The Loudenia Crier

Comments on the “Bill on Trade Relationships with the Russian Federation” now before the Loudenian Parliament

William Tompson, Professor of Political Economy, Birkbeck College, University of London

[Testimony couriered to Gordon Mitchell via email July 28, 2008, 2:57 am]

While the aims of the proposed legislation, as set out in the bill, are
clearly laudable, Loudenian policy-makers will want to consider a number of
serious questions before passing this measure into law.

1. The need for a Loudenian-Russian Pipeline.

a. What are Loudenia’s current energy supply arrangements? Is there reason to
believe that they are inadequate in terms of capacity or in some way insecure
(thereby exposing Loudenia to potentially serious supply disruptions?

b. If there is no evidence of capacity constraints or supply insecurity, what
is the rationale for a dedicated pipeline?

c. How confident are Loudenian policy-makers of Russia’s ability and
willingness to supply volumes of oil and gas to make the pipeline a
worthwhile investment? There are currently serious debates about whether or
not Russia will be able to sustain — let alone raise — oil and gas
production over the coming decade and thus to meet its existing export
commitments (let alone any new ones), as well as rising domestic consumption.

d. On what basis do Loudenian policy-makers believe that they need to
increase oil and gas imports from Russia by 1% p.a. over 10 years? In a
fast-growing economy, energy demand is likely to grow by more than 1%,
implying that Loudenia’s reliance on Russian hydrocarbons will decline over
the period. This could be a good thing — diversity of energy supplies can be
important for energy security — but it raises the question of whether import
volumes will grow by enough to warrant large-scale investment in a new
pipeline.

2. The terms of the deal with Russia.

a. On what basis have policy-makers decided on a 70-30 division of ownership?
Has Russia agreed to this?

b. At what point will the issue of price be addressed? Are the Loudenian
authorities confident that oil and gas supplies will be provided at
acceptable prices? For oil, the norm would be to use world market prices, of
course, but there is no “world market” for natural gas, and natural gas
tariffs often vary widely from region to region and country to country. How
will the gas shipped through this pipeline be priced?

c. Will the pipeline be available for the import of non-Russian hydrocarbons?
(For example, could Loudenia use the pipeline to receive Kazakh or Turkmen
oil or gas that was shipped to Loudenia via Russia or will Russia be the sole
supplier?)

d. Will re-export or transit of Russian oil and gas to third countries via
the pipeline be allowed? If so, this could be an argument for building the
pipeline even if there is uncertainty about the answer to 1d above.

3. The degree of state involvement in foreign trade.

a. What is the basis for clause 6? There are large international markets in
coal and copper, in which buyers are free to contract with sellers. What need
is there for an inter-state agreement regulating coal and copper supplies?

b. A similar question arises in connection with respect to clause 5. Here it
is important to distinguish between oil and gas.

i) The global oil market is very large and very liquid (in every sense of the
word!). What is the rationale for an inter-state agreement concerning
purchases of oil? (By the way, I must admit to a certain ignorance of
geography: is Loudenia landlocked? If Loudenia has decent ports, then I would
question the need for a new oil pipeline, since tanker transport is generally
cheaper than pipeline transport: one can ship a barrel of oil around the
world in a very large crude carrier for not much more than a dollar a
barrel.)

ii) As noted above, there is no global gas market. That is because gas is so
much more difficult and expensive to transport and to store. While liquid
natural gas is developing rapidly and may eventually allow for such cheap
transport and storage as to create a global gas market, most gas is still
delivered via dedicated pipelines and storage facilities are generally
limited. Gas supply is therefore much more commonly subject to inter-state
agreements (or agreements among public-sector utilities), dedicated
infrastructure, etc. Parliamentarians may want to consider whether the bill
makes more sense for gas than for oil. Even in respect of gas, however, the
absence of any obvious input from the private sector raises questions.

4. Natural resource management. The bill provides for a reduction in coal and
copper extraction over a 14-year time horizon. In principle, there is no
reason why the state should not regulate the rate of extraction: I assume
that Loudenia adheres to the international legal norm that holds that subsoil
resources are state property (as far as I know, the United States is the sole
exception to this rule). It is therefore up to the state to govern the
“extraction path”, even if private companies are awarded licences to the
develop these resources. So far so good. But on what basis do legislators
wish to reduce extraction? Determining what economists call the “optimal
extraction path” is no easy task.

a. One might wish to reduce extraction if one were confident that coal and
copper prices would rise even higher in the future — and that this increase
would be so great as to offset the benefits that could be gained by
extracting the resources now and investing the income generated in other
activities. In the present economic environment, this may seem like a
“no-brainer”: there is a widespread expectation that high commodity prices
are here to stay and that the future will bring even higher prices. I would
not be so sure. There was the same feeling during the 1970s oil shocks, but
prices subsequently collapsed and did not recover for over 20 years.
Moreover, the future value of coal reserves will be affected by environmental
policies and technological change. Don’t assume that coal will be worth more
in 2023 than it is today.

b. The bill refers to the next generations, implying an argument about what
economists call “inter-generational equity”. Subsoil resources do not belong
only to the present generation but are the patrimony of all Loudenians,
including future generations. By extracting less now, Loudenia would, as a
nation, be saving more. Current generations would consume less (and would
experience slower economic growth) so that later generations could consume
more. This can also be done by extracting the resources and saving a large
part of the income they generate: Norway, for example, operates an oil fund
designed to ensure that future generations of Norwegians will also profit
from current exploitation of a non-renewable resource. In the case of an
emerging economy like Loudenia, there is a less compelling case for such an
approach than there would be in a wealthier, more mature economy like
Norway’s. I assume that, being a neighbour of Russia, Loudenia is an emerging
market. There is good reason to expect that, given reasonable economic
policies, the economy will tend to grow fairly rapidly over the
medium-to-long term, leaving future generations of Loudenians substantially
wealthier than the current generation. Why, then, should the current
generation reduce its potential consumption in order to increase that of
future generations that will in any case be much richer?

The resources now in the ground can be thought of as a form of savings
deposit for Loudenia. Leaving them untouched would make sense if: (1)
policy-makers were confident that they would appreciate in value faster than
alternative uses of the resources that could be generated if they were
extracted and sold today, and (2) inter-generational equity meant that there
was a good argument for asking today’s Loudenians to tighten their belts in
order to make things easier for their children and grandchildren.

5. Corporate governance. The bill would create two potentially large new
state companies. In most emerging market economies — and especially in the
former communist states of Eurasia — state companies have often proved to be
very vulnerable to corruption and rent-seeking by insiders (i.e. their
managers and employees, and the officials who oversee them). Scandals over
oil and gas trading, in particular, have been common. In many countries,
state-owned companies are managed primarily in the interests of those who run
them rather than in the public interest. Before creating such companies,
therefore, policy-makers will want to consider whether and how they can
ensure that the people running these companies are properly motivated — that
they should be subject to both adequate monitoring and proper incentives, so
as to run the companies efficiently in the national interest. Transparency
and accountability will be critical issues.

6. Environmental management.

a. Why is it expected that NGOs should revitalise areas damaged by
irresponsible mining? What of the liability of the mining companies
themselves? If these are/were state-owned companies, why is not the state
directly engaged in the clean-up?

b. What arrangements are envisaged for ensuring that mining activities in
future will be undertaken in a more environmentally responsible way?