Throughout its existence, the Soviet Union was one of the leading hydrocarbon producers in the world. After its break up in 1991 production levels dropped, but the region's overall potential increased further, as the successor states, to various degrees, opened up to international markets and important new discoveries were made in the Caspian basin. Russia and the Caspian states (Azerbaijan, Kazakhstan, Turkmenistan and Uzbekistan) are increasingly seen as providing an alternative to Middle Eastern oil, a view that will have gained grounds since the September 11 events.

Yet, so far these countries have not taken full advantage of their energy reserves, and they face significant challenges in their attempt to develop this potential. Not the least of them is the massive amount of capital needed for productivity enhancement, pipeline capacity and field development. The total investment requirements are difficult to estimate, but are likely to exceed $300 billion over the next decade, with perhaps three-quarters of this amount to be spent in Russia. Most of this money will have to be raised externally. The cash flow in Russia's hydrocarbon sector is sufficient to finance modest production growth over the next few years, but is not enough to step up production significantly. In the Caspian region the investment needs are already higher than cash flows, and all sector development depends on external capital injections.

For these investments to materialise, major improvements are needed in terms of industry structure, governance and the investment climate. In parallel, the governments of the region need to improve their management of resource revenues and strengthen environmental compliance to ensure macroeconomic stability and sustainable development. These two issues, although central, are not further pursued here. They are discussed in more detail in the 2001 Transition Report (EBRD 2001). The focus of this paper is on the measures needed to unlock the region's considerable potential and attract the necessary investment. We begin with a look at the region's energy production and reserves and the history of reforms to date.

Production levels and reserves

Russia and the Caspian basin account for a significant share of global hydrocarbon reserves. This is especially true for gas; Russia alone holds one-third of proven global reserves. Oil reserves in Russia and the Caspian region are estimated at around 7 and at least 2 billion tonnes respectively, putting the Caspian region roughly on par with the North Sea (see Chart 1).2

Like output in general, energy production in the region fell dramatically at the beginning of transition, particularly in Russia. In 1989, the Soviet Union was the world's largest oil producer, ahead of Saudi Arabia, with an annual output of about 600 million tonnes. At its lowest point, in 1996, the production of the Soviet successor states had fallen to some 350 million tonnes, and in 2000 was 395 million tonnes. Output of natural gas has performed better, but still declined by about 9%, or almost 70 billion cubic metres, between 1989 and 2000.

However, over the medium and longer term, hydrocarbon output is expected to accelerate significantly. By some estimates, crude oil production in the Caspian region could reach 200 million tonnes per year by 2015, up from 65 million tonnes in 2000. Russia's crude production is expected to rise more gradually to around 375 million tonnes a year, up from 325 million tonnes. The major source of this projected increase will be new fields, which are still far from reaching peak production levels, such as Azeri-Chirag-Guneshli in Azerbaijan, Tengiz and Kashegan in Kazakhstan and Sakhalin in Russia.

The increased production is predominantly intended for export. In contrast to domestic energy consumption, export demand has increased significantly since 1989. Crude oil exports from Russia and the Caspian region to non-CIS countries have increased by over 50% since their trough in 1993, while gas exports rose almost continuously from below 90 billion cubic metres in 1990 to over 130 billion cubic metres in 2000. This trend is likely to continue as the region develops into an important global supplier of energy, particularly for the European market. Faced with declining production from the large North Sea oil and gas fields, and a structural shift in demand towards natural gas, western Europe is looking increasingly to the transition countries to cover its energy needs. The East Asian market, in particular China and Japan, represents the other main source of growth in demand for the region.

Energy sector privatisation and investment to date

Russia and the Caspian region have not been among the transition economies' most ardent reformers.3 The energy sector is no exception. Indeed, Russia and the Caspian are wasting up to half of their total resource rents in untargeted energy subsidies and are so far failing to save sufficiently to safeguard the interests of future generations. However, the reform measure with the greatest impact on investment in the energy sector to date has been the process of privatisation.

In Russia, the major oil producers have been privatised (Table 1), although the state remains the biggest shareholder in the most important energy company of them all, Gazprom. The resulting ownership structure left major energy assets in the hands of oligarchs with few incentives to re-invest cash flows into increasing production. Instead, as shown, production plummeted and profits largely left the country for foreign bank accounts. Foreign investment has been extremely limited given this poor governance record, and the few investors who tried more often than not faced significant difficulties. Following a process of consolidation of ownership, this now seems to be changing, but much more progress is needed to make Russian oil companies attractive for foreign capital.

In the Caspian countries, privatisation of energy assets proceeded largely through trade sales to foreign investors in the context of Production Sharing Agreements (PSAs), or joint ventures. This has brought in around $7 billion in net foreign direct investment into Kazakhstan, and maybe half this amount in Azerbaijan (the gross figures are of course considerably higher). In Turkmenistan and Uzbekistan, foreign presence is much smaller. However, throughout the Caspian the state retains important equity stakes in production and state-owned assets have been consolidated under the roof of one or two national companies. This is now causing difficulties for some of these companies as they are faced with considerable financial demands to meet the cash calls for further field development. Again, significant improvements in corporate governance will be needed here as well, if external financing is to be raised successfully.

For both Russian and Caspian energy companies access to external finance will be critical in the years to come. The corollaries to this need are growing opportunities both for financial and strategic investors. To increase the confidence of investors, further reform progress is needed in the following three areas: i) fiscal and contractual arrangements; ii) corporate governance and iii) transportation and access to export markets.

Fiscal and contractual arrangements

A key element of a good investment climate is a fiscal regime that allows governments to maintain their share of resource rents, while offering competitive tax terms to investors. International best practice suggests using multiple fiscal instruments to cause as few distortions as possible as risks and returns change over time. These include a percentage royalty fee on volume recovered as compensation for depleting the nation's resources, a corporate profit tax with deduction of reasonable business expenses, as well as taxes to capture resource rents above defined thresholds.4

Over the past years, Russia in particular has deviated substantially from this type of practice. The heavy reliance on multiple revenue and production-based levies has led to a complex and inflexible fiscal regime, providing a disincentive for investment in higher-cost or new oil with more exploration risk. Another tax-related problem that has stifled investment in the Russian context has been uncertainty in federal-regional fiscal relations, with many regions and local governments introducing taxes not anticipated in the federal legislation, combined with arbitrary implementation.

The tax arrangements for Caspian energy producers vary in terms of their adherence to international best practice. Azerbaijan and Kazakhstan provide simple profits-based systems. The current tax regime in Turkmenistan, on the other hand, is heavily weighted toward the use of revenue taxes including the application of value added tax (VAT) on oil and gas exports. Uzbekistan also makes use of substantial excise levies and additional contributions for the replacement of the mineral raw material base. Both of these countries, together with Russia, present investors with a regressive structure where the government's percentage share of the profits increases as prices and profitability decline (see Table 2).

Apart from the level of taxes and their incidence, the stability of the tax regime is a key concern for investors, particularly when the strength of the state is weak. To mitigate this problem, a growing number of countries have adopted PSA legislation. PSAs are contractual agreements between investors and governments, covering all key rights to execute a project, including production, import, ownership, export, currency and fiscal rights. They provide an agreed structure and level of taxation and in doing so help to create the legal stability missing under a licensing system. This stability is ensured most effectively, when the PSAs actually acquire the status of laws, such as is the case in Azerbaijan, where PSAs have been particularly successful with more than a dozen agreements signed since 1993.

In Russia, domestic companies are used to operating under a licensing regime, and the need for PSAs is limited to fields that are to be developed with the help of international companies. However, as noted above, considerable improvements need to be made to the tax provisions under the current licensing regime. Moreover, the Russian approach to PSAs has been less than satisfactory. Although Russia passed its PSA law in 1996, with amendments in 1999, necessary implementing regulations remain incomplete.5 As the reliance on foreign investment for new field development increases, strengthening the PSA framework is a key aspect of creating a more attractive investment climate, and the development of several projects depends on establishing a workable PSA framework.

State control and corporate governance

The energy sectors in the CIS have become renowned for their lack of transparency in financial management and decision-making. Poor governance is now a major impediment for their development. This is true as much for the state-controlled firms that dominate in the Caspian region, as it is for the privatised firms that dominate in Russia. A principal consideration across the region therefore has to be improvement to the quality of corporate governance.

Over the past year or so, there are signs among Russian companies that changes to corporate governance are being implemented, including measures designed to safeguard creditors and minority shareholders. The move is paralleled by a more forward-looking business strategy. The need for capital is a key driver of corporate governance improvements, with companies adopting Western accounting practices and other standards to gain access to international financial markets. On the regulatory side, the adoption of the new Corporate Governance Code and the new Law on Joint Stock Companies should make it more difficult and more costly for controlling shareholders to engage in opportunistic behaviour. Yet, real investment will only flow if both the Code and the Law are effectively implemented and enforced.

In the Caspian, the biggest problem concerns the lack of transparency of resource flows within the public sector. This is most evident in Turkmenistan, where sector reforms have progressed the least. But it is also a problem in Azerbaijan and Kazakhstan, where the national oil companies own or control a host of subsidiaries with no arms' length trading between them. There is an inherent conflict in all Caspian countries between the need to attract outside finance into the state energy companies to meet investment demands and the present practices of using state companies as a means for redistributing energy rents. There are signs that this is being slowly addressed. For example, in Kazakhstan, Kaztransoil (recently merged with Kaztransgas into a single transport operator) is undergoing a restructuring programme, which would separate its multiple business interests into independent commercial entities. These moves are paralleled by efforts to access international capital markets. Kaztransoil issued a $150 million seven-year Eurobond in June 2001, priced at about 300 basis points over US treasuries.

Pipeline access and market entry

While investors will look at the contractual regime and at governance practices before committing funds, maybe the most important concern aside from production costs, are the costs of transportation and the ability to access export markets. In this respect, the region being far from the main sea-borne transportation routes still has far to go.

The transportation network of the region is under the control of just two companies, Transneft ? a state-owned monopoly which controls over 97% of Russian crude oil transportation ? and Gazprom, which control the gas network. Since both systems were originally designed to serve the Soviet market, there are increasingly bottlenecks at the main export points to Europe, such as on the Slovak-Ukrainian border, in the Baltic states and on the Romanian-Ukrainian border (see Charts 2a and 2b).

Under these circumstances, equitable and cost-effective access to pipelines is a key issue, particularly for exports, and the absence of a proper regulatory framework remains a major drawback. In the past, capacity allocation has often been arbitrary and not devoid of political overtones. Russia has used its control over the transport network to secure spare export capacity at the expense of Caspian producers.

Part of the response to this situation has been for the oil companies to develop their own pipelines, thereby creating a system of competing networks. Numerous proposals are on the table to overcome transport constraints and break Russia's monopoly over energy transit. While some of them concern northern routes, competition for the Transneft and Gazprom transport networks is more likely to arise from new transport capacity for the Caspian region, where the bottlenecks are greatest (see Chart 3a). However, Russia is likely to retain a key role because of geographical reasons, and because most alternative routes face political and security problems of their own.

Improving market access in this way involves major economic, environmental and political hurdles. The costs of building new pipelines are significant, requiring large annual throughput commitments to make projects financially viable and attract commercial funding. There are also environmental constraints related to the siting of pipelines through sensitive areas. To minimise the risk of leakage and spills, pipeline projects must meet stringent environmental standards. Lastly, most pipeline proposals from the region involve transit through third-party countries (see Chart 3b). This complicates the political negotiations necessary for reducing the risk of delays by transit countries.

However, while the costs of building new pipelines and mitigating their environmental impact are high, their existence, or even just their potential construction, increases competitive pressure and can have a dramatic effect on transit. For instance, since construction of the competing CPC pipeline began, Kazakhstan's transit quota through the Transneft system has increased by a factor of four.

Conclusions

Russia and the Caspian region are likely to become increasingly important suppliers of energy, particularly gas, to the international market. The policies that are needed to unlock this potential can be grouped into three main challenges.

The first challenge is to improve the investment climate. Over the next decade Russia and the Caspian countries will face huge investment needs for the development of their hydrocarbon sectors. Much of this money will have to be raised from external sources. However, foreign investment will begin to flow only if the countries can offer a stable, predictable business environment, and competitive tax arrangements. The region has had some successes with PSAs but tax rules vary widely and doubts remain over the rule of law. Equally, for the incumbent domestic producers to become attractive to outside investors, they need to improve their corporate governance, become more transparent financially and respect the rights of creditors and minority shareholders.

The second challenge is redefining the role of the state. To increase the efficiency of the sector and attract investment, government interference has to be reduced, and the role of the state needs to change from owner to regulator. Despite the drive for privatisation in 1994, the state still wields considerable influence over the Russian hydrocarbon sector while in the Caspian the state continues to exert a strong role in production and transportation through the national oil companies. At the same time, governments need to improve regulatory supervision to rein in the widespread violation of corporate governance standards, and ensure environmental compliance in a sector where environmental risks can be extremely high.

The third challenge is introducing competition. State control over the sector must not be replaced by private market power. A key condition for competition is open and non-discriminatory access to pipelines. At present, the region's pipeline network is controlled by two companies, Transneft and Gazprom, which are themselves under the strong influence of the Russian government. As a result, pipeline access and transit fees often reflect political as well as economic concerns, and market power is used to transfer rents from producers to pipeline owners. Remedying this situation requires root and branch reform in both Transneft and Gazprom, and a clear regulatory framework governing market access. In parallel, competition may be strengthened through independent pipeline projects, where these can be justified on economic and environmental grounds.

The energy potential of the region is huge. Investors will look to governments to address the issues highlighted in this paper. If governments are responsive, the opportunities for investors and the benefits for the people will be considerable. n

References

R. Auty, R. Mikesell (1998), Sustainable Development in Mineral Economies, Oxford University Press, Clarendon.

EBRD (2001), ?Transition Report 2001. Energy in Transition?, London: EBRD.

EBRD (1999), ?Transition Report 1999. Ten Years of Transition?, London: EBRD.

D. Gray (1998), ?Evaluation of taxes and revenues from the energy sector in the Baltics, Russia, and other Former Soviet Union countries?, IMF Working Paper No.34.

J. Sachs, A. Warner (1995), ?Natural resource abundance and economic growth?, National Bureau of Economic Research Working Paper No. 5398, Cambridge, MA.

J. Stijns (1999), Natural Resource Abundance and Economic Growth Revisited, mimeo, University of California at Berkeley.

Footnotes

1 This paper draws heavily on Chapter 4 of EBRD's 2001 Transition Report (EBRD 2001). We are grateful to the co-authors of the chapter Simon Commander and Mark Dutz and to the many experts that commented on it, as well as to Nataya Shevtchik for research assistance.

2 The figures are for proven reserves, but estimates vary widely. In the Caspian region reserves could be much higher. In Russia, where the government does not publish data on the size and location of reserves, they may be lower.

3 The Transition Report 2001 shows that on average reform effort in the energy rich CIS countries has been slightly below that in energy poor CIS countries and much below levels in central and eastern Europe. The phenomenon of insufficient reform and below-average economic growth in resource rich countries is known as the resource curse. See for example Auty and Mikesell (1998); Sachs and Warner (1995) and Stijns (2001).

4 Gray (1998).

5 Russia's first three PSAs were signed before the formal introduction of PSA legislation and were grandfathered in the law.