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. Last Updated: 07/27/2016

Doubling GDP and Russia's Energy Strategy

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The Russian administration wants to have its cake and eat it too, at least as far as the tariffs of Gazprom and Unified Energy Systems are concerned.

President Vladimir Putin recently, in his state of the nation address, set the goal of doubling the country's GDP over the next decade. This implies an average annual growth rate of 7.2 percent compared with 5.1 percent in the recent four-year period of recovery since the 1998 economic crisis (1999 to 2002). During this period, only in one year did annual GDP growth exceed 7 percent.

One of the preconditions supporting such a dramatic growth spurt would be for the government to rein in increases in electricity and gas tariffs. In the same address, regarding tariff policy, the president said: "State-regulated tariffs of the infrastructural monopolies are increasing faster than prices in the free-market sector of the Russian economy. As a result, there is growing redistribution of economic resources in favor of the monopoly sector, and its share in the Russian economy is growing. And yet the monopoly sector is not exhibiting a high level of efficiency. Thus, the monopolists strangle the competitive sector in our economy. The government should control this more strictly."

However, a national energy strategy, which was released not long after the state of the nation address, envisages a gradual liberalization of prices for gas and electricity in order to eliminate price distortions and to create incentives for replenishing capital stock in Russia's gas and power sectors. The government approved the energy strategy in general terms on May 23 and was supposed to finalize it by the end of June, but is still dragging its feet.

To reach the ambitious GDP growth target set by Putin while allowing tariffs to grow at the pace stipulated in the new energy strategy, the government will have to perform a nightmarish juggling act.

Current government thinking links tariff increases with a slowdown in economic growth in the first seven years of the reform. For example, there are four possible scenarios with different policy instruments and corresponding projections of economic growth within the energy strategy. The scenario envisaging a quick restructuring of Gazprom and UES and rapid increase in energy tariffs is associated with average annual economic growth over the next decade of just 2.5 percent to 3.0 percent.

A new economic growth model for Russia, extending beyond the current reliance on oil and gas exports, is required, but the government has yet to spell out what it might entail.

To add confusion to an already complicated picture, the government's energy strategy contains contradictory tariff projections. The troubling discovery that the strategy is suffering from a mild case of schizophrenia can apparently be explained by the fact that the section on economic scenarios was prepared by the Economic Development and Trade Ministry, while the section on the gas industry comes from the Energy Ministry. What is more worrisome is that they could not resolve their differences and included two conflicting sets of numbers in the publicly presented draft.

Gas prices are the key energy input for domestic consumption. Furthermore, natural gas is a key input for electricity generation (accounting for over 68 percent of fuel inputs for thermal plants producing electricity and heat), and therefore higher gas prices will directly translate into rising electricity bills for both businesses and homes, sending a shock wave across the entire economy.

The administration wants to avoid a painful "shock therapy" at all costs, especially on the eve of parliamentary and presidential elections. But the low gas prices in Russia threaten to undermine the security of gas supply, because they prevent Gazprom from investing in a new generation of gas projects and also make it uneconomical for independent gas producers to be in business unless they have access to the profitable gas export market.

Against this backdrop, Gazprom has been pushing for a safe option: the creation of a two-tiered market for natural gas in Russia as an alternative to the breakup of the company. The two-tiered market idea is a compromise solution. Broadly speaking, the proposal calls for introducing higher "commercial" prices that will coexist with lower "regulated" prices. The two market segments and associated prices will eventually converge, but the transition will be gradual and tightly controlled.

The zone of unregulated gas would gradually expand to 30 to 40 billion cubic meters by 2005 and amount to approximately half of Russia's domestic consumption by 2015. Initially Gazprom was not enthusiastic about the idea, but recently, it seems, the new Gazprom management -- now facing an acute problem of maintaining its current production levels -- decided to embrace the idea of expanding the zone of liberalized gas.

This course may indeed provide a way out of the current tariff deadlock and secure better aggregate rates of economic growth for Russia, at least initially, but it comes with a price tag -- prolonging overall inefficiency of the Russian economy. To put the current tariff policy on natural monopolies into perspective, Putin's challenge is to reconcile two competing objectives.

On the one hand, he wants to shield the energy-inefficient economy from the inflationary and destabilizing effects of an overly rapid increase in energy tariffs. On the other, he understands that low prices for key inputs will deter investment in Russia's energy-producing and energy-consuming infrastructure and industry. His solution up to now has been a go-slow approach: a gradual and highly controlled increase in natural monopoly tariffs.

All indications are that the state will continue to squeeze UES, Gazprom and the Railways Ministry in an effort to test their pain threshold and determine their true costs. A policy of limiting natural monopolies' tariffs may reduce pain in the near term, but is likely to add to Russia's economic problems in the longer term.

This is because distorted prices for major inputs such as gas and electricity distort all other prices throughout the economy and send the wrong signals to economic agents. The resulting inefficiencies create a self-reinforcing trap.

The administration's progress in formulating and implementing its strategy on energy tariff regulation in the coming months will provide an important indication of the Russian state's ability to deliver on its goal of doubling Russia's GDP over 10 years.

Vitaly Yermakov, an analyst with Cambridge Energy Research Associates, contributed this comment to The Moscow Times. The opinions expressed are the author's own and do not represent those of CERA.