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The West should not go strategic on energy security

January 13th, 2008 by Pierre Noël, University of Cambridge

On both sides of the Atlantic, foreign policy analysts have convinced policy makers that the West faces a severe energy security challenge. They promote either ‘energy independence’ or a ‘strategic approach’ to energy security. The West, they say, should stop being naïve about markets. Exporters are renationalising the energy industries and placing their energy assets at the heart of their foreign policy. Large new importers secure their supply through government-to-government deals. Energy policy has become high politics and energy security is hard security. The appropriate institution to deal with these concerns is no longer the International Energy Agency but NATO. It is time to challenge this vision.

The dynamics of global energy markets do not justify a new paradigm for energy security policy. The global oil market is not falling apart. Despite the move towards greater government control upstream, oil is still traded in a globally integrated, highly liquid commodity market. Accessing this market requires no diplomatic or military capacity whatsoever. If anything, the commoditisation of oil is still increasing as the rapid integration of China into the market boosts liquidity of Eastern oil trading.
The world economy does face a mid-term risk of liquid fuel scarcity and a short-term risk of oil supply disruption, but there is nothing here we are ill-equipped to deal with. The answer to the first concern is higher taxes on oil products, tougher fuel economy standards and increased spending on research, development and deployment of alternative transportation technologies. As for the higher risk of supply disruption, a new wave of investment is required in emergency storage, a move the United States seems to have already embarked on.

When the risks go up it makes sense to buy more insurance: more spending is needed on oil security policies. It is also important to go from an OECD-based regime to one that includes the fast-growing energy economies of China and India. Whether that means bringing these countries into the OECD or taking the International Energy Agency out of the Paris-based organisation is for governments to decide, but the goal is clear.

Both risks, above all, require that we let the markets work. One of the key lessons learnt since the painful experience of the 1970s is that free markets are the consumers’ first line of defence. Freedom to import and the absence of price regulation is what protected the US from physical disruption during the Venezuelan strike of 2002 and again after the 2005 hurricanes. Conversely, import and price regulations are the only cause of the chronic oil product shortages in China. As Beijing is learning and as we should not forget, oil supply security is too serious not to be left to the market.

Similarly, higher prices are not an energy security problem but a solution. Since the first oil shock, the energy intensity of the US GDP (the amount of oil used per unit of wealth created) has declined by almost 60%. The rate of decline had sharply slowed down when prices collapsed but since 2005 it bounced back to twice the ten-year average. US oil imports – for those who care about that – have not increased in almost three years and are about 10% higher than in January 2001. At this point in the Clinton presidency, US oil imports were 40% higher than when he took office, and rising.

The case for ‘strategic’ energy security policies is not much stronger for natural gas. True, reserves are concentrated and gas exporters might organise themselves to extract monopoly rents. This is no threat to security of supply, which is determined by the ability of the gas economy to cope with supply disruptions. And there is a good case for saying that the structural dynamics of natural gas markets provide consumers with an increasing degree of supply security.

Contracts become more flexible, gas-to-gas competition increases, once isolated regional markets are linked through arbitrage opportunities actively exploited by traders. Accordingly, bilateral relations become less relevant and the potential for spontaneous re-allocation of physical flows across markets increases.
The single biggest contribution to international gas supply security would be for the European Union to create a competitive, integrated gas market through unbundling of transmission networks from gas production and marketing. It would also radically diminish Russia’s ability to leverage the bilateral gas relationships, increasing the chance for Europe to speak with one voice to Moscow.

The dreams about ‘energy independence’ lead to expensive policies with no real energy security benefits and lots of adverse consequences. The nightmares about ‘energy wars’ feed discourses that fuel the very politicisation which the West should try to defuse and reinforce prejudices in China and India about the need for aggressive foreign energy policies – a process that looks like a vicious circle.

Energy security risks have probably gone up but have not changed in nature. More money is needed to buy more collective insurance. It should come in part from emerging countries, which should be brought into the consumer-led energy security regime. But energy independence is nonsense and a NATO for energy is dangerous nonsense.

Pierre Noël, Researcher at the University of Cambridge (EPRG) and at the European Council on Foreign Relations

P.S. A slightly different version of this article was published in the Financial Times on 11th January 2008.

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4 Responses to “The West should not go strategic on energy security”

  1. Daniel Kirschen Says:

    While I generally agree that markets are the most efficient way of dealing with demand and supply balance issues, I think that we need to keep in mind a few facts:

    – Market are efficient if all significant actors behave in an economically rational way. If a large actor (e.g. Putin’s Russia) stops behaving in a rational manner, the optimality of the market disappears very quickly.

    – Markets are not very good at dealing with large, infrequent events, particularly those of a technical nature . In particular, I don’t think that they factor in properly the economic consequences of a large disturbance in energy supply.

  2. Jon Stern Says:

    Pierre Noel’s analysis is spot-on.

    Daniel Kirschen’s second comment has force but is essentially an argument in favour of more expenditure on emergency/collective insurance. His first comment ignores that Russia is as dependent on us continuing to buy their oil and (even more) gas exports as we are on them continuing to sell – hence the fact that the Soviet Union NEVER failed to observe the terms of its export contracts through the most high-tension periods of the Cold War.

    As Pierre rightly points out, full unbundling of gas transmission networks in EU countries would do much to ease the risks of cartel games playing.

  3. Marie-Lys Edon Says:

    According to this analysis, energy security should rely exclusively on an open market and not on energy independence or strategic approach. Oil and gas supply security should be left to the market and price regulations have to be avoided. The risks can be mitigated by collective insurance.

    As energy security risks have gone up, more money is spent for collective insurance and energy prices have increased. As a result, investments in alternative energy solutions are becoming more and more competitive.
    In my opinion, energy independence includes two different aspects.
    – Energy dependence toward gas and oil:
    As oil is totally necessary at least for transportation, importers need to ensure their supply and have to be able to pay a high price for this purpose. At the same time, high prices of oil and gas (due to open market) will encourage importer countries to take action to reduce their domestic consumption and invest in new technologies that can reduce or avoid the use of oil and gas. The leverages on the consumption for transportation are diverse: investment in technologies that reduce the consumption of vehicles, implementation of policies that foster public transportation or reduce the use of private cars. These are some of the possible domestic actions that can improve energy independence toward gas and oil. And that’s how market prices will naturally influence the use of energy.
    – Energy independence by means of other sources of energy, namely nuclear, hydroelectricity, and other renewable energies.
    Hydroelectricity is almost saturated in Europe but several European countries have greatly invested in other renewable energies. Besides, some European countries have recently decided to invest in nuclear energy. These decisions comply with the objective of reducing CO2 emissions but they are, at the same time, policies toward better energy independence. They confirm that the mid-term risk of liquid fuel scarcity leads to a change in the policies regarding the energy mix of every fuel dependent country.

    Regarding the risk of oil and gas depletion, open energy markets lead to an increase of energy prices, which consequently leads to proportional efforts to reduce oil and gas consumption. Open energy markets can therefore be considered as a tool that enables a natural balance between fuel prices and investment in alternative technologies. However, as long as no serious solution has been found for alternative transportation technologies, international tensions regarding oil and gas dependence will increase as the risk of liquid fuel depletion becomes higher, and nightmares about “energy wars” could become a reality.
    In the meantime, open markets, which are generally considered as the best way to balance offer and demand, seem to offer the best solution to energy supply issues.

  4. Florian Garcia Says:

    Why do people want so much to be independent? This is both an illusion and a danger!
    Commerce – not worth precising it is fundamental in any society – is all about dependence. When you buy something, it is always because you need it. You need it either for your own consumption, i.e. to satisfy your basic needs but also your hunger for the non-vital things you cannot live without anymore, or your business, which is eventually the same reason since you do business for a living. The interesting thing is, as Jon Stern accurately pointed out for Russia’s gas exports, that when you sell something, it is also because you need to! Nobody can afford to stop selling their product, because it is what they do for a living and thus are highly dependent on it. The contrary would be very unfortunate for the buyer since it means he or she would totally lose his bargaining power.
    Actually, this tends to happen when a big monopolist addresses a very wide market constituted of small consumers. In this case, the situation is watched very closely by competition authorities to prevent abuses and according to the type of monopoly, governments try to instigate competition and encourage it as far as possible with unbundling measures and internationalization for example. Thus, the French electricity monopoly is shrinking to the transportation network only, allowing new producers and retailers to operate.
    Nevertheless, everybody (fortunately!) seems to agree that a global competitive and fluid market for energy is the most efficient way to deal with supply and demand and that we must concentrate our efforts on its implementation, but still thinks that it would be better if their country was energetically independent, especially in case of conflict or shortage. Even in economics, nationalism is stupid. As I said, independence is an illusion. Investing billions of Euros in heavy industry facilities such as nuclear power plants for example is great. It employs thousands of people, gives a high-tech image people may be proud of, and above all allows us to export electricity and bring money from abroad. Yet, the countries who buy our electricity do not have to worry about the security of their supply, it would be too painful for us to stop a plant and thus not only let go a certain amount of cash but also face thousands of unemployed people and a huge debt to pay. We simply cannot afford that, we need to export our electricity; it is part of the investment plan.
    So, security of supply may just mean stability of the transportation network and protection against terrorist attacks. For sure this represents a certain amount of risk we may pay insurances for, but it is not linked at all with national energy independence policies and has not particularly been growing during the last five years. If by security of supply you mean stable prices; that is another story. Of course, some country may have interest in slowing production to sell at higher prices, but that just upholds the point that we need to intensify competition on production markets, i.e. interconnections and dependence toward the market. Plus I totally agree with Marie-Lys Edon on the fact that a rise in prices encourages consumers to change their behavior and look up for new solutions, thus sending them the right signal in a very sane mechanism.
    As a matter of fact, seeking independence, assuming we could reach it, would also be a stupid thing because it would lead us to a very instable balance where every country has interest in conquering its neighbor to access and secure new resources (since having access to these means being dependent and we assumed this country was totally independent). Definitely, independence is a thing of the past. Long time ago we decided to trade to improve our life standards and it led us to the recent and still running globalization movement which brings fluidity into markets and thus lots of benefits. Commercial links mean progress, and as we refuse to step back to middle age, peace !
    To conclude, I will call upon the example of electricity transportation network. It symbolizes the perfect interdependence and its righteousness. Recently, an overload in Germany caused several blackouts around the area of the incident, actually until Morocco! Is it a danger? Not one bit. It means that European countries (and some extra ones) agreed to connect to each other, knowing that physics law would put all of them in the same boat with no possibility of going back. In other terms, they signed for peace via energy market. Once the extra power plants built and the networks synchronized, exporters cannot afford to cut off the connections at the border and importers simply cannot do without energy. This is the most stable balance we know, and it is based on extreme dependence. So… Make networks, not war !

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