Economic Statecraft
The Illusion of Control: Introducing Price Caps on Russian Energy Might Backfire

The energy systems have tremendous inertia, and it would be a strategic blunder to think that a political directive can provide the EU with alternatives to the Russian energy by a wave of the magic wand. The EU wants to be in control of when it stops importing Russian oil and gas, but this may not be possible, writes Vitaly Yermakov, Expert, Centre for Comprehensive European and International Studies, HSE University.

The EU has been trying to lessen its dependency on Russian energy for many years, most recently via a gradual and “managed” separation as part of the energy transition process. The EU energy transition agenda with its emphasis on a higher share of domestically produced renewables in the energy balance has been designed in part to address not only the environmental concerns of the Europeans, but their energy security concerns as well. The practical implementation of these policies, however, turned out to be problematic. The attempts to fast-track the transition and remove hydrocarbons from the energy balance too soon has resulted in underinvestment into the traditional forms of energy and has led to price spikes. The problems are obvious, and the need for a course correction is undeniable. The politics, however, has been trumping economics and forcing the EU to double-down on policies that might become destructive for its economy.

The events in Ukraine have produced the largest political conflict between Russia and the EU since the end of the “cold war” and had profound effects on the EU policy towards Russia’s energy supplies. It has turned a long and carefully planned separation between Russia and Europe that both sides were contemplating for quite some time into a hasty and ugly divorce in which ex-partners are trying to hurt each other as much as possible regardless of consequences and collateral damage. In the process we have witnessed the attempts to identify and use vulnerabilities in the energy value chains by each of the opponents leading to the weaponization of energy and making it part of the ongoing proxy war between Russia and the West.

The EU policies have changed from reducing dependence on Russian energy to its complete phaseout, as soon as possible. The reality is, however, that the energy systems have tremendous inertia, and it would be a strategic blunder to think that a political directive can provide the EU with alternatives to the Russian energy by a wave of the magic wand.
The EU wants to be in control of when it stops importing Russian oil and gas, but this may not be possible.

Yet, it seems, the illusion of control has been driving the EU practical steps, only backfiring via price spikes and energy shortages.

Since spring the EU has announced a series of measures that have been designed to reduce Russia’s revenues from energy exports. Most important of these are the bans on imports of Russian hydrocarbons, starting with coal since August 11th, 2022, crude oil (to take effect on December 5th, 2022) and refined products (to take effect on February 1st, 2023). The EU also announced its plans to phase out Russian gas imports completely by 2027 despite the fact that it desperately needs more gas in the short term amid record-high prices and global tightness of supply through at least 2025.

So far, Russia has been resilient and managed to introduce effective counter measures. It has been redirecting its coal and oil exports to Asia. It had to offer its commodities at significant discounts to the international price benchmarks but avoided the need to sharply reduce output and exports. Meanwhile, global oil prices significantly increased due to geopolitical tensions in 2022, and Russia received a booster shot of much higher export revenues even after the price discounts.In the area that represents a strategic vulnerability for Europe — Russian pipeline gas exports — Gazprom first reduced and then completely halted the flows on natural gas via the Nord Stream pipeline, pointing at the failure of the European counterparts to perform their contractual obligations on servicing the gas turbines at the Portovaya compressor station. This contributed to the incredible increases in natural gas prices in Europe and is threatening de-industrialization of Europe as many energy-intensive industries have lost their international competitiveness and had to stop their operations.

The first shots in the energy war have been fired. But the oil and refined product embargos announced for the coming winter would mean a tremendous escalation of the standoff. Will the EU embargo work? How will Russia respond? Oil is a globally traded and fungible commodity. It is becoming increasingly clear that a partial embargo on Russian crude is not going to be effective due, first, to the opaque nature of the global tanker trade, making the enforcement practically impossible and, second, to the desire of numerous buyers in Asia to obtain discounted Russian supplies in spite of the risk of the secondary sanctions. Put simply, most of the world is not going to join the sanctions regime against Russian oil.

The hastily announced EU embargo was probably supposed to have a psychological effect on Russia and make it bend to pressure. The expectation was that by autumna negotiated peace in Ukraine would be reached, and it was necessary to provide Ukraine with a bargaining chip in the upcoming negotiations. But the conflict in Ukraine is still dragging on, and the winter is coming. The EU is now facing a choice: to actually put the announced oil embargo into effect in December and risk another spike in oil prices with the consequence of potential political unrest at home orcall the whole thing off and lose credibility.

It is against this background that the idea of the oil embargo started to morph into the idea of price caps on Russian energy that would deny Russia extra revenues and simultaneously shield Western economies from higher energy prices. According to the plan made public on September 2nd, the G7 countries’ embargo on maritime deliveries of the Russian oil planned for the beginning of December should be complemented by the creation of the buyers’ cartel that would pay a designated price for the Russian crude. The price level should be set low enough to deny the seller any market upside and limit its revenues. At the same time, the capped price should barely cover the costs of production and maritime transportation for the Russian exporters. To induce buyers and shippers to cooperate on the plan, international maritime insurance should be denied to any Russian cargo that is not complying with the price caps. Without shipping insurance, so this logic goes, no ship will sail, and no port will clear the cargo. Most of the global maritime insurance business is currently concentrated in the UK with Lloyds of London handling close to 95 percent of the world’s transactions in this area.

The apparent logic of the price cap idea is that Russia might be scared into taking the bad deal to avoid a worse alternative of having to cut its oil output.
It would be able to export as much crude and products as it wishes but the West would control the revenues.

Similar ideas about fixing prices started to be floated in the EU in relation to Russian gas supplies. For this clever plan to work, however, the nation states outside of the G7 group, most importantly China and India had to agree that the West was in control of global energy flows and could dictate prices to all market participants (the calculation by the authors of the idea was apparently that China and India might be lured by the prospect of obtaining Russian crude at a significant discount). Any collective action is extremely difficult to achieve, and it is unlikely that China or India are ready to risk damaging their relations with Russia for the sake of the G7. But, most importantly, Russia had to agree to be effectively pushed into the corner and accept “punishment” while not attempting to retaliate.

Russia’s response was swift and decisive. President Vladimir Putin, speaking at Eastern Economic Forum in Vladivostok on September 7th warned that Russia would cut off all energy supplies to countries that attempted to impose price caps on Russian energy exports. “They are not in a position to dictate their will to us” — he said. Putin characterized the price cap idea as “another stupidity, another non-market decision that has no prospects”. “All administrative limitations to global tradeonly lead to market distortion and higher prices”, — he concluded.

There is every reason to take President Putin’s words seriously.
There is no doubt that Russia is not bluffing, will not negotiate at a point of a gun and is ready to cut energy exports rather than agree to the “compelled trade”.

Russia is the world’s second largest crude oil and refined products exporter. Reduced Russian supplies to the already tight global oil market are going to increase oil prices in a situation when the world is balancing on a brink of the global economic recession. How high oil price can spike is anybody’s guess but the test of wills would represent experimentation on a grand scale with uncertain economic and geopolitical consequences in the midst of the winter (or winters) of discontent. The first signpost to watch will be the mid-term elections in the US in November and the fortunes of the Democratic administration that has been taunted by public criticism over high gasoline prices. And in Europe it all depends on how severe the upcoming winter might be and whether the EU countries manage to avoid energy rationing. Before making a next move in the escalation game it might be worth remembering the old saying: “People who live in glass houses shouldn’t throw stones”.
Economic Statecraft
Price Cap on Russian Oil: The Mechanism and Its Consequences
Ivan Timofeev
It is time for Russia to start thinking about adjusting to the Western restrictions, including by developing its own tanker fleet and abandoning the US dollar in oil deals. The latter is the prevalent task of Russia’s foreign trade in the new political conditions, writes Valdai Club Programme Director Ivan Timofeev.
Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.