How Russians Can Tap Their Energy Wealth with Market Reforms

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How Russians Can Tap Their Energy Wealth with Market Reforms

October 8, 1993 39 min read Download Report
John R.
Senior Visiting Fellow

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961 October 8,1993 HOWRUSSIANS CANTAPTHEIRENERGYWEALTH WITHMARKETREF'O INTRODUCTION Russian President Boris Yeltsin has put down an armed rebellion of communists, fas cists, and other extremists led by former Vice Presiden t Alexander Rutskoi and Parlia ment Speaker Rush Khasbulatov. While the political crisis in Russia is not over Yeltsin has struck a powerful blow for democracy. As the democratically elected. leader of Russia, Yeltsin had no choice but to use force to foi l this attempt by his opponents to derail his reform program and to restore a totalitarian order.

While Yeltsin's attention is now rightly focused on the streets around the Russian Par liament building, or White House, his government must not lose sight of the need for con tinued economic reform If Russia is ever to rise above the cycle of reform and violent backlash, it must move quickly to create a working market system. In last April's referen dum, Russia's voters, by a clear majority, expressed their c onfidence in Yeltsin and his economic reform program. One of Yeltsin's most formidable challenges in achieving his goal will be to reform Russia's hugely inefficient and ineffective energy sector.

A growing and dynamic energy sector is central to the healt h and well-being of the en tire Russian economy. Endowed with enormous and untapped energy resources, Russia is the world's largest exporter of energy and second only to Saudi Arabia in the produc tion of oil. Energy exports, moreover, are the single larg e st source of Russian hard cur rency earnings and government revenue. 2 1 2 Oil Production Fell 30 Percent World Bunk News, June 24, 1993, p. 5 Oil and gas exports are responsible for some 60 percent-70 percent of the Russian foreign-currency earnings from exports Tapping Into New Profits Commersant: The Russian Business Weekly, April 7, 1993, p.

27. And "oil is Russia's only source of hard currency, accounting for 46 percent of budget foreign exchange revenues Raw Materials Export: The StateTightens Its Grip Commersunr, May 5,1993, p. 4.

Yet, at a time when world energy consumption is growing at an estimated annual rate of two to three percent, Russian energy production is declining and shows no signs of rising any time soon. Oil production alone, for ins tance, has declined by more than 30 percent since 1987 The Clinton Administration and the World Bank would like to address this problem through Western foreign aid. Foreign aid, however, cannot solve this problem. In fact quite the contrary: by relieving t he pressure for fundamental reform, foreign aid actually will.perpetuate and even deepen the crisis in the Russian energy sector. The problem with the Russian energy sector is not a lack of money; rather, it is a problem of structure organization, and own ership.

The Russian energy sector is dominated by huge and highly inefficient monopolistic state enterprises that have few incentives to maintain production at current levels, let alone to increase production. And it is heavily burdened by rules, regulatio ns, and taxes that disrupt the workings of the free market, that fail to protect private property rights and that cripple entrepreneurial activity resource-energy reserves-then it must rapidly restructure its energy sector through privatization and the ab a ndonment of state controls. Impelled by the profit motive, the private sector has a direct financial interest in producing the most energy in the most effi cient manner. Unlike a government monopoly, it has every incentive to halt the decline in Russian e n ergy production, revamp the energy sector's structure and operations, and search for and invest in new, but as of yet unexplored, sources of energy 3 If Russia is to take full advantage of what is perhaps its most important natural To revitalize Russia's e nergy industry, the Russian central government should d Free domestic energy prices d Eliminate the existing multitude of taxes on energy production and exports and levy instead a single low flat tax of 25 percent or less on energy producers and exports p r ivate property rights in the Russian energy sector d Establish a clear and unambiguous legal framework that secures and protects d Radically reduce and simplify the regulations governing the energy sector 3 Richard L. Holman POS tscrip The Wull Street Jou mul, October 19

92. However, according to the U.S.

Department Energy, world energy consumption is increasing at an average annual rate of only 1.6 percent.

Intemutwnul Energy Outlook 1993, Energy Information Administration, office of Integrated Analysis and Forecasting, U.S. Department of Energy, Washington, D.C., April 1993, p 19. Moreover, reports The Wull Street Jouml. European demand for natural gas coul d rise by as much 50 percent over the next two decades. Because of its proximity to the European continent, Russia already provides Western Europe with as much as one-third of its natural gas supply. It is. therefore, well-positioned to meet Europe's incre asing demand for natural gas. Bhushan Bahree and Elisabeth Rubinfien, "Disruptions in Flow of Natural Gas From Russia Give Europe Jitters,"-Zle Wull Street Joumul October 22,1992.

World Bunk News, op. cit 4 2 d Privatize the energy sector by Fully incorpor ating the energy sector into its mass privatization program Contracting with foreign investors and private-sector companies for the develop Directing Russian local and city governments to privatize unrelated social and municipal services that are. now bei n g managed by energy-sector enterprises ment of new oil and gas fields I RUSSIA'S ENERGY CNSIS Many attempts are already underway to reform Russia's energy sector. One of these is through foreign aid. The Clinton Administration's Russian aid package, for e x ample in cludes some $125 million in credits to promote sales of U.S. environmental technology including equipment for Russia's giant oil and gas ind~stries And according to the Rus sian business weekly, Commersunt, the World Bank recently approved "a $1 b illion in vestment project in Russia's oil and gas complex.d This is a mistake. Foreign aid will do nothing to promote the necessary restructuring and privatization of the Russian energy sector, and thus will do nothing to resolve the deeper and more intr a ctable problems that exist within this key area of the economy. To be sure, by enabling state energy companies to purchase horizontal drilling equipment mobile well workover units, and other more advanced extraction technology, forei n aid may well result in a temporary increase in Russian oil and natural gas production?Such assistance, however, actually will work to keep the energy sector in crisis by relieving much of the pressure for fundamental reform.

That is because the problems with the Russian ener gy sector lie much deeper than a lack of money and investment. Some 70 percent of all incremental industrial investment in the former Soviet Union, after all, was earmarked for the Soviet energy sector. And today, some 46 percent of Russia's industrial in v estment programs are, likewise designed to boost Russian energy production. Nonetheless, the Russian energy sector is now in the midst of a financial and technological crisis If there is one area where the Russian economy ought to be booming, it is in its ener gy sector, where Russia has a natural comparative advantage with the rest of the world.

More than 40 percent of the world's proven 4.9 million billion cubic feet of natural gas 8 9 5 6 7 Doyle McManus, "Administration Reworks Russian Aid to Promote U .S. Business Los Angeles Times, June 3, 1993 Even so, however, any potential increase in production would be minuscule. According to The Wall Street Journal for example, the $1 billion aid package would boost Russian oil output by only 3 percent. Richard L. Holman Russian Energy Help Advances The Wall Street Journal, April 26,1993.

Julie Corwin The Soviet Union's new energy crisis U.S. News & World Report, November 26, 1990, p. 48.

Historically, approximately 50 percent of all industrial investment in the former Soviet Union was earmarked for the Soviet energy sector Some Sectors Swimming in Investments, Others Wither Commersant, May 26, 1993, p. 18 Raw Materials Export: The StateTightens Its Grip Commersant, May 5, 1993, p. 5 8 9 3 reserves, for instance , lie in the Commonwealth of Independent States (CIS And it is estimated that as much as 90 percent of CIS natural gas reserves lie in the Russian Repub lic Russia is also re orted to possess some 90 percent of the CIS'S proven 57 billion barrels of oil re s erves ings and overnment revenue l4 Russia exports more than 40 percent of its energy pro duction which in the late 1980s accounted for some 40 percent of total hard currency earnings.16 In 1992, Russian exports of fuel amounted-to nearb $21 billion;17 re v enues gained from oil exports alone reportedly have topped 600 billion over the past twenty years Russia'sTroubled Energy Sector. Despite its enormous potential, the energy sector is one of the most troubled areas of the Russian economy. Oil production is declining at a rate of more than 1.5 million barrels per day on an annual basis, and has fallen by an es timated 30 percent since 1987, from 570 million tons in 1987 to less than 400 million tons in 1992.19 Production is projected to drop even further ove r the next few years, per haps to as little as 260 million tons of oil in 1994.2' If present trends continue, by 1995 Russia could well be a net importer of oil.

According to the World Bank, simply revamping the Russian oil sector to the point where it cou ld produce as much oil in the year 2000 as it did in 1991 would require an initial investment of $25 billion and an additional annual investment of $6 billion to $7 billion.21 And according to Russian Energy Minister Yuri Shafranik, simply to maintain the present depressed level of oil production in Russia would require a sustained annual investment of at least 4.5 billion?2 a and 45 percent of the world's total proven coal reserves.13 Energy exports, moreover are the single largest source of Russian hard c urrency earn 18 10 11 12 13 14 15 16 17 18 19 20 21 22 Oil and Gas Journal, December 28,1992, pp. 44-45 Oil and Gas Journal, January 4,1993, p. 56 Zbid Energy Industry wins World Bank support Petroleum Economist, September 1992 World Bank News, op. cit Wo r ld Bank, Russian Economic Reform: Crossing the Threshold of Structural Change A World Bad' Country Study Washington, D.C., August/September 1992, p. 175 International Monetary Fund (IMF International Bank for Reconstruction and Development (IBRD European B ank for Reconstruction and Development (EBRD and Organization for Economic Cooperation and Development OECD The Economy of the USSR: A Study Undertaken in Response to a Request by the Houston Summit December 1990, p. 42 Eastern Bloc Energy: A Monthly Revi ew of Oil and Energy in the CIS and Eastern Europe, Eastern Bloc Research Ltd., United Kingdom, Volume VI, No. 1 (March 1993 p. 10.

Farman Salmanov. an academician and member of President Yeltsin's Expert Consultative Commission, as quoted in Alexei Frolov Salmanov tackles chaotic industry We: The First Independent Russian-American Newspaper Special Report: Oil and Gas, April 19-May 2,1993, p. 4.

Oil and Gas Journal, December 28,1992; World Bank News, op. cit.

Sergei Seninsky CIS threatened by energy crisis Moscow News, March 19, 1993, p. 6.

Otto Storf Russia's energy industry a factor of uncertainty for the reform process Deutsche Bank Research Focus: Eastern Europe, January 6,1993, p. 4.

John Lloyd, "Russian ministers differ on energy Financial Times, March 5, 1993, p. 3 4 Clearly, such investment will not be coming any time soon. In 1992, the World Bank estimated that international oil companies allocated approximately $54 billion for explo ration and development worldwide, and that, given a favorable investment climate in Russia, upwards of 10 percent of that amount could be invested in Russia.23 In fact, how ever, very little has been invested in the Russian energy sector. Experts estimate that less than 350 million in foreign energy-sector investmen t flowed into Russia in 1992.2A And according to the Petroleum Economist, there are now only six joint ventures actually pro ducing oil in Russia.25 Many of the foreign investors in these projects say that Russian government rules and regulationsmake it im p ossible for themt0turn.a profit A recent study by two banks, Daiwa Europe and Bankers Trust, found that at the begin ning of 1992 less than one percent of Russian oil output was produced either in whole or in part by foreign companies?6 The reason: Highly confiscatory and prohibitive rates of taxation on energy production and exports as well as a rapidly changing and uncertain legal environment that fails to protect private property rights, make investment in the Russian petroleum sector extremely risky an d imprudent.

The situation is better in the Russian natural gas sector, where production has re mained constant, but even there recent trends are ominous. The World Bank reports that the worlds largest on-shore deposit of natural gas, in the western Siberi an province of Urengoy, has been significantly damaged by use of anti uated and wasteful extraction practices that are endemic to the Russian energy sector which notes that much new information and investment will be needed to remedy this situationF8 The B ank predicts a fall in gas extraction through 1995 and only moderate growth till the end of the decade. Some experts, however, think that Russian natural gas production might even shrink in the further course of the 1990 Russian coal production has fallen as well, from a high of 426 million tons in 1988 to 353 million tons in 1991-an amount roughly equivalent to all of the Russian coal mined in 1970.3 And the shorta e of electricity-generating capacity in Russia is now es timated to be 25,000 megawats. All told, combined production of oil, gas, and coal fell 6.1 percent in 1991 and 5.6 percent during the first half of 1992.32 97 Increasing water encroachment is causing problems and raising costs, says the Bank 4 23 24 25 26 27 28 29 30 Storf, op. cit.

Interview with Sheldon R. Stoughton, European Energy Group, BankersTrust Company, London, May 1993.

Moreover, according to Yuri Shafranik, Minister of Fuel and Energy, in 1992, joint ventures with Western firms invested a mere $150 million in Russias oil and natural-gas sectors. Joint ventures are the principal means by which foreign firms invest in the Russian energy sector. Seninsky, op. cit.

Isabel Gorst, Taxing oil to death, Petroleum Economist, March 1993, p. 3.

Bankers Trust and Daiwa Europe [Bank New Policies and Structures for the Russian Oil Industry, a report prepared for Rosneftegaz Corporation, July 1992, p. 4 1.

Leslie Dienes, Istvan Dobozi and Marian Radetzki, Energy and Economic Reform in the Former Soviet Union Implications for Production, Consumption and Exports and for the International Energy Markets (Washington, D.C The World Bank, February 1993 p. 52.


Storf, op. cit p. 3.

World Bank, Russian Economic Reform, op. cit p. 178 5 REFORMING RUSSIA'S ENERGY SECTOR The problems with the Russian energy sector are systemic and structural. What is needed is privatization of the Russian energy sector, whereby Russia's huge state energy conglomerates would be restructured into private joint stock companies and shares of company stock issu ed to the public.

When the Yeltsin government'smass privatization program was designed and im plemented last-year, the energy .sector was .exduded.-h .November 1992, however, Presi dent Yeltsin issued a decree orderin all state petroleum companies to sell shares of com pany stock to private-sector buyers! Nevertheless, it was not until August 1993 that Russia launched its first official privatization of oil companies; even then, only an 8.3 percent company stake was proffered for private p~rchase The Russi an central govern ment recentl announced plans for the privatization of Gazprom, the Russian natural gas monopoly?'And in accord with a December 1992 presidential decree, most state coal as sociations have been transformed into joint stock companies.36.

No netheless, under the terms of the plans now being considered by the Russian central government, private-sector holding in the state petroleum sector will be limited to no more than 60 percent of natural gas and to a similar share of oil Gazprom will remai n a state-sanctioned monopoly And it will be at least three years before Russian state oil and natural gas companies are privatized In the meantime, the Russian petroleum sec tor will continue to deteriorate, new fields will remain unutilized, and producti on will continue to fall well below what is optimum.

The Yeltsin government, therefore, needs to speed up privatization of the Russian en ergy sector. Privatization alone, however, is not sufficient because even most private-sec tor companies will fail if they are hobbled by the rules and regulations of the old system.

To make privatization work in the Russian energy sector-and indeed, all sectors of the economy-the Russian central government must create a legal regime conducive to new private-sector growt h and development. Specifically, the Russian central government should USF Free domestic energy prices.

The Russian central government freed prices on nearly 90 percent of goods and ser vices in January 19

92. However, it retained price controls on energy products and 31 Estimate made by officials of the U.S. Department of Energy 32 Fred Hiatt Siberia's Exploited Mines Losing Production The Washington Post, October 9.1992, p. A32 33 "On Distinctive Features of Privatization and Corporatization of State-Owned Enterprises and Production and Science and Production Amalgamation in the Field of Oil Production, Oil Refining and Oil Product Supplies,"

Presidential Decree No. 1403, November 17,1992. reprinted in Com mersunt, December 1.1992. pp. 22-23 34 hyla Boulton. "Russia launches oil privatization Financial Times, August 18,1993 35 Keith Bush Gas Industry to be Privatized RFmL Daily Report, April 6,1993, p 1 36 Eastern Bloc Energy, March 1993, p. 8 37 "Gas monop o ly survives reform Petroleum Economist, December 1992 38 Ibid 39 "Russia too sluggish on oil privatization Oil Gas Journul, November 23,1992, p. 17 6 other so-called essential goods such as bread and milk. Russian fuel and energy prices President Yeltsin h as tried to remedy this situation by issuing a decree that ostensi bly will liberalize coal prices he reportedly would like to free oil prices as we1142 Nonetheless, coal, oil, and other domestic energy prices remain far below normal, mar ket levels. The R ussian domestic price of oil, gas, and coal, for instance, is but 15,5 and 4 percent respectively of what it is internationally In part, this is because of the precipitous decliqin the value-of the ruble that has.taken place this past year, which has larg ely offset administrative increases in the prices of energy products in Russia.

Nonetheless, administrative price increases, no matter how great, are no substitute for free market prices, which have a number of advantages, particularly in the Russian energ y sector were, instead, administratively increased, by a factor of 80 in 1992. 40 d They would help eliminate domestic energy shortages and increase Russian Free market prices on energy products would help eliminate domestic energy short ages and increase Russian energy production because they would allow producers to reap profits from energy exploration and production If producers are not willing to in vest their time and money in energy exploration and development, then energy produc tion will decline an d shortages will develop.

Certainly this is the case today in the Russian energy sector, where price controls make it unprofitable for producers to invest even in the rehabilitation of existing en ergy fields Oil prices at the wellhead for instance, barely cover operating costs on av erage, according to the World Bank.d And more than 30,000 oil wells are reported idle as producers hoard their output in anticipation of greater future profits when price controls are relea~ed.4 More ominously, price controls h ave stymied the development of new oil fields since producers lack both the capital and incentive necessary to fi nance additional oil exploration This is a real problem because 75 percent of Russia's most highly productive oil reserves have been exhauste d !6 energy production d Free market energy prices also would encourage more efficient use of energy Free market prices on energy products would raise Russian energy prices to world market levels. The resulting higher energy costs would cause Russians to ma k e more efficient use of energy As a result, energy once wasted on inefficient internal con sumption would now become available for export to the West. These exports would within Russia 40 "Gas Exports Lead the Energy Industry Commersant, February 9,1993, p . 4 41 Erik Whitlock Coal Prices to be Freed RFDRL Daily Report, June 22,1993, p. 1 42 "Politics as Usual: Yeltsin Frees Oil Prices Commersant, June 2,1993, p. 27 43 Sheila Mamie, "Russia's Energy Sector to Increase Exports RFE/RL Daily Report. June 29,19 9 3, p. 1 44 World Bank, Russian Economic Reform, op. cit p. 175 45 "Tapping into New Profits Commersant, April 7, 1993, p. 26 46 "The state of Russia's fuel and energy complex Commersant, March 23, 1993, p. 27 7 earn Russia valuable and much-needed hard cu rrency and would strengthen the entire Russian economy.

For example, energy conservation alone could result in a tripling of Russian oil ex p0rts.4~ According to Russian government officials, a decrease of domestic oil and gas consumption through conservat ion of only 10 percent would increase Russian energy export revenue by $15 billion Similarly, a December 1991 study by the Intemationd Monetary Fund (IMF) four,J that:if oil and gasprices .were-merely dcmbled-in-which case they would still remain far belo w world market levels-and the energy saved as a result were channeled to ex port at the world market price, Russian export revenue would grow by at least 8 bil lion annually in the short run (one to five years beyond the price doubling) and at least 25 bil l ion annually in the long run (five or more years beyond the price do~bling Regardless of the exact amount, however, the potential gain certainly would be sub stantial. Price controls have dramatically lowered the cost of energy for Russians, who as a resu l t, make far less efficient use of energy than do most people in the world. Con sequently, energy consumption relative to economic output in Russia is now roughly twice what it is in the economically advanced countries of the West Indeed, the Rus sian econ o my produces only 30 percent to 50 percent as much as the economy of the United States, yet it consumes three-fourths as much energy Vouchers. Many Russian officials are loath to free domestic energy prices because they fear that doing so will destroy Russ i an industry and impoverish the populace. It is true that liberalizing energy prices will impose temporary economic hardships and dis locations on Russian enterprises and the Russian people. However, if these are deemed too severe, they can be dealt with s u ccessfully through compensating vouchers For example, vouchers could be issued by the Russian central govemment and ear marked for those individuals and enterprises most hurt by the impact of market prices on energy products. Voucher recipients should, of course, be allowed to sell and trade their vouchers, which would be redeemable for a specified quantity of energy. Their use, however, should be only a short-term measure aimed at helping Russian enter prises and the public at large adjust to energy-secto r price liberalization.

In accordance with this end, the Russian central govemment should announce ahead of time when use of the vouchers will be proscribed and when they will be withdrawn from circulation. On the one hand, the time period in which the vou chers are issued and used should be sufficiently large so as to allow voucher recipients time to adjust to market prices on energy products. On the other, it should be sufficiently brief so as to 47 "Russia: Privatise or be damned Petroleum Economist, Aug u st 1992, p. 26 48 "Gas Exports Lead the Energy Industry Commersunr, February 9.1993, p. 4 49 Manmohan S. Kumar and Kent Osband Energy Pricing in the Soviet Union IMF Working Paper, December 1991 50 Istvan Dobozi Prospects for Energy Consumption in the For mer Soviet Union: The Impact of Market Reforms,"

December 1992. p 3. Paper presented at the Association for Comparative Economic Studies Meetings. Allied Social Science Association Annual Meeting, January 5-7, 1993, Anaheim, California 51 William U. Chandl er, "Investment Guarantees Needed in Russia's Energy System Policy Memomndum, Advanced International Studies, Battelle, Pacific Northwest Laboratory, Washington. D.C., February 10, 1993, p. 1 8 minimize the inflationary effects of a new (voucher) currency . In developing countries and countries now making the transition from socialism to capitalism, vouchers typi cally are used as an alternative form of currency and thus contribute to the inflationary effect of too many monetary units (rubles in the case of Russia) chasing too few goods usr Eliminate the existing multitude of taxes on energy production and exports and levy instead a single low flat tax of 25 percent or less on energy producers and exports Taxes on energy production in Russia amhighly punitiv e and, therefore, greatly dis courage private-sector entrepreneurial activity in the Russian energy sector. Total cu mulative rates of taxation amount to 80 percent to 85 percent of gross revenue valued at world prices, according to the World Bank?2 No oth e r country in the world taxes its energy sector at such a high le~el?~When coupled with other Russian central govem ment taxes-the export tax of $5 per barrel on oil, for example, and the 60 percent in come tax on foreigners-Russia's tax system is cripplin g foreign investment in Rus sia. Indeed, tax rates are so high that, according to the Petroleum Advisory Forum it costs a Western company 22 percent more to produck oil in Russia than to sell it.

The unpredictable and complex nature of the Russian tax syst em also works to stifle new investment and new private-sector entrepreneurial activity in the Russian energy sector. At present, for example, oil producers in Russia are subject to a 32 percent tax on "profits,"55 an 8 percent tax on royalties, a 10 perce n t minerals replacement tax, a 4 percent road-use tax, a 1 percent mandatory conversion tax, and'an export tax of roughly $5 per barrel of Frequent and abrupt changes to the Russian tax code moreover, make it extraordinarily difficult for prospective inves tors to analyze invest ment opportunities in the Russian energy sector This, of course, raises the percep tion of risk and thus discourages potential investors.

Thus, replacement of the existing Russian tax code on energy with a single flat tax of 25 perce nt or less on energy producers and exports would achieve a number of im portant objectives 54 t/ It would fuel new foreign investment in the Russian energy sector Russia's economic environment is now one of the least hospitable to investment in the world, and this is especially true as it concerns the Russian energy sector. For ex ample, according to Farman Salmanov, a member of President Boris Yeltsin's Expert Consultative Commission, less than 10 percent of Soviet oil profits were reinvested in the count r y's oil sector?8 And up to 95 percent of Russian oil profits are taken by the 52 World Bank, Russian Economic Reform, op. cit., p. 180 53 "Internationally, total tax rates vary from the mid30 percent range to the mid-80 percent range. The top of this rang e is relatively rare, and is found in countries where there is a high degree of political stability Bankers Trust and Daiwa [Bank op. cir p. 31 54 Irene Ertugrul Oil producers press for better investment climate We, March 22-April 1 1,1993, p. 6 55 This ta x does not actually apply to profits; rather, it applies to company revenues 56 Interview with Sheldon R. Stoughton 57 BankersTrust and Daiwa [Bank op. cit p. 27 9' central government in the way of taxes? Consequently, energy companies in Russia often lack the capital and resources necessary to invest in new, more up-to-date tech nology and equipment through which they can increase Russian energy production. Be cause it would allow energy companies to keep more of, and make better use of, their earnings, a f lat tax of roughly 25 percent would help remedy this problem and, there fore, would fuel new foreign investment in the Russian energy sector. would strengthen and enlarge Russias contracting tax base d Radically reduced and simplified taxes on energy prod uction and exports A dramatic reduction and simplification in Russian tax rates on en ergy production would reverse the present shrinking of Russias en ergy-sector tax base.

That is because tax re duction would put invest ments back into the pri vate secto r, where they would be used to fuel rapid growth and expan sion of the Russian en ergy sector This will en able Russia to increase energy production and exports and earn billions of dollars in export reve nue.

It also will provide producers with a strong incentive to avoid work ing through the black or informal market, in which they are able to es cape government taxa tion. With tax rates so Revenue from Russian Natural Gas Exports Current Projections vs. Alternative Scenarios Billions of I99 I Dollan 550 1 I 85 86 87 88 89 90 91 92 93 94 95 96 97 00 05 IO CurrentEstimatesof Gas Production Same as Current Estimates, But 20% of Gas Destined for Domestic Use Is Expomd Gas Production Same as Current Estimates. But IO% of Gas Destined for Domestic Use Is Expor t ed Natunl Gas Export Revenue Gas Production Grows at 3% per Year Beginning in 1993 and All Production Above Current Estimates IS Exported iourca: Heritage cakulations based on AanEcon. Inc hegy Oudook fbr the Fomrer Soviet Republics June 1993 Energy Infor mation Adminktration, U.S. Department of Energy, lntemotioml Energy Outlook f9

93. Apnl 19

93. HerirageDmCIrvl high, energy producers now have a strong incentive to operate illegally. Many already do; as much as 40 percent of Russian export oil, for examp le, is exported through black market channels and thus escapes taxation by the Russian central government.

Because modem economies are so heavily dependent upon energy for their growth and development, new private-sector investment in this sector would spur new growth 58 Frolov, op. cir 59 Oil Producers Complain About Their Lot, Commersunf, May 12,1993, p. 13 1 0 throughout the entire Russian economy, and with that, new tax reve nue as well. It also would strengthen Russia's capacity to ex port energy. This is im portant because the reve nue gains 'from increased energy exports are con siderable and could be use d to revive Russia's collapsing energy sector.

For example an in crease in Russian oil ex ports of between 40 per cent and 50 percent would earn the Russian Federation at least $4.8 billion-more than enough to put its some 30,000 oil wells back on line. Me anwhile, dur ing the time in which the wells are being revived Russia stands to lose be tween $3.5 billion and 4 billion in lost energy exports 60 61 Revenue from Russian Oil Exports Current Projections vs. Alternative Scenarios 1 85 '86 '87 '88 '89 .'90 ' 91 '92 '93 '94 '95 '96 '97 '00 '05 'IO I I Current Estimates of Oil Production Grows Oil wort Revenue at 3% er Year Beginning in I99e and All Production Above Current Estimates Is Exported Oil Production Remains Constant at 1993 levels and 40% of All Prod u ction Above Current Estimates Oil Production Remains Constant at I987 levels and All Production Above Current Estimates Is Exported Is Exported vier Rep&& June 1993 Sou Heritage calculations based on AanEcon. Inc Energy Outlook fir the Energy Information Adminotration. US. Department of Energy, lntemtionol Energy Outlook 1993, April 19

93. Heritage DaaChvt Russian energy exports currently are increasing. Oil exports, for instance, grew by an estimated 40 percent during the first half of 1993.62This is not, however, because the Russian oil sector is beginning to recover; rather it is because the Russian economy is collapsing and as a result, has less need for energy.

Also, because administrative price increases have raised the cost of energy to enterprises and consumers, they are making somewhat more efficient use of oil, coal, and natural gas. Consequently, pro ducers have more energy available for export; hence, the rise in Russian oil exports.

Nevertheless, Russian energy exports are still well below wha t they otherwise would be in the absence of high and prohibitive rates of taxation on Russian energy produc tion and exports. Witness, for exam le, the fact that Russian. oil exports are rising even as Russian oil production is falling. 13 60 "Tapping Int o New profits Commersunt, April 7,1993, p. 26 61 Ibid 62 Interview with Matthew Sagers, Energy Analyst, PlanEcon, Inc Washington, D.C August 1993 63 Charts on pages 10 and 11 show the potential revenue gains from Russian oil and natural gas exports 11 A dr a matic reduction and simplification in Russian tax rates on energy production also would provide entrepreneurs and businessmen with the money and flexibility needed to invest in new, more up-to-date extraction equipment and technology with which they can i n crease Russian energy production. Energy extraction practices in the former Soviet Union are antiquated, wasteful, and inefficient. For example, on average in Russia, only 7 percent of oil is extracted from the oil field.64 In the United States by contras t , the comparative figure is closer to 35 per~ent.6~ Seventy percent of dril ling rigs in the former Soviet Union were built in the 1950~6~ With tax rates so high producers cannot afford topurchase would help reduce Russia's high deficit s p ending d Radically reduced and simplified taxes on energy production and exports The Russian central government spends billions of dollars to subsidize its energy sector. Recently, for example, the Russian energy sector was awarded hundreds of bil lions o f rubles worth of low-interest investment ~redits.6~ With trillions of rubles of ad ditional subsidies still needed by the energy sector!* more such credits are on the way.

Russian energy-sector enterprises, moreover are owed more than three trillion ruble s approximately $2.8 billion) by consumers6' To make matters worse, the central gov ernment heavily subsidizes many industries, such as animal husbandry and agriculture that are heavily reliant on energy.

Such massive financial support is necessary becaus e the Russian energy sector re tains very little of its profits and revenues, turning most of them instead over to the Russian central government in the form of high taxes. Yet, high taxes are a major rea son so many energy-sector enterprises in Russia lo s e money. Some 75 percent of Russia's oil companies, for example, operate at a loss and survive only because of spe cial government support and "black" market exports Because it would lessen these companies' need for government financial assistance, radica l ly reduced and simplified taxes on energy production and exports would help reduce Russia's high deficit spend ing d Radically reduced and simplified taxes on energy production would help reduce Unlike the economically advanced countries of the West, whic h can and do finance high deficit spending mostly by raising taxes and by drawing upon the reserves of in ternational capital markets Russia can finance high deficit spending only through the excess printing of rubles.%his, of course, inflates the ruble cu r rency and causes infla 70 Russia's high and hyper rates of inflation 64 Vladimir Kvint Eastern Siberia could become another Saudi Arabia Forbes, September 17, 1990, p. 131 65 Ibid 66 Dienes, Dobozi, and Radetzki, op. cir p. 56 67 Erik Whitlock More Financ i al Preferences to Russian Energy Industry RFURL Doily Report, March 23, 1993 68 "Tapping Into New Profits Commersunr, April 7,1993, p. 26 69 "Spring oil output turns out higher than expected Commersunr, June 30,1993, p. 5 70 "Gasoline Prices Follow a Wind i ng Path Upward Commersunr, June 2, 1993, p. 13 71 Eastern Bloc Energy, March 1993, p. 7 p. 3 12 tion, which in 1992 alone was more than 2,000 percent in Russia. Therefore, to the ex tent that it reduces Russias high deficit spending, tax reduction in the Russian energy sector would help reduce Russias high and hyper rates of inflation ES Establish a clear and unambiguous legal framework that secures and protects private property rights in the Russian energy sector.

Establishment of such a legal framework a nd accompanying market-oriented institu tions would, of course, benefit the entire Russian economy. However, because in its ,n ergy sector Russia has a natural comparative advmage with the rest of the world most of the benefits of private property rights protection would become manifest there first.

Foreign investment will never materialize in large amounts unless foreign investors are confident that their investments are legally secure and well-protected. This requires a legal framework to allow for unfet tered foreign private-sector investment in the Rus sian energy sector. This would include full ownership rights for foreign investors, as well as their right to fully repatriate profits.

Fears that this will lead to a foreign buy out of Russia are unfound ed and misdi rected. With roughly one of every five Russian oil wells idle, for example, Russia is losing an estimated 30 million tons of oil a ~ear.7~ This is costing the Russian econ omy approximately $3.6 billion?4 and there is no possibility that dome s tic Russian in vestment can put a halt to this de~line.7 Indeed, the real potential danger in Russia today is not that its energy plants and fa cilities will be bought out by foreigners; it is that foreign businessmen and entrepre neurs will invest their m oney elsewhere, and that, consequently, energy production will continue to decline. A well-established and well-protected system of private prop erty rights is essential for private-sector development. Thus Russia needs 72 Theoretically, of course, it als o could raise taxes. However, this is not a viable option for two reasons: first, because Russian tax rates, particularly on energy production, already are too high. Raising them further would simply weaken an already weak economy and thus reduce economic o utput. Far from raising revenues, this would reduce them over the long term. Second, because the Russian government simply does not have the administrative means at its disposal to ensure taxpayer compliance. Higher tax rates, therefore, would simply acce l erate and perpetuate the process whereby productive entrepreneurial activity would be driven underground into the black market where it would escape all taxation. 73 Interview with Matthew Sagers. According to Sagers, Russia is losing somewhere between 15 and 50 million tons of oillyear because of idle oil wells. Most analysts estimate that the actual loss of oil is closer to 30 million tons of oillyear. 74 According to PlanEcon, Inc Russian oil costs approximately $120/ton.Thus, at a loss of 30 million to n s of oillyear Russia is losing approximately $3.6 billion 75 Foreign investment, however, can. Western investors are eager to invest in the Russian energy sector. For example, a recently published repon by the United Nations Economic Commission for Europe found that as a result of deals signed between 1990 and early 1993, the former Soviet Unions oil, gas, and mineral sectors could realize upwards of $85 billion in foreign investment. Frances Williams. Oil boom in CIS may attract $85 billion, Financial Tim es May 5.19

93. Russia, significantly, stands to gain the lions share of this investment, with 22 of the reports 39 projects located on its territory. But again, none of this potential foreign investment will ever materialize unless foreign investors are c onfident that their investments are legally secure and well-protected 13 d a system of contract law that clearly defines the various types of legally pro tected contracts and which actions are permissible d a titling system that establishes a citizen's cl a im to ownership rights and re d a system of tort law to protect owners from civil infringements upon their d commercial codes governing the sale of goods and services d an independent system of adjudication that arbitrates contractual disputes sponsibili t ies c property fairly and objectively, on the basis of the contract in dispute and other rele vant case law L d an independent private banking system that provides ordinary citizens and en trepreneurs with loans and credit, on the basis of sound market pr i nciples d systems of collateral that allow ordinary citizens and entrepreneurs to lever age their existing assets for business and wealth creation Radically reduce and simplify government regulation of the energy sector Streamlining state rules and regula t ions that govern the energy sector will help make it a more attractive investment to investors. That is because it would eliminate and re duce in scope bureaucratic hindrances and obstacles that make the cost of new private sector entrepreneurial activity in the Russian energy sector prohibitive.

Russian regulatory policy, particularly with regard to the energy sector, ought to be guided by three essential principles 1) Everything not expressly forbidden is permitted 2) A given regulation is to be imposed only after conducting a careful cost benefit analysis of its effect on private business and only after it is found that its anticipated benefits outweigh its anticipated costs 3) Retroactive regulations and taxes are forbidden Adherence to these principle s would mark a decided change in Russian regulatory policy As things now stand, foreign investors in the Russian energy sector often are subject to arbitrary seizure of their hard currency revenues and must cope as well with a discriminatory customs struct u re?6 Because of these and other punitive regulations 76 The Oil and Gas Working Group of the U.S.-Russia Business Development Committee published a two-page memo that lists the specific difficulties Western firms have doing business in the Russian energy s ector Investment and Trade in Russia's Oil and Gas Sectors: Concerns of United States Investors March 31, 1993, Energy Division 24 investors are loath to invest in the Russian energy sector. Other countries such as Kazakhstan and China are addressing this problem and, consequently, are succeeding in attracting energy-sector investments that otherwise might go to R~ssia As one ob server explains The difference between Kazakhstans rapid deal-making and Russias lagging performance is that the latter subjects companies to an excruciating set of bureaucratic layers, while#izakhstan has streamlined the process down to a few government officials I U%F Privatize the energy sector by Fully incorporating the energy sector into its mass privatization program.

The Russ ian energy sector must be opened up to private-sector capital investment and restructuring, with an emphasis on privatization. Privatization is far advanced in Russia. More than 60,000 of Russias estimated 196,000 state-owned enterprises, for instance, ha v e been privatized, with many more soon to be privatized? These include 60 percent of small-scale enterprises? 70 percent of light industry, and 50 percent of Russian construction firmsg In addition, more than 3 OOO large-scale enterprises nearly 20 percen t of the total-have been privatized and more than 20 percent of Russias industrial work force now work for privatized furn All told, by the end of 1992, more than 18 million people-some 30 percent of all workers in the Russian non-agricultural state sector -had participated in this historic process?4 and with six to seven hundred enterprises being privatized each month through voucher auctions, thousands more will soon participate.

The Russian government ought to build on this success and fully incorporate the en ergy sector into its mass privatization program. This will benefit Russia economically because, as a growing body of empirical evidence from other countries shows, private s ector energy companies are far more productive and efficient than their state-run coun terparts. For example, Argentinas state oil company, Yucimienfos Pefroliferos Fiscules, saw a five-month jump in crude oil production of 12 percent within a year of its partial privatization in 1991 and 1992g6 Crude oil production by private-sector 85 United States Department of Commerce, Washington, D.C 77 Kurt S. Abraham, Kazakhstan rises to top of FSU heap,World Oil, January 1993, p. 31 78 Ibid 79 Anatoly B. Chubais, R ussia: Birth of an Entrepreneurial Nation, The Wall Street Journal, June 16,1993 80 A small-scale enterprise is defined as one that employs fewer than 250 people; a mid-sized enterprise is defined as one that employs between 250 and 10,OOO people; and a l a rgescale enterprise is defined as one that employs more than 10,OOO people 81 Interview with Jeffrey Gayner, Director of The Heritage Foundations Moscow Office, September 1993 82 Interview with Adrei Shleifer, Professor of Economics, Harvard University, A u gust 1993 83 Ibid 84 The State Committee of the Russian Federation for the Management of State Property, Annual Repon 1992, Moscow 85 Interview with Adrei Shleifer 86 Argentinas Energy Sector Sell-Offs Reap Rewards As Investment, Output Grow, Oil Market L i stener, Energy 15 L companies grew even more dramatically, by some 340 percent.87 All told, the Argen tine govemment expects to achieve a 50 percent increase in crude oil production by the year 2000 throu h energy-sector privatization.88 It also expects t o net some $8 billion in new revenue f9 A recent World Bank study confirms that Argentina's experience with privatization is typicalgo The study examined twelve instances in four countries (Chile, Malaysia Mexico and-great Britain in- which government ente r prises were privatized and found that, taken .together, the twelve privatizations resulted in ar! average increase in en prise wealth of nearly 26 percentgl In eleven of the twelve cases studied, privatization had a beneficial impact on domestic welfare?2 which, on average, grew by 33.25 per cent. And in nine of the twelve cases studied, privatization had a beneficial impact on enterprise productivity, which also grew, by an average of 14.6 percent.

The Russian central government has taken several importan t steps toward privatiz ing its energy sector, most recently by announcing a plan for privatization of the Rus sian state gas industry. According to the plan, the Russian natural gas monopoly Gazprom, will be converted into a joint stock company in which 1 5 percent of its shares will be sold to Gazprom workers, 28.7 percent of its shares will be sold to peo ple living in Russia's gas-producing regions 5.2 percent will be sold to residents of Yamalo-Nents, Gazprom's home region, and 10 percent sold to the p u blic. The govern ment will retain some 40 percent of the company's stock. 93 Similarly, the November 1992 presidential decree required all state oil companies to convert themselves into joint stock companies by January 1, 1993g4 As a result, 38 percent of all shares in Russian state oil companies have been distributed to workers.

And a December 1992 presidential decree re uired that all state coal associations con vert themselves into joint stock companies. Conversion into joint stock companies represents a necessary first step toward privatization. The process of restructuring however, is proceeding slowly. It will be at least three years, for example, before Russia's oil sector is privatizedg6 And since the present distribution of oil shares is confined solely to workers, it will not significantly change the Russian oil sector's 99 87 88 89 90 91 92 93 94 95 96 Information Limited, New York, New York, September 23,1992, p. 1.


Ibid Argentina to fully privatize state owned YPF Oil Gas Journal, October 5,1992, p. 46.

Ahmed Galal, et al., The Welfare Consequences of Selling Public Enterprises: Case Stdiesfrom Chile, Malaysia.

Mexico and the United Kingdom (Washington, D.C.: The World Bank, June 1992).

In this instance wealth is defined essentially as the percent increase in the firms' turnover that resulted from privatization.

Domestic welfare is measured in this report by changes in costs and benefits for all the economic actors affected by the privatization-that is, buyers, governments, consumers, workers, and competitors Gas Industry to be Privatized RFmL Daily Report, op. cit On Distinctive Features of Privatization and Corporatization of State-Owned Enterprises and Production and Science and Production Amalgamation in the Field of Oil production , Oil Refining and Oil product Supplies."

Presidential Decree No. 1403, November 17.1992, reprinted in Commersunt, December 1.1992.

Eastern Bloc Energy, March 1993, p. 8 Russia too sluggish on oil privatization Oil & Gas Journal, op. cit 16 present antiqu ated structure. In addition, most state oil companies affected by the de cree missed the January l deadline for submission of their plans for restructuring.

Thus, it remains unclear how and when they will convert themselves into joint stock companies. Gaz prom, moreover, will remain a state-sanctioned monopoly even after privatization 97 d Contracting with foreign investors and private-sector companies for the As part of Russia's privatization program; development -righis over underutilized and unutilized e nergy fields would be put up for bid to foreign investors and private sector companies This would help put new market forces at work in the Russian en ergy sector and thus would spur competitive market pressures throughout the entire in dustry-pressures t hat would help to transform Russia's huge state energy conglomer ates along market-oriented lines.

This could be done through a competitive contract, whereby the Russian govern ment would solicit bids for the right to explore and develop a specific energy field.

These bids should be solicited from entrepreneurs and private-sector companies and ought to be evaluated fairly and impartially on the basis of objective criteria. The entre preneur or company whose bid most closely matches the stated criteria should be a warded the right to explore and develop the energy field being put up for tender.

Here, too, the Russian central government has experience and thus need only build upon what it is already doing. Last June, for instance, it announced its intent to award an international tender for the right to prospect for, and extract gas in, the Magadan sector of the continental shelf of the Sea of Okhotskg' Oil and gas fields off the far eastern island of Sakhalin also are being put up for tender And, according to the Ru ssian business weekly Comersun a wave of international oil tenders continues to sweep Siberia panies, none of which have exclusive development rights over the entire sector, inter national tenders are an important part of anti-monopolization policy.

Anti-m onopolization policy is essential to Russia and other countries now making the shift from socialism to capitalism It is especially important in the early stages of the transformation process when industrial enterprises retain close ties to the state and a r e only just beginning to restructure themselves along market lines. Indeed, in the ab sence of an effective and coherent anti-monopolization policy, there exists a real dan ger that former Soviet enterprises will conspire amongst themselves to raise price s and hurt consumers development ofnew oil and gas fields 100 Anti-Monopoly Policy. By opening the Russian energy sector up to competing com 97 "Gas monopoly survives reform Petroleum Economist, op. cit 98 "Tender Announced for Magadan Oil-and-Gas Deposits Commersant, June 16,1993, p. 11 99 John Lloyd, "Russian oil and gas fields out for tender Financial Times, September 29, 1992, p. 7 100 "TheVerkh-Tarkskoye Oil Field Put up for Sale Commersant, March 11, 1993, p. 9 17 Thus far, there is scant evidence tha t this is happening in Russia. Most enterprises are finding it so difficult to survive that they have neither the time nor the ability to act in collusion with like-minded firms against consumers. Moreover, although not steady and consistent, the liberal t h rust of the Yeltsin governments economic reform program has nonetheless spurred a host of new competitive market pressures in the Russian economy that are serving to check its generally monopolistic tendencies Indeed, sweeping and broad-based market refor m s are the most effective anti-mo n-opolization policy since they foster.fa and unfettered market competition through which monopolies seldom develop and almost never last. For example, in the U.S. dur ing the 1970s, International Business Machines Corpora t ion so dominated the Ameri can computer market that it could be argued that it was a monopoly. However, because the U.S. has a relatively free and open market, IBMs hold on the American computer market did not last. By the early 1980s a number of small-sc a le competing firms had emerged to challenge IBMs dominant position. Among them was Apple Computers founded by a young college drop-out in his early 20s, Steven Jobs. As a result of the challenge from these entrepreneurs, Americans have a wide choice of pe rsonal and home computers, and the once-small challengers dominate the market.

The lessons for Russian government officials are clear. They must persevere with a sweeping and broad-based economic reform program. This program must create a free and open mar ket in which new entrepreneurs can easily and fairly compete with exist ing firms.

Toward that end, the Russian government must not empower any monopoly or mo nopolistic enterprise with the sanctioned force of law. If a monopoly emerges, it should be beca use of its success in the free and open market and not because of special favors and protection from the government. Private-sector monopolies tend to be tem porary and fleeting since they are subject to the vagaries of the market. On the other hand, stat e -sanctioned monopolies tend to be permanent since they are backed by the full force of state law As concerns the Russian energy sector, this would mean ending Gazproms privileged legal status as a state-sanctioned monopoly and allowing subsid iary state o il and gas companies to become independent.

For these same reasons, business licensing ought to be made nearly automatic and the Russian central government ought to move as quickly as possible to eliminate trade barriers that isolate Russia economically fr om the rest of the world. When the Russian people and Russian enterprises are able to import energy freely from anywhere in the world, it will pressure domestic Russian energy companies to reduce costs and lower prices so as not to lose business. Moreover , to spur competitive market pressures in the Russian energy sector, foreign investors and private-sector companies ought to be granted the right to explore and develop new oil and gas fields.

Only when these and other like-minded policies are pursued in e arnest will Russia have an anti-monopolization policy worthy of the name. All other approaches to this problem, such as state controls on the prices charged by monopolistic enterprises, risk creating a worse problem than the one they purport to resolve. I n the case of price con trols, for instance, shortages and queues will develop such as were common in the Communist era. Full-fledged market reform where all enterprises can compete freely and fairly in an unencumbered market is the only effective answer 1 8 d Directing Russian local and city governments to privatize unrelated social and municipal services that are now being managed by energy-sector enterprises In many towns and cities, many social and municipal services, such as housing schooling, agricultu r e, and the building of roads and bridges are subsidized by the eamhgs of energy-sector enterprises. These often are the only enterprises with the wealth and financial resources necessary to subsidize needed local services. Indeed they typically are more w e althy than the local government But while these services are important to the locd community, they are a costly bur den to those that must pay for them. Therefore, before the Russian energy sector can be fully privatized and opened up to foreign investmen t, it must shed itself of these ser vices, which are unrelated to the production of energy.

The Russian central government can help solve this problem by directing Russian local and city governments to privatize each of these services on a case-by-case bas is with the aim of making them independent services paid for either by the local govern ment or service recipients, not the energy sector enterprises.

With regard to many services, such as housing and agriculture, privatization can be achieved relatively quickly since the Russian private sector already is a well-estab lished service provider. For example, according to U.S. government estimates, some 25 percent of Russias housing stock has been financed privately by citizens and was never part of state inv e And more than 25 percent of Russian agricultural production is grown by Russias private-sector farmers,02 who now number more than 250,000, up from less than 1,OOO only three years ago.lo3 tion will prove more difficult. The reason: the Russia n private sector is only in its in fant stages and thus is not well-established. consequently, in many instances, when a Russian local government attempts to privatize a given service, it will be unable to find an indigenous private-sector service provider .

This can be remedied, in part, by allowing foreign private-sector companies to com pete for the right to provide social and municipal services. Privatization is a well-estab lished tool of government economic policy in the West, where there exist a multi tude of private-sector service providers in many different fields. Moreover, by implement ing a formal privatization procedure for social or municipal services, Russian local and city governments will encourage the development of indigenous Russian privat e -sector companies able to provide social and municipal services With regard to other services, however, such as building roads and bridges, privatiza 101 Central Intelligence Agency, Measuring Russias Emerging Private Sector. Intelligence Reseurch Paper 1 0 2 Roy L. Prosterman and Leonard J. Rolfes, Jr Status Report on Russian Agmrian Refom RDI Reports on Foreign 103 Interview with Konstantin A. Mezentsev, International Development Head, Association of PrivakSector Fanners in November 1992 Aid and Developmen t #80 (Seattle, Washington: Rural Development Institute, March 31,1993 p. 2 Russia (AKKOR Moscow, June 1993 19 CONCLUSION What is remarkable in Russia today is not that turmoil and violence have broken out in Moscow Few expected that Russias road to democr a cy and a free market economy would be a smooth one. Rather, it is that, for the first time in Russian history, a democrat ically elected government favoring market reforms has used force against political oppo nents who sought to establish a dictatorship D espite-theprogress Yeltsin has-rnadein economic-reform, there is one area in particu larly where Russia has made little headway, and that is in reforming its energy sector where production is either stagnant or declining This need not be the case, because if there is one area where Russia can readily attain Western-style free-market prosperity, it is in its energy industry. Russia is blessed with enormous and largely untapped natural energy deposits, including 10 percent of the worlds oil reserves, 40 perc ent of its natural gas reserves 10 percent of its hard coal deposits, and 20 percent of its brown coal.

Yet, despite this natural comparative advantage with the rest of the world, Russian pro duction of oil and coal has declined precipitously these past se veral years and continues to decline. Moreover, Russian natural gas production has stagnated and likely will de cline in the latter part of this decade. Russia is suffering as well from an acute shortage of electrical generating capacity This can easily c h ange, but only through privatization. Russias energy industry must be fully privatized. Central to this process, of course, is the elimination of bureaucratic rules and regulations that act to impede private-sector entrepreneurship in Russias en ergy sect or, which not only is dominated by huge and highly inefficient monopolistic state enterprises, but which is burdened as well by a wide array of bureaucratic rules and regulations that act to hobble entrepreneurship.

Indeed an increasing number of countries worldwide are now privatizing their energy sectors-and with very good results. Nonetheless the Clinton Administration and World Bank are trying to solve Russias energy problems with Western foreign aid. But putting good money into a bad system will not s olve these problems In fact, by relieving much of the pressure for fundamental reform, Western foreign aid actually will make the situa tion worse.

A better and more cost-effective alternative is private-sector investment, which is nearly absent in the Rus sian energy sector. If Russias energy sector were privatized, the amounts of foreign investment coming into Russia could easily dwarf any amount of Western foreign aid. Such investment will never materialize, however, until the Russian government removes t he bureaucratic obstacles to entrepreneurship in the Russian en ergy sector and pushes ahead with privatization of its state energy complex. The benefits of doing so will accrue not only to the Russian energy sector, but to the entire Russian economy and indeed, to all the people of Russia John R. Guardian0 Policy Analyst


John R.

Senior Visiting Fellow