The EU's energy dependence on Russia was put to the test again right after New Year. By halting oil deliveries to Minsk, Russia sent a new signal to Brussels as well. But the problem is not only made in Russia. For some years the EU has been demanding that the country develop an open market infrastructure (pipelines, short-term exchanges) in the hope of accessing cheap fossil fuel reserves on demand, while Russia is instead more interested in long-term strategies. As a result of this lack of understanding for its counterpart the EU not only has not achieved what it wanted and forfeited important commercial opportunities, but it has also lost much of its overall clout in the country. It is also due to the mixed and inconsistent signals from Brussels that Russia is now upgrading its transport infrastructure to switch fuel deliveries to China and Japan.

A case in point of failed EU policy is represented by Gazprom. Europe repeatedly demands the “unbundling” of its production units from the transport infrastructure (incidentally, why isn’t the same requested of the vertically-integrated ExxonMobil or Shell?), but Russia is obviously not interested in breaking up a company that, despite all its problems, still works reasonably well. On the contrary, when Russia proposes to market its gas directly within Europe, the EU complains against the use of energy as political weapon. In the Russian electricity sector the case is somewhat different, the unbundling of generation, transmission and distribution has already been carried out, in fact largely according to EU-approved blueprints. By the end of 2008 the major generation companies shall be privatized and the state shall retain control only of the high-voltage grid. Regrettably, what has so far not materialized are private investments, earlier indicated as the main reason to initiate the reform process in the first place (the last EU company to back off Russian investment plans in power generation was E.On last December). The electric holding RAO UES has so far been unable to raise the necessary investments from generator asset sales and Gazprom is now thinking of stepping in. As a result, electricity assets would still remain in state hands, under different names and with much more complex control structures than before.

The real challenge in the Russian energy sector, however, is not competition or lack of it but the low overall energy efficiency of the economy. Conservative estimates put heat demand at twice the necessary level under the country's climatic conditions, which means that about half of all heat for residential use is lost along leaking pipes or through poorly insulated building walls. Only in the case of gas-powered heating about 75 bln cbm of natural gas are burned each year to make up for such losses - an amount roughly equivalent to the total annual gas consumption of countries like Germany and Italy or, in greenhouse gas terms, the total yearly equivalent emissions of a country like Belgium or the Czech Republic. Electricity demand in Russia is also at least 20%-30% above necessary: efficient lights and variable speed drives are here still as good as unheard of. The City of Moscow has recently started a demand-side action to save 88 MW with help of 2 million low-consumption lamps, thus avoiding the need to build a new power plant, yet such a move is still the exception rather than the rule.

Russia's path to Kyoto
The Kyoto Protocol entered into force thanks to Russia’s ratification in November 2004. Due to the choice of 1990 as the benchmark year for emissions reductions, which happened to coincide with the breakup of the Soviet Union and a heavy downturn in the Russian economy, the country has now up to 1 billion tonnes CO2 equivalent per year potentially available for the world emissions market. This amount has been dubbed “hot air” because, if sold, it would help other countries formally fulfill the Kyoto requirements without actually doing anything to reduce their emissions. To avoid financing hot air, Kyoto-related investments are therefore supposed to demonstrate that they lead to emission reductions that would otherwise not have occurred (“additionality”). This reasonable requirement, however, leads to paradoxes of its own. Under the current system of subsidized prices most energy-efficiency measures are recognized to be additional because they would not be carried out without the additional incentive provided by Kyoto financing. With energy price reforms most energy efficiency projects would no longer be additional because they would be able to pay for themselves anyway. Under the current formal rules inefficient projects can therefore receive Kyoto financing more easily than economically viable ones. Moreover, despite the fact that demand-side energy-efficiency measures represent the best long-term solutions for emission reductions, it is very difficult to define them in terms of Kyoto projects. This absurd situation follows in part from the fact that the original rulebook for JI and CDM emissions reduction projects has been tailored to the needs of development aid projects in tropical countries and is ill-suited to meet the realities of a cold industrialized country such as Russia. An example of inconsistency is that fuel switch projects, e.g.coal to gas, lead to emissions reductions than can be marketed in form of emissions allowances, but the opposite switch, from gas to coal, remains well below the ample emissions cap assigned to Russia and does not need to be accounted for.
A Kyoto implementation law has long been awaited and it may have finally become a reality by the time this text is in print. In the meantime, Russian project proponents are showing a brilliant imagination in exploiting loopholes and inconsistencies in the current normative framework. A sensitive issue is about the reference baselines of emissions scenarios, which are necessary to estimate the emissions that a project will help to avoid. In Russia baselines are typically prepared only on the basis of theoretical assumptions, because measuring equipment is still quite rare in electricity, gas or heat distribution networks (until not long ago these were not billed anyway) and consumption figures are based on norms still rooted in the long-gone Soviet reality. It is therefore quite easy to provide inflated figures for the reference scenarios to generate extra allowances at a profit for the proponent, again without real emissions reductions on the bottom line.

The financing challenge
The country’s systemic inefficiencies are to a large extent the consequence of artificially low internal prices for energy carriers, which are kept at between two and five times below international prices. The situation is a Catch-22: full price liberalization is not possible out of concern over negative economic and social consequences, but low prices make the financing of energy-efficiency measures comparatively uneconomical. Moreover, fossil fuels are still allocated to major users, e.g.large municipalities, under a rigid, centralized system. To break out of this situation it would be necessary to reason not in financial terms, but in fuel quantities and give any investor, national or foreigner, the right to the fuel amounts that can be saved with energy-efficiency measures. For the state this would not change anything, but investors would get new opportunities to access large quantities of gas or other fuels at below-market prices once these are “unlocked” with help of energy-efficiency projects. In this respect important elements have already fallen into place in the last years in Russia, in particular the communal sector reform with transfer of budget responsibility to lower administrative levels and the housing sector reform with the tenants now in charge of their residential premises.

From failed dialogue to real partnership
In order to achieve real energy efficiency and real emissions reductions both Russia and the EU need to take important steps. The first should distance itself from tradition and continue a reform path oriented to sound economic methods, the other should drop abstract market ideology. Today the main priority for Russia is to build a functional country. The EU should support such process and motivate its own companies to participate in it. At the same time it should drop ideologically motivated demands to unbundle Gazprom or the electrical system, and focus instead on projects with demonstrable benefits in terms of saved resources and reduced emissions. An important example of EU legislation that could be transposed to Russia is the buildings energy efficiency directive, whereby EU know-how, capital, and management skills would be more than welcome in the country. A major review of the Kyoto implementation rules is also overdue, with a more pragmatic approach and longer time-frames in project financing.
The EU should also take other small but significant steps to improve its overall standing in Russia. The most pressing action is a review of its current penalizing visa policy (of course,under full reciprocity). Russian citizens are mature enough to plan and finance their travels. The introduction of a unified EU-visa system without petty differences even among Schengen countries, or dropping visa requirements at all would do more to improve the EU image in Russia than any other possible policy today. With such move the EU would regain part of its lost credibility and would then be taken more seriously, also on energy issues.