The European Union has recently taken a number of legislative initiatives indented to reform the gas industry. They include the Third Energy Package and the draft EU Regulations on the gas supply reliability. Alexander Medvedev, Deputy Chairman of the Gazprom Management Committee and Director General of Gazprom export told how badly they may impact the relationship currently existing among market participants and how these innovations will affect the Company's business in Europe in his interview to the Gazprom website.

Mr. Medvedev, what challenges will Gazprom face after the Third Energy Package comes into force?

Gas industry reforms in Continental Europe are determined not solely by this document, but by a whole set of legislative initiatives of the EU authorities including, for instance, the draft EU Regulations on the gas supply reliability recently endorsed by the European Parliament. One should consider these documents all together to understand the difficulties they may cause for business on the European gas market.

After implementation of the measures envisaged by the reformers we may face the problems both in operational activity and in property rights. Even if Gazprom manages to evade direct obligations to sell gas transmission assets in some countries and remains their owner, the Third Energy Package still deprives the Company of the access to managing these assets in the European Union.

It is obvious that depriving suppliers of the opportunity to manage gas transmission assets devaluates the investment they made in these assets. Here is the example. In the late 1990s when Russia experienced problems with convertible currencies Gazprom Group found an opportunity to build the Yamal – Europe gas transit pipeline across Poland used to supply gas to Germany, inter alia. Now we see an emerging threat that the asset management meant for reliable gas supply to our customers will be transferred to an independent operating company that will start acting on their own account. Thus, the pipeline owner turns into a financial donor obliged to execute investment decisions taken by an independent system operator!

We have to adjust the operational activity of Gazprom Group as well. The mechanism providing reliability of our existing long-term contracts and involving readiness of a supplier to maintain backup transmission capacities allowing to swiftly meet the demand in pursuance of the changing day-ahead nominations, is regarded as unfair competition under the new system. From now on, instead of the right to change their nominations several times a day, our customers will be entitled to it only once and on the day before supply. However, it will be very difficult to provide the envisaged reliability and flexibility of supplies without such backup capacities. I would like to stress that taking into account seasonality and extremely uneven demand throughout a day – reliability and flexibility are of paramount importance for the gas industry.

What risks does it bring to the European energy security?

The new gas market model patterned upon the Anglo-Saxon one has its own merits and demerits if compared to the existing model. It doesn't need long-term contracts since volumetric risks are relatively low on liquidity markets. However, without long-term price contracts the volume of gas coming to market starts depending on the price appeal. The gas will be available when the price is high. If the price is low, the volumes may outflow to more attractive markets or stored until better times. Hence, the reliability of European gas supply will be determined by the competition with other global gas markets, primarily, with Asian ones.

The development of gas transmission and storage capacities also runs some risks. The market witnesses that gas companies are most interested in developing the gas infrastructure which is cost-intensive and features a very long payback period; therefore, it is not pretty attractive for regular investors. However, these very companies will not be allowed to take part in such work: a sort of the Great Wall of China separates them from the infrastructure. Having no opportunity either to get reasonable income while the gas pipeline is operating or to take part in its operation, the suppliers will not wish to make such significant investments, they will start searching for more attractive markets and projects. Thus, the ongoing reform brings a real risk of the investment shortfall in the European gas industry – with all the consequences that come with it.

It is worth noting that a EU Member State that has implemented an asset separation principle resembling the Third Package – the United Kingdom – has already experienced problems with maintaining an appropriate level of gas supply during the past winter periods. Neither did the British liberalized market manage to provide enough incentives for investments in the new infrastructure.

Moreover, any copying without regard to local conditions may turn the merits of the Anglo-Saxon competitive market model into demerits and demerits into long-standing problems. Unlike, for instance, North America, Continental Europe doesn't have now and will not have in the foreseeable future thousands of independent producers and consumers. Thus, it is necessary to invent and introduce additional mechanisms that would ensure appropriate operation of the market dominated by bilateral oligopolies. The imagination of reformers leads them to creation of a centralized bulk procurement mechanism for the entire EU, but one can hardly call this proposal a market-based one.

Are there any guarantees that the property created in previous years and long-term Russian gas supply contracts will remain intact?

I have already mentioned a threat to property, now I would like to dwell on an institution of long-term export contracts pegged to oil and oil product prices.

They were subject to hard pressure by the European Commission regarding it as suppliers' competition restricting tool. Europe's domestic gas market is currently dominated by short-term contracts. The Third Energy Package is pro forma neutral to long-term export contracts pegged to oil and petroleum product prices. For some reason, exporters are experiencing problems with fulfillment of obligations under such contracts. These derive from refusal to extend exporters' long-term transmission contracts after their expiry, different terms of export and domestic gas purchase-and-sale contracts, as well as introduction of a new “use-it-or-loose-it” principle when contracting transmission capacities.

How will Gazprom's business activity in Europe change once the Third Energy Package is put into effect?

We suppose that the new rules of play can be only applied to the uncontracted gas volumes. As for the obligations undertaken under long-term contracts, they have to be strictly observed.

At the same time, the European Commission still has time to determine the final structure of the future gas market. By now the initiators themselves are not sure what it will look like. It is instructive to recall that the 2006 Group of Eight Summit formulated the global energy security as the integrity of secure supply and demand. We in Gazprom are confident that compromise decisions still can be worked out in cooperation with major gas suppliers from third-party countries. We are working towards resolving this issue.

How is the dialogue between Gazprom and Brussels evolving relevant to the energy market reforms and protection of Gazprom's interests? What is the progress on it?

We maintain a constant contact with various European institutions, both political and expert ones.

Gazprom Group and the Russian Government, on its part, are closely examining the implementation of the Third Energy Package. This is a necessary measure to make sure that the damage caused by this process to our Company's interests and the interests of our partners and consumers will not go beyond the bare minimum. I also hope that we will be granted the opportunity to make a significant contribution to updating the document.

European consumers insist on further revision of the contract terms and conditions, as well as the price formula claiming that the gas market has completely changed. How do you evaluate the necessity of these changes?

Under the global crisis conditions the gas market has undoubtedly evolved but not so drastically that the abolishment of the decade-proven, reliable and viable system of long-term contracts was needed. Besides, underway is the market revival amidst a gradual process of crisis overcoming.

Ensuring the balance of interests between natural gas purchasers and sellers is among the indisputable benefits of long-term contracts. Officially, everyone speaks in support of these contracts, but some purchasers, however, demand to upgrade them in such a way that is equal to a total destruction. There is a variety of options to perform such “modernization” including a complete transition to spot price indexation, waiver of the “take-or-pay” principle or adjustment of the contracted volumes and the basic price on an annual or, rather, on a quarterly basis if the link to the petroleum product-based formula is retained. As a result of these proposals, the contract “modernization” will entail an imbalance of interests that could be unfavorable for gas exporters and, therefore, considered by them as unacceptable.

When defending the link to oil and petroleum products in long-term contracts as the sole alternative to spot prices, Gazprom Group demonstrated flexibility in the relations with partners considering the unprecedented situation on the current European gas market. By adjusting the long-term contracts Gazprom's aim was to avoid a significant gap between the contract prices and the similar competitors' prices and, therefore, to facilitate an increase in gas off-takes. However, the contracts adjustment did not change their basic principles.

Is the gas price pegging to the oil price still necessary?

Long-term contracts with the link to petroleum products as the predominant feature still guarantee a balance of interests between the purchaser and the seller. Taking into account a high import dependence in Europe, linking the gas price to the “third” commodity – oil – will protect the consumer against possible price manipulations by the major supplier as none of the major gas exporters to Europe can influence the oil and petroleum product prices. Over the contract period that may reach 35 years the exporter's interests are not only protected by this link, but also the “take-or-pay” principle as well, which guarantees the minimum off-take amount under contracts. In this way, volumetric risks are assumed by the purchaser, which assures the return on the supplier's long-term investments. The purchaser's interests have an extra support through the contracting obligations taken by the supplier that incurs penalties if the day-ahead nominations are not met. The supplier also assumes the “make-up” gas obligations.

Has natural gas already become a separate exchange-traded commodity?

The gas pricing model based on the supply and demand doesn't function successfully on any of the global markets.

Even in the USA where, unlike Continental Europe, there are all preconditions to apply this model efficiently, the prices don't fully cover gas producers' costs. This also refers to shale gas producers. Only the oil link can retain natural gas prices at the adequate level that is convenient for producers.

How do the European customers fulfill their obligations on minimum contracted volumes off-take? Will the “take-or-pay” rule further change in European contract practice under pressure of crisis and gas oversupply on the market?

The “take-or-pay” principle remains a cornerstone of the long-term contract system, reliable and flexible gas market organization in Continental Europe. Gazprom Group acts to preserve this principle but at the same time shows flexibility and considers specific market conditions. Basically, every country has a different market but the situation is acceptable in general.

Our experts forecast that the current gas oversupply in Continental Europe will not last long: the pre-crisis level will be reached around 2012 while by 2020 the EU states will have to import more extra gas under declining domestic gas production. Our consensus forecast shows that the gap between demand and domestic gas production in the EU states will reach 380 billion cubic meters a year in 2020 and 440 billion – in 2030. Thus, the future challenge is not related to gas oversupply but to inevitable need of having additional volumes delivered in a reliable manner.