakes of gas-distribution organizations controlled by JSC Gazprom are being transferred to Gazpromregiongaz, a new subsidiary of JSC Gazprom. Constant political pressure is applied for transferring shares and stocks to this company. A payment for energy value is being introduced. Thus, the administrative procedure of quality control (and collection of corrective payments) is being entrusted to the regional sales company.

Nevertheless, JSC Gazprom is not going to equalize the rights of domestic and foreign consumers. The reason behind this is legal rather than economic and consists in different legal and legislative frameworks of contracting and different backgrounds of commercial relations.

In particular, foreign wholesale buyers of Russian gas may conclude long-term contracts with guaranteed predictability of business development for 5, 10, 15 years and more.

Export contracts stipulate the price for the moment of gas supply as well as for the entire period of contract and guarantee supplies of gas regardless of the situation with transportation capacities. Foreign consumers are in fact insured against any problems of JSC Gazprom related to the management of its property (the gas-transportation system). Russian consumers, on the contrary, are facing constant uncontrolled risks that cannot be eliminated or reduced by any means or actions of consumers.

1.3         Regulation of Export Supplies of Natural Gas

Until recent times, export of natural gas outside the customs territory of the Russian Federation was regulated by Resolutions of the President of the Russian Federation No.2213 «On Regulation of Export of Natural Gas» issued on December 26, 1994, No.538 «On Operation of the Unified Gas Supply System in the Country» issued on June 1, 1992, and No.2116 «On Reliable Supply of Gas to Consumers by the Russian Joint-Stock Company Gazprom in 1994-1996» issued on December 6, 1993. These resolutions assigned the Russian Joint-Stock Company Gazprom (later, the Joint-Stock Company Gazprom) as the state exporter of natural gas and entrusted it with the function of exporting gas outside Russia under transnational and intergovernmental agreements.

These circumstances complied with the situation at that moment on the gas market, because JSC Gazprom was the main producer of natural gas in the country exporting natural gas from Russia and providing guaranteed supplies of gas to the domestic market at regulated prices. Apart from that, the fact that JSC Gazprom was the sole owner of the gas-transportation infrastructure also serving for expert of gas strengthened its position as the only exporter of gas.

The main changes in the late 1990s and early 2000s were as follows:

• decline of gas production in actively developed fields that accounted for the main gas production volumes of JSC Gazprom against the background of increasing demands for gas on the domestic and export markets;
• growth of natural gas production by independent organizations;
• decline in the profitability of gas supplies to the domestic market (where the prices are regulated by the state) compared to the profitability of export supplies of gas (with export prices formed in competition of different types of fuel);
• emergence of new gas projects based on product sharing agreements outside the territory of the unified gas supply system and beyond the common regulation regime;
• emergence of new large-scale gas-export projects owned by independent organizations outside the territory of the unified gas supply system; and
• development of projects for liquefied natural gas production by independent organizations.

Substantial changes in the conditions of gas industry operation led to the necessity of revising the existing system of relationships between JSC Gazprom and independent organizations associated with export gas, including independent organizations working under production sharing agreements.

For retaining its positions as the only exporter of gas, JSC Gazprom worked out in the framework of the policy of unified export channel declared by the state and then initiated adoption of Federal Law No.117-FZ of July 18, 2006 «On Export of Gas.»

This law was based on the fundamental provisions of Article 26 of Federal Law No.164-FZ of December 8, 2003 «On the Principles of State Regulation of Foreign Trade Activities» that regulate the exclusive right to export and/or import certain commodities, according to which:

• the right of conducting foreign trade activities may be limited by granting the exclusive right to export and/or import certain commodities (Paragraph 1);
• the commodities export and/or import of which requires the exclusive right and the organizations given the exclusive right to export and/or import certain commodities are determined by federal laws (Paragraph 2);
• the exclusive right to export and/or import certain commodities is granted on a license basis (Paragraph 3);
• transactions for export and/or import of certain commodities implemented without a license for the exclusive right to export and/import said commodities are invalid and void (Paragraph 4);
• organizations given the exclusive right to export and/or import certain commodities carry out transactions for export and/or import of certain commodities based on the principle of non-discrimination and guided only by commercial considerations (Paragraph 5).

The earlier version, Federal Law No.157-FZ of October 13, 1995 «On State Regulation of Foreign Trade Activities» implied the possibility of state monopoly on export or import of certain commodities (Article 17).

This provision went against the norms and provisions of the World Trade Organization and in the new version was given a gentler formulation: «exclusive right to export and/or import of certain commodities.» The exclusive right to export and/or import certain commodities is one of the forms of non-tariff regulation of foreign trade activities (Article 20 of the Federal Law «On State Regulation of Foreign Trade Activities»).

Establishment of the exclusive right to export and/or import certain commodities is a legally permitted way of limiting rights to foreign trade activities. The law (Article 26) provides only general principles for application of this instrument for state regulation of foreign trade activities, which should be properly interpreted in bylaws for each concrete case.

For example, non-discrimination may be ensured by introduction of quotas as it was done for regulation of export of precious metals and defense-related products.

Export of precious stones and metals:

According to Resolution No.742 of the President of the Russian Federation of June 21, 2001 «On Import of Precious Stones and Precious Metals into the Russian Federation and Their Export from the Russian Federation» (enforced in accordance with Article 10 of Federal Law No.41-FZ of March 26, 1998 «On Precious Stones and Precious Metals»), affined platinum and affined metals of the platinum group in the form of ingots, plates, powder and granules are exported by the state unitary enterprise «Foreign Trade Association Almazyuvelirexport.» According to the aforementioned resolution of the President of the Russian Federation, the Ministry of Finance of the Russian Federation exercises control over adherence of its subordinate state unitary enterprise Almazyuvelirexport to the «principles of non-discrimination and bona fide commercial practice and prevention of cases of groundless rejection of or violation of contracts by this state enterprise and sets the maximum size of commission collected by this state enterprise from organizations with quotas for export of affined platinum and affined metals of the platinum group.»

Organizations having export quotas and willing to sell these commodities shall conclude a contract of commission agency with the state unitary enterprise Almazyuvelirexport and pay the commission approved by the state (Order No.62 of the Ministry of Finance of the Russian Federation of March 29, 2002 «On Approval the Size of Commission of the State Unitary Enterprise Almazyuvelirexport»).

Military and technical cooperation

The legislative regulatory document for military and technical cooperation is Federal Law No.114-FZ of July 19, 1998 «On Military and Technical Cooperation of the Russian Federation with Foreign States.»

On of the principles of state policy in the sphere of military and technical cooperation of the Russian Federation with foreign countries formulated in this federal law (Article 4) is the state monopoly on activities in the field of military and technical cooperation.

The main methods of state regulation and implementation of state monopoly in the sphere of military and technical cooperation (Article 5) include the following:

·        prevention of monopoly by a single participant in military and technical cooperation in the Russian Federation;

·        prevention of competition among several Russian participants in military and technical cooperation on the export market by division and separation of the spheres of their activities;

·        coordination of activities in the sphere of military and technical cooperation by state authorities of the Russian Federation and control of these activities.

Decision-making on the establishment of quotas for export and import, determination of methods for their distribution, and definition of procedures for organization of tenders involve regulation of economic processes, which is a function of the Russian Federation Government according to the Constitution of the Russian Federation and Federal Constitutional Law No.2-FKZ of December 17, 1997 «On the Government of the Russian Federation.» Article 23 of Federal Law No.164-FZ of December 8, 2003 «On the Principles of State Regulation of Foreign Trade Activities» corroborates the provision that distribution of quotas should be based on the equality of all participants in foreign trade activities.

According to Resolution No.443 of August 27, 2004 of the Russian Federation Government «On Approval of the Regulation on the Ministry of Economic Development and Trade of the Russian Federation,» the federal executive authority entitled to organize tenders and auctions for selling export and import quotas is the Ministry of Economic Development and Trade of the Russian Federation.

The absence in the Law «On Export of Gas» of an immediate directive for the Government of the Russian Federation to work out a bylaw that would concretize export regulations may serve only as a formal reason for delaying the issue of a corresponding resolution of the Russian Federation Government. However, the necessity of working out and issuing such a document is based not only on the need to develop and unveil the non-discrimination principle (formulated in Paragraph 5, Article 26 of the Law «On Foreign Trade Activities») but also on a number of objective reasons such as the following:

• under conditions of growing foreign and domestic demands for gas and the growth of gas production of JSC Gazprom lagging behind these growing demands, it is necessary to prescribe a procedure for determination of export volumes of gas (contracting volumes) and their distribution among different gas producers (owners) at the level of a resolution of the Russian Federation Government;
• it may be stated with certainty that adoption of the Law «On Export of Gas» curtailed JSC Gazprom’s flexibility in negotiations with gas exporters. Adoption of the Federal Law «On Export of Gas» destroyed the existing schemes of gas export by independent producers of gas and did not change the need for gas export. This means that sooner or later this problem will be solved in one way or another. Recently, JSC Gazprom refused to export gas in several cases and an independent organization played Gazprom’s role till the completion of negotiations between the customer and JSC Gazprom.

2.   Proposals for Access to Export Capacities

2.1         Organization of Sales of Russian Gas Outside the Customs Territory of Russian Federation

A summary of possible directions for the adjustment of governmental regulation of export of Russian gas has yielded three basic alternative methods. The difference between the methods is the extent of the necessary modifications to the existing system of regulation.

• Minimum adjustment. The first direction of development of gas export regulation is the enhancement of the regulation within the framework of existing laws governing the export of gas. Even in this case, however, some amendments will most likely be necessary to the Gas Export Federal Law currently in force, although such amendments will be of clarifying nature. The fundamental philosophy of export that provides for gas exporting via a single channel represented by the owner of the gas transmission network will be preserved.
• Alteration of export philosophy. The second direction assumes more fundamental changes in the legislative base so as to alter the export philosophy that is consolidated in the applicable laws. Examples are abandonment of the single channel, or retaining it with major limitation of powers and functions of the exclusive exporter company.
• Alteration of the sectoral structure. The third direction of adjustment of governmental regulation assumes not only modifications in the gas export area, but also alteration of the general structure of the whole gas industry.

Table 2 briefly describes the main characteristics of each direction.

TABLE 2. Main Characteristics of Directions of Adjustment of Governmental Regulation of Export

Characteristic	Direction 1.Minimum Adjustment	Direction 2.Alteration of Export Philosophy	Direction 3.Alteration of Sectoral Structure
Amendments to applicable export laws	NO or minimum	YES	YES
Amendments to applicable gas industry regulation laws	NO	NO	YES

Each of the directions in question assumes the use of different instruments of regulation. These directions are differentiated by the extent of changes in the existing situation in the gas industry.

A total of four legal arrangements for export exist (see Appendix 1).

It should be noted that the key issue of applicability of a particular legal export arrangement is the meaning of the term «export»:

• according to Article 165 of the Customs Code of Russian Federation, export is a customs regime, under which items that are in free circulation within the customs territory of Russian Federation are exported from this territory without reexport commitments;
• according to Clause 7, 28 of Article 2 of Federal Law No. 164-FZ, «On the Principles of State Regulation of Foreign Trade Activities,» dated December 8, 2003, foreign trade activity is defined as the import and/or export of goods. Export of goods is the exportation of goods from the customs territory of Russian Federation without the obligation to return them.

In other words, export is the exportation of goods; trade.

Definition of the term «export» makes it possible to delimit the feasibility of the legal arrangements in question and assign them to various directions of adjustment of legislation.

Figure 2 schematically illustrates the differences between the gas export arrangements.

FIGURE 2. Choice in Terms of Radicality of Alteration of Regulation

Producer	Licensed Exporter	Sales Markets
			Direction 1 Minimum adjustment  Contract for Domestic Purchase of Gas
			Direction 1 Minimum adjustment  Contract of Commission Agency (Brokerage Contract)
			Direction 2 Alteration of export philosophy  Trust Deed
			Direction 2 Alteration of export philosophy  Supply Contract
			Direction 3 Alteration of sectoral structure  Procurement Agency

Let’s consider each direction more closely.

Direction 1

According to Clause 1 of Article 3 of the Federal Law No. 117-FZ of July 8, 2006, «On Export of Gas,» export of gas is a licensable activity. Licensing of this activity takes place on the basis of the general regulation — Regulation for Licensing of Foreign Trade in Commodities approved by Resolution of the Government of Russian Federation No. 364 of June 9, 2005. The licensor is the Ministry of Economic Development of Russia. Then, on the grounds of licenses issued by the Ministry of Economic Development of Russia, the Federal Customs Service of Russia regulates the exportation of goods outside of the customs territory of Russian Federation by way of telegrams or telephone messages to all customs posts.

Following the limitations set by us for the first direction of adjustment of governmental regulation of export, and considering the available legal arrangements, the conclusion can be made that the least modification of applicable legislation is required for the implementation of: gas export under the contract of commission agency (brokerage contract), and contract for domestic purchase of gas for its subsequent export (see Paragraphs 3 and 4 of Appendix 1).

The first direction may be called the implementation of the «single export channel» strategy. The world experience of implementation of such strategies, the aims of governments in their implementation, and the particulars of their use will be discussed in this section in the item World Experience.

Let us consider each of the proposed legal arrangements in greater detail.

Contract for Domestic Purchase of Gas for Subsequent Export

Implementation of this legal arrangement will not require additional costs (neither financial, nor organizational). Practically, the enactment of the law «On Export of Gas» was aimed exactly at legal capturing of the established situation. We will not reiterate the description of the established situation, which was described in sufficient detail in Section 1.2.

Certainly, avoidance of governmental regulation with respect to control over the conclusion of gas sale contracts between gas producers and gas sellers to consumers is a progressive move. But all the advantages of this move are reduced to zero by unresolved issues of access and the absence of rules for conclusion of such transactions. In addition, concentration of production, transmission and dispatching within a single company gives rise to interest of such company in transactions, which leads to discrimination.

The result would be a market virtually regulated by a dominating monopolistic player-the owner of the transmission infrastructure-instead of government.

Contract of Commission Agency (Brokerage Contract)

Just as in the case of a contract for domestic purchase of gas, the implementation of gas purchase for its export supply on a commission basis (under a brokerage contract) will not require substantial modifications to the applicable laws.

But the implementation of this legal arrangement will require enactment of a document at least at the level of the Government of Russian Federation that will specify the procedure for allocation of gas quantities (quotas) delivered for export, and the compensation to the company that owns the gas export license. These requirements stem from the necessity to ensure the non-discrimination and the export economy, as provided for in the Federal Law «On the Principles of State Regulation of Foreign Trade Activities:».

Allocation of gas quantities (quotas) for export supply could be performed using the following methods:

• administrative method, in which the state itself allocates a quantity (quota) of gas to each particular company on the basis of previously announced principles;
• competitive method, in which gas quantities (quotas) are allocated by way of auction between companies wishing to export gas via a «single export channel» (i.e. with participation of the organization that owns the gas export license).

Allocation of gas quantities (quotas) is discussed in more detail in the next Section.

Direction 2

The second direction of adjustments is a revision of the entire export philosophy. The framework in which the government removes restrictions for access to export markets is widely accepted in the world. Cancelling regulation, at least in what regards its statutory consolidation, appears simpler than building up a logical and closed system of governmental regulation. It should be kept in mind that even in case of complete abandonment of direct regulation, the government will still retain indirect levers, which may provide acceptable efficiency. But to employ such levers requires extensive practice with them.

Legal arrangements that suit this direction the most are gas export under a trust deed and a supply contract (see items 1 and 2 of Appendix 1).

Let us consider more closely each of these arrangements.

Trust Deed

Implementation of gas purchase for its export supply under a trust deed will require considerable revision of the established export philosophy. JSC Gazprom and its subsidiaries are currently practically the sole exporters of gas (independent companies only deliver gas in rare cases and only to FSU countries, with the tacit consent of JSC Gazprom), whereas conclusion of trust deeds between JSC Gazprom and independent companies assumes the delivery of gas by those independent companies. In other words, the owners of the exported gas, and hence the gas exporters, will be the independent companies. JSC Gazprom and its subsidiaries will act in the interests of gas owners for a fee.

A trust deed may to some extent be seen as an enhancement of the contract of the commission agency (brokerage contract). In a trust deed, independent companies get an additional (as compared to the contract of commission agency) right to deliver the gas on their own behalf.

The advantage of this arrangement is that it gives the opportunity to companies other than JSC Gazprom to emerge on the Russian export market. Removal of restrictions and development of competition may have a beneficial effect on the overall attitude of investors towards Russian gas projects. But at the same time, competition between Russian producers on export markets may lead to decreased income of Russian Federation for the gas being sold.

The solution to the problem of competition between Russian producers on export markets may be a Resolution of the Government of Russian Federation, in which a company will be appointed to function as the single export channel, i.e. a negotiator for the export supply of gas on behalf of all producers (JSC Gazprom and the independent companies), that shall observe the state requirements specified beforehand (such as conclusion of export contracts at at least the specified price). In addition, the government may allocate gas export quotas in the same way as in the case with the contract of a commission agency (brokerage contract).

Supply Contract

A direct gas export supply contract assumes cancellation of all middlemen in the chain of export gas supply between independent companies and consumers. A supply contract is the next stage of development of relations between independent companies and export purchasers of gas.

Competition in export will increase in comparison with the trust deed. The problem of competition between Russian companies also remains.

A decision of the Government of Russian Federation regarding the allocation of gas export quotas (allocation among the exporters by target of export or division of deliveries to export markets between exporters) may reduce the urgency of the problem.

Direction 3

The third direction of adjustment of governmental regulation of export assumes not only modifications in the gas export area, but also alteration of the general structure of the whole gas industry.

Use of the Procurement Agency Model (see Section 1 of this Report), in which gas is sold by independent companies at the entry point of the monopoly company’s gas transmission network, does not assume the export supply of gas. Further allocation of gas to the domestic and the export market is performed by the procurement agency. However, as was mentioned earlier, this assumes competition at the level of production. Affiliation of producers with the procurement agency will reduce the advantages of this model to zero.

Provided that competition at the producer level will be implemented, the issue of fair gas selling price would be resolved. In the determination of gas purchase price, specifics of the existing market shall also be taken into account. In particular, presence of the regulated domestic sector, as well as considerable export deliveries at prices differing from the regulated prices by 3-4 times.

2.2         Principles of Access to Export via Existing Pipeline Capacities

Implementation of any of the considered purchase arrangements will require the determination, at the level of the Government of Russian Federation, of:

• quantity (quota) of gas directed for export that will be allocated among the producing companies;
• facilities for non-discriminatory allocation of this quantity to the producing companies or companies wishing to supply the gas for export;
• principles of determination of the gas price or the commission fee, as well as definition of gas selling/transfer points for subsequent export delivery;
• rights and obligations of the organization that owns the exclusive gas export license.

The system of quota allocation is already implemented in the export of oil. Particularly, Article 6 of the Natural Monopolies Federal Law No. 147-FZ of August 17, 1995 states that «the right to access the system of Russian trunk pipelines and terminals for the export of oil outside of the customs territory of Russian Federation shall be granted to organizations that carry out oil production and are duly registered, and to organizations that are principal organizations with respect to those which carry out oil production, proportionate to the volumes of the produced oil that are transferred into the trunk pipeline system, taking into account the 100-percent throughput capacity of the trunk pipelines (judging from their technical capabilities).» Moreover, in ministries and departments, an issue of improving the existing procedure by way of access specification by targets (countries) of transmission is being seriously considered. But in this connection it should be remembered that oil is being exported mostly in one direction (to Europe). Construction of the Eastern Siberia — Pacific Ocean (ESPO) pipeline will considerably complicate the existing export situation; it will require the revision of the entire system of allocation of export access among oil companies.

This is the very reason why unified principles and approaches shall be laid in the foundation of the framework for allocation of gas export quotas and access to oil export.

The primary drawbacks in the implementation of the framework for allocation of gas export quotas and the formulation of the procedure for determination of price of gas (amount of commission charge in case of gas export sale under the contract of commission agency) supplied under these quotas are as follows:

• a resolution of the Government of Russian Federation (or even amendments to the Federal Law «On Export of Gas») shall be drafted and enacted in order to specify the provisions of the Federal Law «On Export of Gas;»
• existing relations between JSC Gazprom and independent companies will be substantially complicated;
• independent companies might revise the regions of gas supply on the domestic market. This may be due to reallocation of gas supply to socially important consumers between JSC Gazprom and independent companies;
• independent companies may be denied the opportunity to sell the gas directly to consumers and receive additional income.

The advantages of the framework may be:

• increased state participation in gas export supply;
• determination of transparent «rules of play» for export supply;
• stimulation of development of new gas fields by independent producers;
• lowering of risks for independent companies that are taken into account when making investment decisions concerning the development of new fields.

Determination of Gas Export Quotas for Allocation among Producing Companies

Examination of Article 21 of Federal Law «On the Principles of State Regulation of Foreign Trade Activities» shows that the overall volume of gas export quotas to be allocated among those wishing to supply natural gas for export shall be determined by the Government of Russian Federation.

Overall volume of gas export quotas may correspond to the total quantities of gas that are supplied for export during the year, or be a percentage of the total quantities of gas export during the year.

Since long-term and medium-term gas supply contracts usually specify the gas supply profile that may be changed from month to month, in the initial phase of development of the gas export system it would be appropriate to determine the overall volume of export quotas as a percentage of the annual quantity of gas export supply, i.e. by way of averaging.

After that, unless otherwise specified, a contract period of one year term shall be assumed by default.

The case of determination of volumes of gas export quotas as the total quantity of exported gas will, firstly, require no additional elaboration of principles for the determination of percentage of the total quantity of export, and secondly, such allocation will be in better correlation with the non-discrimination principle that is established in the Federal Law «On the Principles of State Regulation of Foreign Trade Activities.»

In this connection it should be noted that the probability of determination of the volume of export quotas as a percentage of the total quantity of gas export is significant, because a direct analogy could be observed with the established procedure of non-discriminatory access to pipeline capacities. It is likely that the volume of export quotas will be determined not on the basis of the total quantity of gas export, but on the basis of available export capacity.

In any case of allocation of quantities, the existing practice for allocation of quantities of gas transmission via gas transmission capacities (the issue of access) will exert influence as a practice that has already been implemented and which continues to operate. Alongside with that, since the export system is being set up virtually in the absence of an existing legal base or the implementation practice, it would be sensible to try to develop the quantity allocation principles without regard to the access practice, which is not the best. Moreover, for the avoidance of confusion, terms associated with access should not be used in export-related documents.

One potential principle for determination of the volume of export quotas (or just the portion of total export quantity) could be reduction of volumes in the amount of gas delivered under intergovernmental and international agreements. JSC Gazprom is responsible for supply under such agreements. At the same time, the examined legal arrangements for domestic gas purchase and exportation under the contract of commission agency (brokerage contract) generally meet the requirements of fulfillment of intergovernmental and international agreements, because the gas consumer deals with only one organization that owns the exclusive gas export license. Probably, in such contracts a company should be nominated that shall serve as a guarantor of gas supply in order to reduce risk of gas non-delivery, if the owner of the exclusive gas export license and the gas supply guarantor will not be the same legal entity.

Short-term transactions (spot transactions) that may be executed on export markets should be regarded separately. The European market for such transactions grows at a quick pace, hence avoiding consideration of them would mean the loss of an expanding sector of the export market. Besides, significant income could be earned in this sector of gas market, because it is more susceptible to price changes. Determination of quantities of gas to be sold in this market sector will require greater promptness of decisions on the allocation of export quotas to companies, as compared to the case of long-term contracts. Since the procedure for allocation of such quantities requires a certain proven practice, its implementation would be appropriate to proceed with after the general system for allocation of gas export quotas has been set up, and only thereafter proceed with its elaboration.

Allocation of Export Quotas

After the determination of the overall volume of gas export quotas, this volume should be allocated (split into quotas) among both the export targets and the companies wishing to participate in the export.

The term «export target» will require additional specification. It may mean:

• export out of Russia as a whole;
• export to Europe or the East;
• export to other FSU countries and beyond;
• export via particular pipeline systems, etc.

Allocation of export by export targets is due to existing technical limitations of capacity, existing differences in the economic efficiency of gas supply, and the established gas supply practice.

In world practice, the following basic non-discriminatory principles of volume allocation are used:

• first in, first out;
• proportionate;
• auction-based.

The first in, first out principle and the auction-based principle represent competitive allocation, while the proportionate principle represents administrative allocation.

In conditions when natural gas production, transmission, and export opportunities are bundled in one company (JSC Gazprom), the first in, first out principle may not be efficient in the organization of non-discrimination. This principle will not work when there is a company with greater market power than others.

An auction for allocation of export quotas may be held using two basic methods:

• by changing the amount of payment (commission charge) for the gas export quota. In such case, companies who wish to acquire the gas export quota will bid in an auction, which will be held with periodicity depending on the duration of the export quota. The bids will indicate the amount of payment (commission charge) that the company is willing to pay for such quota. The quota will be awarded to the company that has offered the maximum payment (commission charge);
• by changing the gas selling price of the exporter company. In such case, companies who wish to acquire the gas export quota will bid in an auction, which will be held with periodicity depending on the duration of the export quota. The bids will indicate the price at which the gas was transferred from the tenderer to the holder of the exclusive gas export license. The tenderer with the minimum transaction price wins the quota.

The Government of Russian Federation has designed and passed the Resolution No. 1299 of October 31, 1996 «On the Procedure of Tenders and Auctions for Sale of Quotas for the Introduction of Quantitative Restrictions and the Licensing of Export and Import of Goods (Work, Services) in Russian Federation.» This Resolution, inter alia, provides for quota auctions. This Resolution may be taken as a basis for the drafting of documentation for gas export quota allocation auctions. This Resolution may not be utilized in full, as it is not designed for organization of export via an organization that owns an exclusive gas export license.

Preparation and holding of auctions requires appropriate market infrastructure and proven practice. It is exactly the complexity of auction procedures and the substantial expense for setting of the necessary infrastructure that makes it difficult to employ this method of price determination. Besides, practice shows that the main bulk of any commodity gets sold under direct contracts, bypassing the auction arrangements.

Adherence to the proportionality principle in gas export quota allocation requires that this principle be specified both by export targets and by sub-allocation within each target (proportionate to production, to gas transfer into the trunk pipeline system, etc.).

An analogy may be drawn in this relation with access to and allocation of transmission capacities (however, in order to avoid confusion and unwanted complications, it is better not to use these terms in export-related documents).

Allocation of Quotas between Export Targets

Gas export may be divided into two large segments: export to FSU countries and export to all other countries. These segments differ not only in terms of the prices that have established in them, but also by the existing practice of gas supply by independent producers. For example, independent companies have experience of gas supply under direct contracts to FSU countries such as Belarus, the Baltic states, Georgia, etc. At the same time, gas to other countries has been supplied exclusively by JSC Gazprom.

Allocation of quotas between particular pipeline systems will make it possible to remove the issue of organization of the secondary market of quotas, which is required for allocation of quantities among different producers, who produce gas from fields distant from each other.

Nevertheless, principles of export quota allocation shall be unchanged from target to target, because otherwise it could lead to emergence of «gray» crossflows between the targets, or a «gray» market of quota allocation.

Allocation of Quotas within a Target

For the convenience of analysis, the potential scenarios of proportional quota allocation by targets are summarized in Table 3.

TABLE 3. Allocation of Quotas within Each Target

	Allocation of export volumes (quotas) within each target proportionate to:
Existing problems	gas production	gas transfer into the gas network	domestic supply	supply to public and socially oriented consumers
allowance required for gas quantities produced in regional gas networks	Yes		Yes	Yes
development required of a transparent facility for gas export quota reallocation after their original allocation	Yes		Yes	Yes
compensation required for inequity with respect to producers that are forced to supply significant quantities of gas to domestic market at regulated prices	Yes	Yes	Yes

As is evident from the above Table, none of the approaches to proportional allocation of export quotas can be considered universal. Each of them has its benefits and shortcomings.

Let us discuss them in greater detail.

Quota allocation proportionate to gas production is rather easily administrated because information about gas production is distributed wide enough and could be verified if necessary. There is only one limitation concerned with the need to account for gas that is produced by companies supplying it to the regional gas networks, i.e. to networks from which the gas basically cannot be delivered for export. Surely, such companies may be discounted during the gas export quota allocation, but then it would be a somewhat different framework (for example, see export quota allocation proportionate to gas transfer into the gas network). Another feature of gas export quota allocation proportionate to gas production is that the differing economic efficiency of gas supply to various segments of the domestic market is not accounted for. JSC Gazprom regularly refers to this argument, each time appealing to the fact that it supplies the gas at regulated prices and is also the main supplier of gas for the population’s needs. In the opinion of JSC Gazprom, such a state of affairs leads to a shortfall of gas sales income, and this should be taken into account in the allocation of export quotas.

Such accounting may be effected either by granting a greater volume of quotas to JSC Gazprom, or by requiring independent gas producers to commit to gas supply to the regulated market and, in particular, to the population.

This very logic is embedded in the quota allocation approach proportionate to supply to public and socially oriented consumers. But the main obstacle to implementation of this approach is the lack of reliable information concerning the supply of gas to such consumers and lack of capability to verify this information.

Replacement of public and socially oriented consumers with consumers receiving gas at regulated prices won’t solve the problem either. Firstly, in conditions of governmental regulation, gas prices for the population and the industry differ significantly. Hence, the difference should be accounted for in the allocation of export quotas. Secondly, even the prices fixed by the government for a particular category of consumers vary depending on the consumption zone. And while the gas supply at the regulated price might be cost effective in zones with lower index numbers, gas supply to zones with higher index numbers may become unprofitable because of misalignment of the governmental systems for price and rate determination. There are concerns that if the proposed principle is ever used, JSC Gazprom may relegate to independent gas producers its commitments of gas supply to public and socially oriented consumers in the most remote locations, and keep the locations proximate to production sites, i.e. the most cost-effective locations.

If we accept the axiom that the gas sales economy is the main factor influencing the allocation of gas export quotas, the delivery to the unregulated market sector of gas quantities produced by JSC Gazprom shall automatically grant export quotas to independent gas producers. Proceeding from the above, a conclusion could be made that in case gas trading begins at unregulated prices, additional gas export quotas should appear.

The approach that provides for export quota allocation proportionate to domestic supply is an intermediate step between the two previous approaches and is given for the completeness of the picture under consideration, since it bears the same drawbacks as the other ones.

Another shortcoming common to all of the above frameworks is the necessity to organize a secondary market of export quotas. This necessity is due to the fact that because of their geographical location, producing companies can deliver gas only through the particular transmission paths. Organization of the secondary quota market will make it possible to handle this problem and provide flexible reallocation of available gas quantities.

This is where another limitation should be mentioned. The complexity of the system being implemented will be in direct correlation with the number of companies holding exclusive gas export licenses. If there will be more than one such holder, additional governmental coordination will be required for allocation of quotas among the holders. Presence of only one such license holding company will greatly simplify the process of administration. But even in the presence of only one owner of the exclusive gas export license, the secondary quota market will still be required. This is due to the physical specifics of gas delivery through various routes (paths).

Price Regulation of Gas Export Service

Let us discuss in more detail the issues of governmental regulation of contract prices (commission charges) for contracts between the company that owns the exclusive gas export license and those who wish to sell the gas for export.

The state may establish a special procedure for control over the company that owns the exclusive license for export of certain commodities. For instance, according to the Decree of the President of Russian Federation No. 742 of June 21, 2001 «On Import of Precious Stones and Precious Metals into the Russian Federation and Their Export from the Russian Federation» export of refined platinum and platinum-group metals in the form of ingots, slabs, powder and grains shall be carried out by the state unitary enterprise Foreign Economic Association Almazyuvelirexport. According to the said Decree of the President of Russian Federation, the Ministry of Finance of Russian Federation «sets the maximum size of commission collected by Almazyuvelirexport from organizations with quotas for export of affined platinum and affined metals of the platinum group.»

Depending on the legal arrangement of export being implemented, the state may either regulate the amount of commission charge that is paid to the holder of the exclusive gas export license, or determine the minimum gas prices at which the holder purchases gas domestically.

In case of gas export quota allocation in an auction, the price shall be determined from the auction results and will not require governmental regulation.

Determination of the minimum price requires necessary fixation of the transaction point, i.e. the gas title transfer point. This point may be located at the entry of the gas transmission network, at the boundary of Russian Federation or at any of the balancing points where gas will be traded in accordance with the Resolution of the Government of Russian Federation No. 534 of September 2, 2006 on the Experiment for Gas Sales at the Electronic Trading Spot.

For each of the selected points, the minimum price may be determined by:

• reverse calculation from the gas prices forming on export markets. The minimum price shall be equal to the gas price established on export markets less costs of customs duties, costs of transportation from export markets to the transaction point, commission fee to the holder of the exclusive gas export license, and other costs (such as fees upon auction sale of gas);
• method of comparison with prices of gas imported into Russia;
• method of comparison with prices of energy sources which may replace gas in conditions of transparent determination of their price, and taking into account the specifics of gas usage.

One of the primary costs accounted for in the price calculation is the cost of transportation via trunk pipelines. On the grounds of the Order of the Federal Tariff Service of Russia No. 151-e/1 of July 28, 2006 «On Rates of Charges for Gas Transmission Services Using Trunk Pipelines of JSC Gazprom for Independent Organizations,» cost of transportation of gas of independent organizations outside of the customs territory of Russian Federation is calculated and is currently $0.97 per 1,000 m³ per 100 km. A regulatory base for the calculation of cost of services for transportation of gas of JSC Gazprom outside of the customs territory of Russian Federation is currently absent.

From the estimates of the Federal Tariff Service of Russia, rate of charges for transportation of gas of JSC Gazprom via trunk pipelines outside of the customs territory of Russian Federation should be the same as the rate of charges that is currently set for transportation of gas of independent organizations.

The commission fee of the holder of exclusive gas export license shall not exceed its expenditures associated with the execution of transactions plus the allowed return on capital. Currently, commission fee for export of precious metals, etc. is fixed at 3-4% of the contract value.

2.3         Principles of Access to Export via Newly Created Pipeline Capacities

Article 4 of the Foreign Trade Activity Law consolidates the basic principles of governmental regulation of foreign trade activity:

• equality of foreign trade activity participants and their non-discrimination, unless otherwise provided in a federal law. The state shall not discriminate among foreign trade activity participants, i.e. it shall not offer better foreign trade conditions to certain participants than those that have been offered to other participants;
• unity of the customs territory of Russian Federation. The principle of unity of the customs territory is aimed at avoidance of customs and foreign trade particularism. It eliminates the possibility of internal customs borders;
• unity of the system of governmental regulation of foreign trade activity. The principle assumes the establishing of a single system for control over the mechanism of governmental regulation of foreign trade activity;
• uniform application of methods of governmental regulation of foreign trade activity throughout the Russian Federation. This principle is closely related to the previous principle of unity of the system of governmental regulation of foreign trade activity itself. Uniform application of methods of governmental regulation of foreign trade activity is ensured by the unity of the existing regulatory and legal base. The principle of uniform application of methods of governmental regulation shall also mean that these methods shall be applied uniformly throughout the Russian Federation.

Examination of the basic principles of governmental regulation of foreign trade activity may lead to the conclusion that the provisions related to the natural gas export shall be universal, i.e. same for each of the export targets.

2.4         Fundamental Provisions of Resolution of the Government of Russian Federation for the Regulation of Gas Export

Due to the vast scope of issues that need to be determined at the level of Resolutions of the Government of Russian Federation, it would be appropriate to split the document that shall govern the relations concerned with gas exportation outside of the customs territory of Russian Federation into two parts: a Gas Export Regulation and the Resolution of the Government of Russian Federation on approval of said Regulation.

The Resolution of the Government of Russian Federation for the regulation of gas export shall be designed in pursuance of provisions of the Federal Law «On the Export of Gas» and the Federal Law «On the Principles of State Regulation of Foreign Trade Activities,» with a view to efficient use of the natural resources of the Russian Federation and elimination of unreasoned competition between Russian companies on export markets. In addition, the Resolution shall include a provision regarding the approval of the Gas Export Regulation, and, if necessary, set terms for the designing of the necessary documents by executive authorities.

Such executive authorities may be:

• Ministry of Economic Development of the Russian Federation: regarding customs clearance of gas, assurance of non-discriminatory provision of export services, determination of commission charges for the provision of such services, determination of quota allocation principles;
• Ministry of Industry and Power of the Russian Federation: regarding determination of quota allocation principles;
• Federal Customs Service of Russia: regards customs clearance of gas;
• Federal Antimonopoly Service of Russia: regarding assurance of non-discriminatory provision of export services;
• Federal Rate Service of Russia: regarding determination of commission charges.

The approximate structure of the Gas Export Regulation could be as follows:

• description of the target of regulation (specification of the concept of «gas» that is covered by the Regulation);
• description of entities who may be entitled to gas export quotas;
• statement of the fact that gas export shall take place in accordance with the duly issued exclusive licenses;
• determination of the body that shall set the overall volume of gas export quotas, and the periodicity of such setting. For example: «Overall volume of natural gas export quotas shall be set annually by the Government of the Russian Federation before ______ day of December, as advised by the Ministry of Industry and Energy of the Russian Federation and approved by the Ministry of Economic Development and Trade of the Russian Federation»;
• additional encumbrances that may be imposed on producing companies and owners of gas who wish to deliver their gas for export. For example: «Gas producing companies and companies that lawfully own the gas may carry out export in the procedure established by this Regulation only after their contractual commitments for gas supply to public and socially oriented consumers have been fully discharged. Supervision of the pursuance of this Clause shall be vested in _____________»;
• determination of the procedure for export quota allocation among companies. For example: «Gas export quotas shall be allocated among gas producing companies in proportion to …»;
• determination of the legal arrangement for the implementation of export. For example: «Gas export shall be carried out by the organization that owns the exclusive gas export license under contracts for commission agency (brokerage contracts) between this organization and the organizations mentioned in Clause … (No. of Clause, in which entities who may be entitled to export quotas are listed) of this Regulation»;
• consolidation of supervision over the adherence to the principles of non-discrimination and good commercial practice in the correspondent federal executive authority;
• entrusting of the Ministry of Economic Development and Trade of Russian Federation with monitoring of prices on export markets and their publication in informational publications;
• entrusting of the Federal Rate Service of Russia with setting of rates of charges and calculation of commission fee to the holder of an exclusive export license;
• entrusting of the federal executive authority with the duty to collect information about the quantities and targets of export supply of gas.

The Regulation shall include an instrument compelling JSC Gazprom and the independent organizations to pursue the rules secured by it.

3.     Description of Currently Actual Issues of Access

Access in the gas transportation infrastructure is referred to as conclusion of a contract between the gas owner and gas transportation company on transportation of previously agreed quantities of gas at a stipulated price.

In order to examine in detail the issue of access to gas transportation infrastructure one should determine the key term constantly used in global and Russian practice, namely the definition of «free capacity».

The Regulation of the Government of the Russian Federation «Provision of Access to Independent Organizations to the Gas Transportation System of Gazprom JSC» No. 858 dated July 14, 1997 gives the following definition: «Free capacity of the gas transportation system means technically possible capacity of the gas reception and transportation system less quantities of gas transmitted for organizations within the system of Gazprom JSC’ and independent organizations, in compliance with contracts effecting in the certain time, as well as in compliance with decisions of the President of the Russian Federation and  the Government of the Russian Federation on mandatory deliveries of gas by organizations within the system of Gazprom JSC.»

For a better understanding of the peculiarities of determining free capacity, let us examine different methods of its determination.

The concept «free capacity» might be broken down in two interrelated parts: «physical (or process) free capacity» and «contractual free capacity.» These two capacities may significantly vary from each other.

Let us examine the different methods of determining «contractual free capacity» in more detail. In this Report we will be using the term «free capacity» with the meaning «contractual free capacity.»

Let us consider three types of contractual free capacity: «post,» «entry-exit» and «point-to-point.» For convenience, let us take a hypothetic pipeline system with two entry points (A and B) and two exit points (C and D) (Figure 5).

The type of contractual free capacity not necessarily should coincide with that of the rate established for the system.

1.     «Post:» the post type of contractual free capacity gives the right to pump gas into each of the entry points (A or B) and pick it from any of the exit points (C or D). Using this system, the company supplying and taking gas from the pipeline system (shipper) may change its entry or exit points without signing new transportation contracts.

2.     «Entry-exit:» a contract defining free entry capacity. It binds the company (shipper) to a concrete entry point but entitles it to take its gas from any exit point. In our example, the shipper may be bound by contract to point A, but as soon as gas enters the system he may deliver it to any customer to sign a contract with him on taking gas from any of the exit points. The company (shipper) does not have the right to deliver gas to point B until it signs a new gas transportation contract. Actually, such a system enables delivering gas to physically unrelated points within the system owing to internal offset of quantity of gas delivered within the system. A similar system can be applied to exit points by making appropriate revisions.

3.     «Point-to-point:» contract for use of free capacity from point to point entitles shipper to pump gas to specific entry point and take it from specific exit point. Moreover, in case the gas can be delivered from point to point through different routes within the system, the contract shall specify concretely which way the gas is delivered. If a shipper concluded a contract for transportation of gas from point A to point C, he may change neither entry nor exit point until he signs a new contract for gas transportation, thus losing the advance payment he has already made for reservation of free capacity for gas transportation from point A to point C. Namely for this reason the shipper’s contract for gas transportation is bound to specific route A-C and may not be switched to other routes like A-D, B-C or B-D.

FIGURE 5. Hypothetical Pipeline System

Flexibility of selection of injection and withdrawal points offered to the company (shipper) is very important for the development of competition in the gas market. The proposed flexibility reduces size-related competitive advantage for companies (shippers). In conditions of a completely inflexible «point-to-point» system the companies (shippers) with significant quantities of deliveries have an advantage linked to an ‘economy of scale’ effect. A big consumer base enables the shipper to perform internal substitution of gas quantities (swap); these consumers offer a huge variety of options for determination of specific entry and exit points regardless of transportation contracts with them. On the other hand, a company (shipper) providing services to a sole consumer can lose throughput for transportation in case the consumer takes less gas than expected. The company (shipper) can attempt to sell (in case such a possibility is anticipated) the free capacity in gas transportation system unless it is still needed, but it is quite difficult to find a customer for this free capacity within the «point-to-point» system. The sold free capacity of the transportation system will be valuable only for another company (shipper) concerned just in the same combination of entry and exit points. On the other hand, the right for free capacity in conditions of a post type system is valuable for all companies (shippers) that use transportation services, regardless of location of their consumers or entry point they are using. It is easier to provide the use of free capacity in a post type system. Moreover, use of a post type system reduces the chance of a small company (shipper) losing unclaimed free capacity.

Flexibility in determination of free capacity intensifies the competition for two reasons. It enables small companies (shippers) to be present on the market and see if they can successfully compete with others, take market shares away from others and grow up gradually. Unless flexible, companies (shippers) cannot enter the new market without initially overcoming the serious competition problem linked to the presence of shippers with a large stock of orders. The new company (shipper) connecting to the gas transportation system can be incurring losses until it grows to a certain size. Such losses may scare new companies (shippers) away from the market. Second, flexibility may raise the competition by encouraging secondary trade of free capacities.

Liquid markets of free capacity provide distinct market signals. For example, if long-term free capacity is sold with a significant premium on a secondary market, it shows the presence of potential limitations. In general, market participants use market signals as a guideline to work out their business strategies. New companies feel most comfortable to enter the market, information on which is available and transparent.

However the flexibility granted to the companies (shippers) directly influences the amount of free capacity to be contracted for on a permanent basis. We will demonstrate this by using the second hypothetical example. (See Figure 6)

FIGURE 6. Hypothetical Pipeline System 2

Figure 6 shows the second pipeline network system that comprises 3 entry points (A, B and C) and 2 exit points (D and E). The pipelines A-D and C-Е have a throughput of 2 units each, while pipelines B-D and B-E have a throughput of just 1 unit each. In this example the gas demand is 2 units in each of exit points D and E, a total demand of 4 units.

Let us consider the amount of permanent free capacity that a gas transportation organization can sell within this system under each of 3 types of contracts.

1. «Post stamp:» setting up this type of contract, the gas transportation organization may sell just one unit of free capacity. This is because when signing a contract for sale of greater amounts of free capacity, the gas transportation organization fails to meet a basic obligation of the contract, viz. free switching of entry and exit points by the company (shipper). For example, if a gas transportation organization sells 2 units of free capacity, it will fail to meet the basic obligations of the contract because it cannot transport 2 units of gas from point B to the consumer located in point D or Е. After the gas transportation organization sells one unit of free capacity, it may sell the remaining 3 units required for points D and E under the discontinuous free capacity contract.
2. «Entry-exit:» Signing this type of contract, the gas transportation organization may sell 5 units of free capacity to entry: 2 units in each of points A and C, and one unit in point B. In case the gas transportation organization sells 2 units of free capacity in point В, it fails to meet the obligation for transportation of 2 units from point В to consumers located in point D. Furthermore, the company (shipper) needs to determine the free capacity in exit points. While selling 5 units of entry free capacity, the gas transportation organization may sell just 4 units of exit free capacity: 2 units in each of points D and E. Since the gas transportation organization knows the demand in point D is 2 units, it may sell 2 units of free capacity regardless of the point the gas will be pumped into the system. Although 5 units of free capacity is more than enough to satisfy the total demand of 4 units, the risk of inefficiency still remains in this system. It is interesting that in this example the gas transportation organization may allow the consumer located in point Е to sign a contract for 2 units with a company (shipper) that owns 2 units of free capacity in point A even if it is physically not possible to pump 2 units of gas from point A to point Е. The gas transportation company knows: if the contract for supply of 2 units from point А to D is signed, then 2 units may be consumed in point E in two cases: either 2 units of gas are delivered from point C, or one unit is delivered from point B and one from point C (two units of gas may not be delivered from point B as the gas transportation organization authorized just one unit of free capacity in this point). Anyway, the gas contracted for delivery to point E will be virtually delivered to point D and vice versa.
3. «Point-to-point:» In the event of such a contract, the gas transportation organization may sell 6 units of free capacity: 2 units through each of routes A-D and C-Е, and 1 unit through each of routes B-D and B-E. Since the free capacity within the «point-to-point» system is determined by specific entry and exit points, the gas transportation organization may, as a compensation for inflexibility (inability to change injection and withdrawal points), maximize its potential sales of free capacity.

This hypothetical example illustrates the fact that the amount of free capacity the gas transportation organization can sell depends on the system of free capacity determination it proposes. Granting more flexibility in determination of free capacity may reduce the amount of free capacity that the gas transportation organization can sell. In the event of its determination with the «post stamp» system, the free capacity is most flexible, but enables the gas transportation organization to sell the minimum amount of free capacity. The «point-to-point» system is the least flexible type of free capacity determination. On the other hand, it enables the gas transportation organization to sell the maximum amount of free capacity, but it is a more expensive approach in terms of flexibility and liquidity of the system (for example, as already stated before, it is not possible for the consumer located in point E to purchase gas from a shipper in point A).

Thus, flexibility growth calls for considerable infrastructure, i.e. the growth of total system costs, while flexibility reduction results in reduction of these costs.

The key issue is how to evaluate the costs compared to the advantages presented by enhanced system flexibility.

Use of the «entry-exit» system in determination of free capacity gives significant advantages for efficient trade, market liquidity and «gas-gas» type competition. These advantages are well-known and may be illustrated by the success of the «entry-exit» system proposed by Transco Company that stimulates trade in NBP. Having divided the entry and exit free capacities, the system automatically created a uniform and homogenous product that may be sold in general conditions to all users of the system as «gas in NBP'» or «gas paid for upon entry.» Through product unification, the system maximizes the number of players that can trade with each other, thus deepening the market. Since any two parties may trade gas regardless of their location, the «entry-exit» system facilitates anonymity.

The «entry-exit» system encourages trade of free capacities in the secondary market by creation of a small quantity of homogenous goods (one for each entry and exit point), compared to hundreds or thousands of those existing in «point-to-point» systems (one for each combination of entry and exit points).

It is very efficient for the gas transportation organization to maximize the free capacity available for trade as this encourages the use of the network and helps avoid limitations and reduce all-system expenses in the long term. However, flexibility maximization is also desirable for stimulation of competition and trade of free capacity as a liquid asset. On one hand we have the inflexible «point-to-point» system that enables the gas transportation organization to sell the maximum amount of free capacity, but with limited trading rights. On the other hand there is a «post stamp» type system that may impose restrictions on determination of free capacity, while maximizing the flexibility for companies (shippers).

The relative advantages of various systems depend on the system topology as a whole and length and nature of existing limitations. In systems with a high degreeof limitations, the amount of additional free capacities (relative to the amounts determined with «post stamp» for the same gas transportation system) might be so great that it justifies the use of relatively inflexible determination of free capacity. For example, if each of the pipes shown on Figure 6 would have 4 units or so of free capacity, then it would have been possible to sell 4 units of free capacity with the «post stamp» system, that is enough to supply the common demand for free capacity by providing maximum flexibility to the company (shipper). And vice versa, in case each of the pipes would have 1 unit of free capacity, the costs for organization of flexibility would be significantly higher in the «post stamp» system, but would not allow for significant flexibility compared to the «point-to-point» system.

For this very reason, selection of a free capacity determination system shall be based upon the topology of the specific gas transportation system as well.

Russia historically uses the «point-to-point» system of free capacity determination.

3.1  Brief Description of Reasons and Premises for Work on Revision of Procedure of Access to Gas Transportation System of Gazprom JSC

The governmental regulation of access to trunk pipelines of Gazprom JSC arises from provisions of Articles 1.1, 2 and 27 of the Law of the Russian Federation «Competition and Restriction of Monopolistic Activities in Goods Markets» No. 948-1 dated March 22, 1991, Clause 3 of Article 8 of the Federal Law «Natural Monopolies» No. 147-FЗ dated August 17, 1995 as well as Article VII of the Federal Law «Gas Supply in the Russian Federation» No. 169-FЗ dated March 31, 1999.

The issue of independent organizations’ access to the gas transportation system of Gazprom JSC arose for the first time when this joint-stock company was created on the basis of the Gazprom State Gas Concern. At that time, the Decree of the President of the Russian Federation «Transformation of Gazprom State Gas Concern to Gazprom Russian Joint-Stock Company» No 1333 dated November 5, 1992 imposed on established Gazprom JSC, among all others, the responsibility for «granting access for any producer to the gas transportation system of the country pro rata to the quantity of gas it produces in the Russian Federation in compliance with the uniform price regulation mechanism.» The following principal provisions of access to the unified gas supply system have been fixed for the first time at the legal level:

• Equal access to the unified gas supply system of Gazprom JSC;
• access granted to gas producers only;
• pro rata access granted depending on quantities of gas produced.

The access issue arose again in Decree of the President of the Russian Federation «Basic Provisions of Structural Reform in Natural Monopolies Field» No. 426 dated April 28, 1997 where it is asserted that one of problems of the gas industry is the need to modernize the procedure of access for independent suppliers to the gas transportation system of Gazprom JSC.

The key difference between the provisions of Decree the President of the Russian Federation No. 426 dated April 28, 1997 on access to gas transportation networks of Gazprom JSC and the provisions of Decree of the President of the Russian Federation No. 1333 dated November 5, 1992 was the replacement of the pro rata access principle with the principle of access to «free capacities.»

In pursuance of Decree of the President of the Russian Federation No. 426 dated April 28, 1997 Resolution of the Government of the Russian Federation «Granting Access for Independent Organizations to the Gas Transportation System of Gazprom Open Joint-Stock Company» No. 858 dated July 14, 1998 was adopted to approve the «Provision on Granting Access for Independent Organizations to the Gas Transportation System of Gazprom JSC» (hereinafter «Regulation of Access»). The «Provision of Access,» along with the aforementioned provisions of the Federal Law «Gas Supply in the Russian Federation,» is currently governing access to gas transportation system of Gazprom JSC.

Analysis of the «Provision of Access» shows that it does not allow for ensuring the required legal regulation of the principle of nondiscriminatory access of independent organizations to the unified gas supply systems of Gazprom JSC set out in the Law «Gas Supply in the Russian Federation.» Such key concepts as «free capacity» and «independent organizations» are not explained, and the right to define them is granted to the unified gas supply system owner, Gazprom JSC. Regulatory authorities and independent organizations do not have the legal capacity to maintain control over the actual technical capabilities of Gazprom JSC with regard to gas transportation by independent organizations.

For example, in accordance with paragraph 6 of «Rules of Gas Supply» approved by the Resolution of the Government of the Russian Federation No. 162 dated February 5, 1998, 3 categories of customers have the right of priority for signing gas supply contracts (and, as a consequence, gas transportation contracts): buyers of gas for governmental use, buyers of gas for residential use, and buyers that signed gas supply contracts earlier (privileged consumers). The «Provision of Access» sets out other priorities for suppliers of gas for residential use and suppliers of gas envisaging gas delivery within a longer period than other applicants. As a result, a situation can arise in which access will be denied to an independent organization to transport gas for the reason of lack of free capacities because they have already been taken by priority applicants.

One more problem arises when a consumer takes more gas than purchased under the contract. A worse situation is when a consumer, having signed contracts with several suppliers, takes gas excess of the total amount specified under all supply contracts. Under which contract should he pay for this excess? Who is authorized to resolve this issue? And from whom should the gas transportation (gas distribution) company request its money? Unfortunately, the current legislation does not give any answers to these questions.

And, finally, the problem of access termination. The regulations of access for independent organizations to the gas transportation system of Gazprom JSC foresee only cases of early repudiation of gas transportation contracts, but the repudiation procedure is not set out.

To make matters worse, in an effort to create nondiscriminatory conditions of access to trunk oil pipeline systems and abet the interests of the government, producers and consumers of energy resources, the Commission of the Government of the Russian Federation for Affairs of Use of Trunk Oil and Gas Pipeline and Oil Product Pipeline Systems, established by Resolution of the Government of the Russian Federation No. 843 dated November 02, 2000,  was discontinued by Resolution of the Government of the Russian Federation No. 215 dated April 16, 2004, containing a «List of Discontinued Coordination, Advisory and Other Agencies and Groups Established by the Government of the Russian Federation.»

Powers of control and supervision over satisfaction of requirements for access to natural monopolies’ service markets and services by natural monopolies on nondiscriminatory terms, as well as over observance of legal requirements on the obligation of natural monopolies to conclude contracts, were delegated to the Federal Antimonopoly Service (Resolution of the Government of the Russian Federation No. 331dated June 30, 2004), which historically has been unable to handle Gazprom JSC.

All this makes it possible to assert that many important issues linked to use of the gas transportation system are not settled.

Gas transportation and relations between gas suppliers, gas transportation and distribution organizations, and consumers is a field where the lack of regulation makes it impossible to solve a number of problems that badly affect economic activities of all entities taking part in these relations. Furthermore, not having solved these problems, one cannot create a full-fledged gas market in Russia, which is necessary for Russia’s integration into the world’s economic system.

In conclusion, we can identify the following directions of solving the access problem:

• Adjustment of existing legislation or regulatory base governing access to services of gas transportation organizations in order to solve accumulated problems (modernization of existing system);
• Change of party (co-signatory) to the gas transportation contract (long-term access for power engineering specialists);
• Elimination of technical (physical) restrictions preventing access to gas transportation system (investment access);
• Change of existing free capacity determination system;
• Change of gas industry operation model.

Let us examine each of the above directions in detail.

3.2  Modernization of Existing System of Access

3.2.1       Legislative Consolidation of Regulations Concerning Operation of Trunk Pipeline Transportation

The lack of basic terms and definitions linked to gas transportation through trunk pipelines has resulted in the necessity in working out a document on the level of federal law. So, the Energy, Transport and Communication Committee of the State Duma intensified its work on adopting the draft of Federal Law «Trunk Pipeline Transportation» (hereinafter the Draft) in its second reading.

The Draft has been under consideration by the State Duma of the Russian Federation for at least five years. It was put forward in late 1990s by Gazprom JSC along with the drafts «Gas Supply» and»Oil and Gas» with the purpose of securing its integrity. It was anticipated that at least one draft would be passed. Due to passage of the Law «Gas Supply in the Russian Federation,» the other drafts were no longer necessary. but they have not been removed from the agenda. Moreover, Transneft JSC and Transneftprodukt JSC have been involved in work on the Draft in an attempt to make the law universal and extend it to all types of hydrocarbon pipeline transportation. This resulted in constant disagreements between the two major parties, Gazprom JSC and Transneft JSC, due to existing significant differences in oil and gas industries operation, which did was not conducive to reduction of the time necessary for adoption of the Draft.

Adoption of the Federal Law «Major Pipeline Transport» is necessary to resolve a number of principal issues accumulated over the period of pipeline operation, in particular the following:

• Definition of a trunk pipeline. There are several approaches to definition of «trunk pipeline:»: «technical,» when trunk pipelines are referred to as facilities satisfying specific technical requirements; «organizational:» when the defining criterion is centralization of organizational interaction among different facilities; «legal:» when the legal criteria of referring a facility to as a pipeline transportation are defined (basically concerning the pipeline system property issues); «mixed:» when several criteria of various types are used at once;
• Definition of trunk pipeline owner. One should determine the possibility of private ownership of trunk pipeline facilities;
• Definition of «trunk pipeline transportation» and «transportation service»;
• Definition of basic principles of establishing rates for trunk pipelines transportation service;
• Definition of access to trunk pipelines;
• Definition of procedure of connection to trunk pipelines;
• Definition of procedure of investment in development and construction of new trunk pipelines;
• Operational management of trunk pipelines;
• Organization of oil quality bank;
• Allocation of land plots for construction of trunk pipelines;
• Procedures for compliance with industrial and environmental safety requirements;
• International cooperation for transboundary transportation and so.

New major gas production projects outside the common gas supply system lead to the question of ownership of newly created gas supply systems.

All aforementioned issues are more or less solved through creation, development and operation of trunk pipelines. However each concrete solution is unique and may not be taken as a universal one. Furthermore, absence of popular approaches to the solution of each of the above-listed issues inhibits the development of trunk pipelines as well as the fuel and energy industry that forms the basis of the Russian Federation’s economy.

Since many parties that have conflicting opinions on a number of issues are participating in development of the Draft, one may expect that a very general document without any concrete solutions will most likely be adopted. Instead of dealing with concrete solution, it will contain reference rules to relevant resolutions of the Government of the Russian Federation that call for further development.

3.2.2       Modernization of Regulatory Governing Procedure of Granting Nondiscriminatory Access to Trunk Pipelines

Accumulated access-related problems resulted in a number of instructions issued by the Government of the Russian Federation concerning revision of effective regulatory documents.

In pursuance of instructions of the Government of the Russian Federation and in order to fix current defects in granting access for independent organizations to gas transportation capacities, and to develop competition in gas industry, the Russian Federal Antimonopoly Service has worked out the draft of Resolution of the Government of the Russian Federation «Nondiscriminatory Access to Gas Transportation Systems in the Russian Federation» (hereinafter «Draft Resolution»).

Through a long period of discussion the Draft Resolution has undergone some significant changes. The developed Draft Resolution suggested quite revolutionary changes in ensuring nondiscriminatory access to trunk pipelines and was based upon advanced world practice. During the approval process, the most revolutionary proposals, in particular trade of capacity (throughput), discontinuous supply, etc. were gradually excluded from the Draft Resolution. As a result, the approved Draft Resolution became an evolutionary, not a revolutionary document. It concretizes the procedure of setting up a contract for gas transportation service provision through gas transportation networks, thus establishing equality of terms of access to service and equality of service provision rights as well as the connection procedure to gas transportation networks and standards of information disclosure by the owner of the gas supply system.

The primary goal of the Draft Resolution reduced to modernization and increase of efficiency of the mechanism of nondiscriminatory access to services of gas transportation through gas transportation networks, process connection services to gas transportation networks, and provision of these services on nondiscriminatory terms.

Nevertheless, even after making all aforementioned revisions, it is much doubted that the Government of the Russian Federation will approve it. This is linked to Gazprom JSC’s negative attitude toward this Draft Resolution and the insufficient administrative power of Russian Federal Antimonopoly Service, which will be unable to pass it through the Russian Federation Government on its own (other federal executive bodies are not active proponents of the Draft Resolution).

One may say the attempts the Russian Federal Antimonopoly Service is making to modernize the mechanism of access for independent organizations to gas transportation capacities are not yielding and will not yield any result in the short term. This is caused by lack of certainty in the development of gas industry and Gazprom JSC’s unwillingness to give up its control over the market.

According to the opinion of many gas industry participants, one of the possible solutions of the problem of access to trunk pipelines could have been the development and approval, on an annual basis, of a mandatory Gas Balance for the Russian Federation (hereinafter: «Balance»).

This is connected to the fact that the gas transportation schedules are drawn by Gazprom JSC on the basis of gas balance. Here, a proviso should be made. The gas balance for the Russian Federation in accordance with Clause 5 of Section 3 of the Rules of Gas Supply approved by the decision of the Government of the Russian Federation No.162 dated February 5, 1998 is developed by the Ministry of Fuel and Energy of Russia per approval by the Ministry of Economic Development of Russia and proceeding from gas resources and forecasted demand of Russian consumers for fuel and energy resources, and is mandatory for suppliers and customers. Gazprom JSC is developing its own gas balance for Russia on the basis of which it draws the schedules of gas transportation via trunk pipelines.

Analyzing the order of Gas Balance drawing and features of granting access to gas transportation capacities, it is expedient to bring development and approval of transportation schedules to the level of a federal agency and make it mandatory. For example, this can be done through appropriate revisions and amendments to the Rules of Gas Supply.

One of regulatory tools that can also be used to solve (or mitigate) the problem of access to gas transportation capacities is authorization of consumers for use of gas.

The development of the Procedure of Use of Gas as Fuel is stipulated in Article 8 of the Federal Law «Gas Supply in the Russian Federation» No. 69-FЗ dated April 31, 1999.

At present, the procedure of establishment of fuel regimes is defined by resolutions of the Government of the Russian Federation «Order of Setting the Type of Fuel for Enterprises and Fuel-Consuming Installations» No.832 dated October 29, 1992 and «Revisions and Amendments to Resolution of the Government of the Russian Federation No. 832 dated October 29, 1992» No. 29 dated January 21, 2002. In accordance with said resolutions, fuel regimes are established by the Ministry of Economic Development and Trade of the Russian Federation depending on amounts of consumption of various types of fuel per approval of the Ministry of Fuel and Energy of the Russian Federation, Gazprom JSC, and executive bodies of entities of the Russian Federation for all types of fuel (coal, peat, shale oil, firewood, reduced fuel oil, diesel fuel, furnace oil, motor fuel and other types of liquid oil fuel and natural gas).

One of the main disadvantages of the Draft is its creation of a multilevel system of authorizations for use of gas, in which the consumer, having obtained authorization for its use, i.e. having confirmed its technical capability of receiving gas, having met all the obligations for installation of equipment and having signed provisional gas supply contracts not only with independent organizations but also with entities within Gazprom JSC, should obtain authorizations for access to gas transportation networks each year. Thus, obtaining the authorization for use of gas as a fuel is a mandatory but insufficient condition for gas receiving by consumer. Moreover, before 2006 the authorizations for use of gas specified not only the gas supplier but also the regional company the gas supplies were provided through, thus depriving the supplier-regional company-consumer chain of its required flexibility.

In 2005, working to eliminate redundant functions of executive bodies, the Russian Federal Antimonopoly Service began work on cancellation of  the authorization procedure for use as fuel of such resources as coal, peat, shale oil, firewood, reduced fuel oil, diesel fuel, furnace oil, motor fuel and other kinds of liquid oil fuel. At the same time, to ensure reliable gas supply to consumers in conditions of limited free resources and throughput of the unified gas supply system, it was suggested to itemize the procudure of natural gas use as a fuel with preservation of minimum control functions for public authorities (setting a reserve fuel type and drawing schedules for transition of consumers to reserve fuels in fall and winter period, if necessary).

The market participants believe that revisions to the Procedure with regard to signing contracts for gas supply to consumer, in case the authorization for its use is issued and amount of supply guaranteed (the gas supply rules set out that the gas supply contract may not be signed for an amount greater than that specified in the authorization) will significantly reduce the severity of the gas transportation capacities access problem.

3.3Long-Term Access for Power Engineering Specialists

The reformation of United Energy System of Russia JSC necessitated the signing of long-term gas supply contracts between gas suppliers and generating companies. This necessity was caused by the requirement for provision of guaranteed electric energy supplies in compliance with contracts signed between generating companies and electric energy consumers.

The long-term contracts represent the basic form of international gas supply contracts to have been concluded earlier between monopolies of various countries. Similar contracts are concluded by large energy companies at the beginning of development of unique natural gas fields and by large consumers at the beginning of construction of large facilities (thermal power plants, chemical plants, etc.).

The obvious advantages of long-term contracts for a gas supplier are the long-range guarantees of sale of its production, predictability of the economy of the production project, and the possibility to attract extra funds on the security of such a contract. The long-term contracts attract customers by the guarantee of fuel supplies, certainty of prices of such supplies, and economic predictability of business built on such supplies.

At the session of the Government of the Russian Federation held November 30, 2006, a proposal of the Ministry of Fuel and Energy of the Russian Federation was approved according to which, starting April 01, 2007, gas will be supplied to energy industry facilities under long-term contracts at prices oriented toward achieving profitability equal to that of export by 2011. It was approved that the quantities of gas delivery to energy industry facilities will total (in billions of cubic meters): 162.9 in 2007; 166.9 in 2008; 174.8 in 2009; 186 in 2010.

In order to adjust the monthly breakdown and conclusion of long-term gas transportation contracts for independent producers, the Government of the Russian Federation assigned:

• The Ministry of Economic Development of the Russian Federation along with its departments shall prepare the drafts of standard documents, including long-term gas supply and transportation contracts, by February 15, 2007;
• The Federal Tariff Service of Russia along with its departments shall work out the price formula for long-term gas supply and transportation contracts on the basis of profitability equal to export  (with account for transportation costs and duties) and in connection with cost of alternative types of fuel, by December 20, 2006. At the same time, price growth shall not exceed the following:

From January 01, 2007 — 15%

From January 01, 2008 — 25%

From January 01, 2009 — 13%

From January 01, 2009 — 13%

From January 01, 2010 — 13%

From January 01, 2010 — 13%

From January 01, 2011 — achievement of profitability equal to export.

It is not clear in the Russian Federation Government’s decision who shall be responsible for guaranteed gas supplies to power industry facilities. The formulation suggests provision of gas supplies under the long-term contracts to power industry facilities not only by Gazprom JSC but also by independent organizations.

The following basic problems shall be resolved to implement the long-term contracts:

• Price or price formula defined;
• The issue of guaranteed long-range access resolved;
• Procedure of application of long-term contracts and prices defined;
• A set of standard documents formalizing implementation of long-term contracts worked out and approved.

One should make a reservation that implementation of long-term contracts practice in the power industry will quite rapidly lead to its spread to other branches. For this reason, it makes sense to consider the problem of concluding long-term contracts in a much broader context, thus going beyond the scope of interaction between the power industry and gas producing companies.

3.3.1.     Determination of Price or Price Formula for Long-Term Contracts

Price determination requires mandatory determination of the deal closing point, i.e. the point of passing of property rights for gas. This is necessary to adequately compare the price of a long-term contract with gas export prices and prices for other energy carriers. This point can be located at the entry to gas transportation system, on the border of the Russian Federation or, for example, in «balance points» where gas is traded in accordance with Resolution of the Government of the Russian Federation «Experiment on Gas Sale at Electronic Marketplaces» No.534 dated September 2, 2006.

Furthermore, the gas price should not be subject to influence from any of the contracting parties and its formation shall be of a market nature.

Taking into consideration aforesaid price formation limitations, the price for each of selected points can be identified:

• By reverse calculation from summed prices of gas in export markets. The price under long-term contracts will be equal to the price of gas formed in the export market less customs duties, costs of transportation from export markets to the deal closing point, commissions of the company having a sole license for gas export, and other payments (for example, gas auction sale charges). In fact, such price determination calls for definition of a price indicator, as gas prices vary in different countries, and, moreover, the price of gas under long-term contracts differs from that of gas sold in the spot market. Furthermore, the country selection also influences the cost of transportation up to the border with the Russian Federation;
• By method of comparison with prices of gas imported to Russia with account for features of its transportation and consumption;
• By method of comparison with prices for energy sources that could replace the gas, given the condition of transparent pricing for them and consideration of gas usage features.

It is noteworthy that all three stated methods make gas price determination dependent on prices formed outside the Russian Federation. Such a state of affairs is subject to criticism as this pricing brings inflation expectations, supply guarantee fees, expected growth in energy carrier prices, and so on to the Russian economy.

While calculating prices, it should be considered that the cost of services of gas transportation by independent organizations outside the customs territory of the Russian Federation shall be established by the Russian Federal Tariff Service.

More details on gas export problems are provided in Section 1.3 of this Report.

Gazprom JSC offers to define the prices for gas sold on the domestic market as follows:

Price of equal profitability to export (net-back value):

Pep = Pо * R * K

Pо = (1 — D) * (Pe * (1 — TAX) — Tz — Tr)

where:

R — ruble-USD rate;

K — some zonal price differentiation factor in the Russian Federation;

D — factor of price convergence to net-back value, it equals 0 at a full net-back value;

P_E — certain averaged gas export price;

TAX — interest rate of export duty;

Tz — transportation costs charges outside the Russian Federation;

Tr — transportation costs across the Russian Federation.

Price of «inter-fuel competition»

P_IC = Pо * (0,5 * (Gt / Go) + 0,5 * (Mt / Mo)) * R * K

where:

G and M — prices of gasoil and black oil in Europe as per Platt’s Oilgram Report (European Monthly);

t — average for previous 9 months;

o — average for January-December 2006.

The frequency ofreview of the price determined by method of «inter-fuel competition» is one quarter.

At the same time, the following issues remain unresolved:

• Determination of gas transportation costs. It is not very clear how to determine the transportation distance and transportation fee that Gazprom JSC pays for gas supply overseas;
• Identification of points the gas value is calculated at in order to, proceeding from them, calculate the gas price in Russia’s regions with account for transportation. United Energy System of Russia, for example, suggested counting the «net-back price» up to some «averaged production point,» and then counting using Russia’s domestic transportation fee up to any point of Russia.

The following gas price formula is used in the event of alternative cost method:

where,

Pmzl   — gas price at the border;

?          — inflation component;

a          — fraction of oil replaced with gas in energy carrier market;

c0        — $/barrel of oil to $/billion cubic meters conversion factor;

P0        oil price, $/bbl;

b          fraction of coal replaced with gas in energy carrier market;

cc        $/ton of coal to $/billion cubic meters conversion factor;

Pc        coal price, $/ton;

The conditions formed in the energy resource market are taken into account through estimation of fractions of oil and coal replaced with natural gas in comparison with prices of oil and coal and adjusted using ? factor.

The constant part (?) is adjusted with an account for inflation using a separate formula:

where,

?0        ? of base year;

CPIn    consumer price index of n-th year;

CPI0    consumer price index of base year;

Inf       inflation;

n          year

Reference on CPI:

CPI is often taken as a basic indicator of inflation rate. At the same time it has a number of disadvantages. By essence, it is a measure of consumer prices for a basket of basic goods and services standardized to the level of years 1993-1995; the index within this period is assumed to be 100. The index value of 171.8 means that the goods basket cost in the current month is 71.8% higher than during the base period.

3.3.2.          Definition of Procedure of Application of Long-Term Contracts and Prices

Long-term contracts have greater regulatory potential than single deals. This is a more powerful tool with a broader range of regulatory capabilities than single and short-term deals.

Long-term contracts set out the long-range obligations that require investments and so on.

The long-term contract legally meets the challenges of a long-range nature, which is absolutely impossible in short-term relations.

The difference between short- and long-term contracts is not at all their duration, but that long-term contracts allow for stipulating obligations that are not possible to be met under short-term contracts.

Conclusion of long-term gas supply contracts turns on conclusion of appropriate long-range transportation contracts between independent organizations and Gazprom JSC. Some cases are known when independent organizations conclude long-term contracts for gas supply, but one of the primary conditions in these contracts is the annual confirmation of gas transportation capacities by Gazprom JSC.

Furthermore, the significant conditions of long-term contracts are:

• Long term of contract effect;
• Definition of price or formula of price for gas;
• Determination of gas supply quantities established for the whole term of contract, with detailed monthly schedule of supplies for the next year;
• Conditions of early termination of contract;
• Accounting of gas quantities and procedure of gas price recalculation due to change of transportation fees;
• Obligations of parties in the event of failure to commit the contract obligations.

Implementation of said proposals calls for revisions to:

• The Federal Law «Gas Supply in the Russian Federation» No. 69-FЗ dated March 31, 1999 with regard to fixing the priority of setting up gas supply contracts;
• Resolution of the Government of the Russian Federation «Access of Independent Organizations to Gas Transportation System of Gazprom JSC» No. 858 dated July 14, 1997 and the Resolution of the Government of the Russian Federation «Approval of Provision for Granting Access of Organizations to Local Distribution Networks» No. 1370 dated November 24, 1998 with regard to fixing the priority in granting access in the event of long-term gas supply contracts approved by the parties. Furthermore, apart from access issues, the issues of balancing and technical connection to gas transportation capacities shall be resolved;
• Resolution of the Government of the Russian Federation «Approval of the Rules of Gas Supply in the Russian Federation» No. 162 dated February 05, 1998 with regard to rules of concluding long-term contracts between consumers, independent organizations and owners of gas transportation infrastructure, on the issues of executing long-term gas supply contracts by independent organizations. Furthermore, gas supply balancing mechanisms under the monthly, weekly and daily schedules alongside the accounting mechanisms shall be anticipated for such contracts.

The standard long-term contract for gas supply usually contains:

• Title of contract;
• Introduction. It describes the parties entering the contract, i.e. «customer» and «seller;»
• Definitions. Definitions are usually placed in the first part of the contract. The contract, as a rule, gives only definitions of terms of technical nature, terms used in meanings that differ from generally accepted, unclear or ambiguous terms, and terms requiring additional explanation.
• Goals and procedures. This section usually describes the goals of this contract and sets forth the procedures of organization of communication between the parties through the contract performance;
• Duration and term of contract. The contract may come in effect upon signing. However, the beginning of supplies may be conditional upon provisional (one-month) notification from Supplier or Customer;
• obligations;
• transportation, dispatching and balancing;
• procedure of gas measuring and its quality;
• consequences of failure to supply gas;
• invoicing and payment;
• financial responsibility;
• default;
• pre-term termination /cancellation of contract;
• force-majeure;
• procedure of tax discharge;
• guarantee and compensation of damages;
• notes;
• other provisions.

The long-term contracts applied in European markets contain a number of significant provisions:

Specifications

Just like in most gas contracts, a mandatory condition for long-term contracts is identification of the supply point. Usually this is a gas distribution network or a compressor station near the state border.

Furthermore, long-term contracts usually contain the absolute obligation to supply natural gas. Delivery quantities in European market have been measured in energy units in recent years. All «old» contracts of Gazprom JSC specify amounts of supplies in billions of cubic meters.

Regardless of the measure unit, the long-term contract shall necessarily contain specifications of physical composition of gas and methods of its determination /measure used by the parties.

Quantity of Delivery

The basis for determination of delivery quantity is assumed to be the Daily Contract Quantity — DCQ. The Maximum Daily Quantity (MDQ) available for taking by the consumer shall be defined in the contract directly in absolute units or as a percentage of the daily quantity.

The Swing is the value equal to ratio of peak delivery to the average for the contract term. The reciprocal of swing is the Load Factor.

Based on these values, one can determine the limitation for total quantity of gas delivered through the year (Annual Contract Quantity — ACQ).

Balancing of Deliveries upon Request

Requests for procurement are usually submitted a day ahead. A consumer has the right to receive gas in quantities greater than requested, but at a higher price.

«Take-or-Pay» Condition

The essence of the requirement is the obligation to pay for all gas stipulated in the contract or a part thereof regardless of actual quantity consumed. In case the Customer takes gas below the specified take-or-pay level, his payment is considered the balancing payment.

The take-or-pay level may be reduced during execution of the contract for the reason of incomplete gas delivery, force-majeure for the Consumer, implementation of the Carry Forward mechanism (see below), breach of supplied gas specifications, and at the Supplier’s will.

The standard take-or-pay level for export contracts of Gazprom JSC is not available.

Flexibility Provision Mechanisms

Make Up is a mechanism by means of which the customer, if paying by the take-or-pay method, is entitled to take part of the untaken quantity of gas (make up gas) in the future contract period (year). It is often set as 100% of take-or-pay amount, but with various additional limitations.

Carry Forward is a mechanism that is inverse in a certain sense to make-up; according to it, if the customer takes more gas than take-or-pay, he can use the «surplus» to compensate take-or-pay obligations of the future (not necessarily next) contract period. Usually carry-forward is counted in fractions (for example, ?) of take-or-pay, thus limiting the upper bound of the taking mechanism (not МDQ).

In general, contract flexibility is ensured by the possibility of taking the daily gas in a quantity from zero to the specified daily maximum (MDQ + surplus gas), and annual quantity from zero to the specified annual maximum (ACQ). However, the minimum level of payment is determined by the level of take-or-pay multiplied by the specified daily pickup and number of days in the period.

Systematization of Incomplete Deliveries

The parties to long-term contracts pay great attention to the reasons of incomplete deliveries and thoroughly differentiate the responsibilities and consequences of such cases.

Deliberate incomplete delivery (proved delivery of contracted quantities of gas to third party) often results in reduction of take-or-pay level, the Supplier covering all (including indirect) losses of the consumer and entitling the customer to terminate the contract.

Undeliberate incomplete delivery (due to accident or any other trouble) results in reduction of take-or-pay level and, probably, reduction of price for the following deliveries.

Force-majeure (natural disasters, government’s decisions or strikes) shall result in reduction of take-or-pay level only.

3.4  Modernization of Existing System of Free Capacity Determination

As it was already said in Section 3 of this Report, the basic problem of access to pipeline capacities is the balance between the flexibility of services provided and determination of the amount of free capacities the user may contract on the long-tem basis.

In the beginning of liberalization, most European countries used the «point-to-point» system of free capacity determination for contracting on the long-tem basis. Apparently, it was a natural choice, since such contracts are analogous to long-term contracts that dominated in the industry in the pre-liberalization period. Afterwards, the free capacity determination systems in European countries underwent significant changes.

Here are many ways to add some flexibility to contracts with free capacity determination by the «point-to-point» system. The first approach suggests that a company that uses the services of transportation from entry to exit point be entitled to choose among several entry and/or exit points. As a rule, such an opportunity proves more profitable for the user of service than discontinuous gas transportation contracts.

The second example of how flexibility may be added to the «point-to-point» system is the application of «segmentation,» where the user of the transportation service may break down the contract transportation route by constituting segments or assemble the required route from different segments. This approach was applied by Gastransport Services in the Netherlands. Gastransport Services broke down the high-pressure gas pipeline system (HTL) by a number of «sections» and «joints» and enabled the users of transportation services to contract the throughput within each section to be brought together later on. Consumers of transportation services were enabled to contract the throughput within each specific section they considered the most convenient for development of their own trade. In the beginning, for example, they could contract just a few HTL sections linked to their entry points and add new sections after the first joint later on. Consumers of transportation services in the Netherlands also could break down the contracted services by constituents. Gastransport enabled the service consumer to contract the throughput within segments 1 -> 2, 2 -> 3 and 3 -> 4, and then sell a part of this throughput in segment 2 -> 3 to another consumer of the service.

Pipelines in the USA also suggest additional flexibility in «point-to-point» contracts, allowing for a similar form of «segmenting» in which the owner of throughput from point A to В has the right to convert it into the throughput from point A to point M located between A and B, and from point M to point В. This alternative approach keeps all existing advantages of point-to-point throughput intact with an addition of extra flexibility to the user of the service.

3.5  Investment Access (Building New or Extending Existing Gas Transportation Capacities)

All aforesaid methods of modernization of access to trunk pipeline capacities may be applied in the presence of sufficient physical gas transportation capacity. In the absence thereof no methods of free capacity determination will help pump more gas than is physically possible.

Let us consider the existing approaches to building new or extending already existing capacities.

Construction of pipeline capacities can be performed by either owner of the already existing trunk pipeline system or a third party. However, in the second case, the necessity arises to settle the issue of connection of newly built capacities to the existing trunk pipeline system and their further operational management.

The right of property for the erected trunk pipeline facilities may be passed to the trunk pipeline owner. This may be performed under the leasing agreement as well as under the contract for creation of such facilities. A significant condition of such contracts shall be the trunk pipeline owner granting, on a long-term basis, preferential rights to the investor of access to gas transportation capacities created by this investor at the approved rate for the period of investments payback.

To examine the issue of construction of new major pipeline transportation facilities the independent organizations are concerned in, Gazprom JSC established a workgroup together with representatives of independent organizations. By the results of the work of the group in late December 2006 the Board of Gazprom JSC approved the Concept and Regulation of participation of independent gas producers in extension, reconstruction and upgrade of the company’s gas transportation system.

It is the opinion of Gazprom JSC that for independent organizations to partake in extension and reconstruction of gas transportation capacities, it was necessary to create a financial and legal mechanism ensuring attraction of funds from independent organizations and work out and approve the procedure and terms of interface between independent organizations and Gazprom JSC.

During transportation of independent organizations’ gas, the only source of payback of investments in construction, reconstruction and modernization of gas transportation system is the payment for services of gas transportation via trunk pipelines established by the Federal Tariff Service.

On August 23, 2005 the Russian Federal Tariff Service’s Order No.388-e/1 approved the Method of Calculation of rates for services of gas transportation via trunk gas pipelines that envisages rates in respect to newly commissioned gas pipelines that allow for repaying investment projects within a specified period of time.

The concept of participation of independent organizations in extension, reconstruction and modernization of gas transportation networks of Gazprom JSC provides for the following:

• Execution of investment projects without involving an independent organization, at the cost of Gazprom JSC;
• Issue of loan proceeds by independent organization to Gazprom JSC for development of gas transportation systems («Loan» financial and legal scheme).

Issue of loan proceeds by a independent organization to Gazprom JSC shall be registered by a loan agreement and an agreement for organization of gas transportation on «transportation or pay» terms. The investment payback is provided by compensation for gas transportation by the independent organization at the rate established with account for the necessity of investment payback and loan repayment.

The scheme of attracting investments for the development and construction of new trunk pipeline transportation facilities offered by Gazprom JSC is not perfect and, most likely, will not be put in practice.

In particular, it does not give an answer to the following basic questions:

• How to determine «narrow» points in the gas transportation system in conditions of the existing system of access to trunk pipelines;
• How to organize investment in extension of gas transportation capacities in presence of not one but several organizations concerned in gas transportation through selected sections of trunk gas pipelines;
• Can an organization concluding a «transportation or pay» type transportation contract with Gazprom JSC sell a part of its unused transportation capacities to a third party;
• What kind of investment terms there should be, what kind of credit agreement rates, etc.

4.   Elaboration of Proposals for Stimulation of Development of Small Gas Fields

4.1         Tax Preferences

On January 1, 2007, the Federal Law No. 151-FZ of July 27, 2006 «On Amendments to Chapter 26 of Part II of the Tax Code of the Russian Federation and Acknowledgement of a Lapse of Certain Provisions of Legal Acts of the Russian Federation» came into force. This law is considered by experts as the first step towards the implementation of differentiation in the tax laws.

In particular, its provisions contemplate the granting of exemptions from the severance tax for the development of subsoil plots located in Eastern Siberia. Tax exemption will be valid until the cumulative oil production at the plot reaches 25 million tons and provided that the period of development of reserves at the subsoil plot does not exceed 10 years or is equal to 10 years, starting from the date of issuance of the development license.

In the adoption of the legal rule, a criterion was debated that could be used to determine the granting of exemption for a particular subsoil plot. On one hand, this criterion should by sufficiently easy to administer. On the other hand, it should adequately reflect the economic processes at the particular subsoil plot.

Cumulative oil production was chosen as the criterion, and the main controversy was whether its limitation shall be set as an absolute or a relative (as a percentage of total reserves) value.

Establishing the limit value of the criterion in relative units (i.e. 20% of the total reserves) has made it possible to take into account the amount of the field’s reserves, hence to determine the economy of development of the field more accurately, but at the same time it considerably complicated the assessment and charging of the tax itself. In this connection, it was taken into account that during the field development the amount of reserves may change, either increasing or decreasing. Establishing the limit value of the criterion in absolute units has made it possible to remove the problem of administration, i.e. assessment and charging of the tax, but has given rise to the question of assessment of tax amount. The value of the criterion is directly dependent on which fields the taxation system will be adjusted for. Should the value be set low, only small fields would get the exemption, and the exemption for large fields will be insignificant. If the value is set high, all fields will be entitled for the exemption, and also the exemption with respect to small and medium fields would be so great that it would practically cover the entire period of operation of such fields.

On the assumption that the main purpose of severance tax exemption was the desire to promote the development of new oil producing regions, the legislature decided to set an absolute value of the criterion, aiming at the development of large fields (the cumulative oil production could reach 25 million tons in 10 years only at large fields).

In addition, the question is currently under consideration regarding application of oil exemptions to small fields throughout the entire Russian Federation.

By projecting the available experience of severance tax differentiation in the oil industry, it could be stated that the most probable directions of work for the severance tax differentiation in the gas industry are:

• exemption of development of new fields at the newly reclaimed territories (Eastern Siberia, Far East, shelf of the Russian Federation);
• exemption of development of small fields located at territories already being developed, with a view to improve the efficiency of hydrocarbon material extraction and use of subsurface resources. Besides, utilization of small fields will allow to compensate partially for the dwindling production of the large working fields, and to use the gas transmission capacities more efficiently.

4.2         Gas Purchase at Wells at Predetermined Prices

Gas purchase at the well at the regulated price seriously alters the existing model of functioning of the gas industry and requires its adjustment. It is essentially a shift to the Single Purchaser model (Procurement Agency), which was discussed in Section 1 of this Report.

The situation with governmental regulation of prices may be described using the following chart.

		Quantity
		Regulated	Unregulated
Price	Regulated	Strict governmental regulation
	Unregulated	Mandatory supply for governmental needs	Developed market relations

The situation in which governmental regulation of prices is introduced without specification of the quantities that this price applies to may be considered as an absence of governmental regulation (being currently the case in the gas industry).

Accordingly, in the determination of the minimum procurement price, the state at the same time should specify the quantity to which this price shall apply. Otherwise, the system won’t work efficiently (if it will work at all).

The primary drawbacks that appear in the implementation of mandatory gas procurement from independent companies at the regulated price are:

• the necessity of drafting and enacting of amendments to the Federal Law on Gas Supply in Russian Federation, and to relevant by-laws that practically define the concept of «legal monopoly» (because it will never be a natural monopoly) in the gas industry;
• abandonment by the Government of Russian Federation of the idea of establishing competition in the gas industry;
• strengthening of the monopolistic position of JSC Gazprom on the domestic market;
• preservation and strengthening of the existing system for limitation of gas supply to customers. It won’t be possible to track the quantity of gas sold by the monopolist using «gray» arrangements, and hence, independent companies will actually be losing some of their gas sales revenue;
• aggravation of the problem of setting the state regulated gas price for the domestic market. The currently existing price regulation framework is not based on the economy of supply to the domestic market. The setting of an averaged price will only aggravate the problem of economic efficiency of the monopoly’s performance;
• unresolved issue of price determination for independent companies for the emerging gas export targets (Eastern targets of export).
• persistent problem of determination of costs of gas transmission both to the domestic market and for export;
• uncertainty in meeting the domestic gas demand. The scenario proposed for the implementation may develop in two basic patterns.
  Pattern 1. JSC Gazprom, just as the independent companies, will actively resume the production of gas, which will result in the necessity to expand gas transmission capacities to accommodate the transportation (assuming that JSC Gazprom’s commitment to purchase of gas from independent companies will be maintained, and there will be no problems in connecting the new fields to the transmission network). Considering that the gas transmission cost has a direct influence on the gas price at which JSC Gazprom purchases gas from independent companies, there is a danger of uncontrolled «inflation» of costs of transmission and construction of new facilities.
  Pattern 2. JSC Gazprom will continue gas production only to such extent as to ensure, together with the independent companies, the optimum utilization of existing transmission capacities. Such approach will not solve the problem of gas deficit on the domestic market;
• abandonment by independent companies of the opportunity to sell the gas directly to consumers and receive additional income.

The advantages of implementation of mandatory gas purchase from independent companies at the regulated price may be as follows:

• solving of the problem of access of independent companies to the gas transmission network;
• emergence of transparent long-term rules of play for independent companies in the gas industry;
• minimizing risks for independent companies that are taken into account when making investment decisions concerning the development of new fields.

5.   Preparation of Customer Strategy Options for the Improvement of Efficiency of Granting of Access to the Gas Transmission System of JSC Gazprom and for the Stimulation of Development of Small Fields

To begin with, it would be appropriate to reiterate the conclusions that we came to after consideration of various ways of development of the natural gas export and enhancement of access to pipeline capacities.

The Report considers three basic directions of implementation of gas export within the framework of the Gas Export Federal Law, being: minimum adjustment of the existing regulatory and legal base; alteration of export philosophy; and alteration of the general structure of the entire gas industry.

Detailed examination of each direction has shown that within the framework of the established relations, the most feasible is minimum adjustment of the existing regulatory and legal base. In this case, use of contracts of commission agency (brokerage contracts) is most appropriate for the independent companies in their export activity. Implementation of this direction will require the drafting of a Resolution of the Government of Russian Federation that will regulate in detail the implementation procedure and the relations involved in the export of gas. Section 2.4 contains a possible structure of such a Resolution of the Government of Russian Federation governing the export of gas.

In particular, the Resolution of the Government of Russian Federation governing the export of gas shall contain the definition of the target of regulation; allocation of powers in the process of gas export among various federal executive authorities; determination of the legal arrangement for implementation of export; allocation of powers among organizations that own the exclusive gas export licenses, if there will be more than one such organization; implementation of principles of non-discrimination and good commercial practice in export, etc.

In addition, issues of organization of the system for «double quota allocation», which shall also be an integral part of the export system, shall be worked out.

Drafting of such Resolution of the Government of Russian Federation is not contemplated in the Gas Export Federal Law. In order to meet the formal requirements of law, the appropriate provisions contemplating the enactment of such Resolution may probably be required to be entered into the Gas Export Federal Law concurrently with the drafting of the Resolution itself.

Besides gas export sales matters, the Report deals with the issues of enhancement of access to gas transmission capacities. Following basic methods for the enhancement of access have been considered: adjustment of the existing legislation and/or regulatory and legal base; changing of the party (counterparty) in the contract (long-term access for power industry); elimination of technical limitations preventing the access; modification of the system for evaluation of available capacities; and alteration of the model of functioning of the gas industry.

Each of the above methods is considered in detail in Section 3 of this Report.

Grouping all the existing methods for the enhancement of access to the gas transmission network of JSC Gazprom, it could be noted that they may be clearly divided into two primary directions:

• enhancement of the existing system for granting of access within sufficient physical gas transmission capacity limits;
• setting up of new and expansion of already operating physical gas transmission capacities.

These directions have a considerable difference between them, and hence the approaches employed for them will also have a considerable difference.

The first direction of the enhancement of access may include:

• adjustment of the applicable laws or the regulatory and legal base governing access to the services of gas transmission companies;
• changing of the party in the gas transmission contract (long-term access for power industry);
• modification of the existing system of evaluation of available capacities;
• alteration of the model of functioning of the gas industry (development of small fields).

The second direction includes the elimination of technical (physical) limitations preventing access to the gas transmission network (investment access).

Sections 3 and 4 of this Report describe the primary ways of solving the access problem and developing small fields in the current situation.

It should be noted that neither of the proposed instruments is universal and, according to estimates of various experts, neither may be implemented in full, i.e. to such an extent that would suit the independent companies.

This is the reason why it would be appropriate for independent companies to participate and make efforts in all the aforementioned directions. Consistent assertion of their interests shall at least prevent the established situation from turning to worse, or may even overcome it.

The main difficulty in solving the access problem is the lack of a single consistent position of independent companies and gas consumers. Their piecemeal actions often cause more harm than good. Such a situation is only aggravated by the fact that ministries and departments do not have their own position (except the Federal Antimonopoly Service of Russia) with respect to the solving of the access problem.

The problem of access shall not be considered separately from the problem of enhancement of relations and the development of the whole gas industry. More importantly, the development of the gas industry shall be integrated with the governmental policy for use of subsurface resources, particularly the place of efficient use of subsurface resources in it, and the development of small fields.

Analysis of methods for the enhancement of the access system that was performed in the Report has shown that all of the above-mentioned directions have roughly the same prospects of implementation. In all cases, the primary factor will be either the interest of the owner of the gas transmission network (JSC Gazprom), or the consolidated position of the governmental authorities. It should be noted that alteration of access through the involvement of the Government of Russian Federation in the issue will be more costly in terms of time and effort.

Appendix 1

 

Legal Arrangements for the Export of Gas

1.              Natural Gas Export under a Supply Contract

The owner of the natural gas alone searches for the customer outside of the customs territory of Russian Federation and concludes the gas supply contract at its own expense and on its own behalf. The export, more precisely, the operations for customs processing of the export of natural gas, is carried out by the company that owns the exclusive license for export of natural gas, for a commission remuneration.

Notes:

The arrangement assumes the maximum independence of the gas owner, but at the same time requires governmental regulation with respect to aversion of competition between Russian gas producers («gas-gas competition») on export markets, i.e. by way of setting the minimum price of export transactions. A plan for contracting of export quantities shall be required to be approved. In addition, governmental regulation shall also cover the setting (limitation) of maximum commission fee (its possible types are described in Paragraph 5) which is paid by gas owner during the execution of export. The government (an interdepartmental board, appropriate federal executive authority) shall be charged with regulation of these issues. The implementation of this arrangement will require the design and implementation of:

• a system for access to gas transmission capacities for export supply of gas that should be fundamentally different from the currently existing system of access for supply to the domestic market;
• a system for surveillance over the proper use of gas, which is required due to the substantial difference in gas prices establishing on the domestic and foreign markets.

2.              Natural Gas Export under a Trust Deed

For a commission remuneration and under the instruction of the gas owner (trustor), the company (trustee) that owns the exclusive license for export of natural gas searches for the customer outside of the customs territory of Russian Federation and concludes the gas supply contract at the expense and on behalf of the trustor. The trustor receives the rights and incurs the obligations under the deal concluded by the trustee.

Notes:

The arrangement assumes sufficient independence of the gas owner that is expressed in the establishment of direct relations with consumers outside of the customs territory of the Russian Federation. Governmental regulation with respect to aversion of competition between Russian gas producers («gas-gas competition») on export markets is not required, because all deals are concluded via the single company (single export channel). It shall be required to approve a plan for contracting of export quantities, and also the maximum compensation to the trustee that will be paid by the trustor upon conclusion of the contract (possible types of compensation are described in Paragraph 5). The government (an interdepartmental board, appropriate federal executive authority) shall be charged with regulation of these issues. The implementation of this arrangement will require the design and implementation of:

• a system for access to gas transmission capacities for export supply of gas that should be different from the currently existing system of access for supply to the domestic market;
• a system for surveillance over the proper use of gas, which is required due to the substantial difference in gas prices forming on the domestic and the foreign markets.

3.              Natural Gas Export under a Contract of Commission Agency (Brokerage Contract)

The contract of commission agency is very close to the brokerage contract, that is why we will describe only the contract of commission agency. For a commission remuneration and under the instruction of the gas owner (principal), a company (commission agent) that owns the exclusive license for export of natural gas concludes the deal for gas delivery outside of the customs territory of Russian Federation on the commission agent’s behalf, but at the principal’s expense. The commission agent receives the rights and incurs the obligations under the deal concluded by the commission agent.

Notes:

Independence of the gas owner in this arrangement is very limited. Governmental regulation with respect to aversion of competition between Russian gas producers («gas-gas competition») on export markets is not required, because all deals are concluded via the single company (single export channel). It shall be required to approve a plan for contracting of export quantities, and also the maximum commission fee (its possible types are described in Paragraph 5). The government (an interdepartmental board, appropriate federal executive authority) shall be charged with regulation of these issues. Implementation of this arrangement will require the designing and implementation of a standard form of Contract of Commission Agency for export delivery of gas.

4.              Purchase of Natural Gas by a Company that Owns the Exclusive Export License, for Subsequent Export Delivery

A company that owns the exclusive license for export of natural gas will purchase the natural gas domestically and then deliver it, by itself, for export.

Notes:

For the implementation of this arrangement, it shall be required to approve a plan for contracting of export quantities, and also the procedure for determination of price at which gas will be purchased from owners (see Paragraph 4). The government (an interdepartmental board, appropriate federal executive authority) shall be charged with regulation of these issues.