How to be smart about Russian energy sanctions

In the gunfight at noon-style stand-off that is the Russia-EU mutual energy trade dependence, it seems like Russia has drawn first. Early this week, its state-owned gas company, Gazprom, cut off supplies to Poland and Bulgaria, sending gas prices soaring.

We are now in a situation I warned about at the start of the war. While it could be painful in the short run for European countries to go “cold turkey” on Russian gas and oil, it is surely better to do so of one’s own volition than to be forced into it at a time of Vladimir Putin’s choosing.

True, Europe has taken steps to begin weaning itself off Russian energy, and the destination seems clear. A coal embargo has been agreed, there is now talk of “smart” sanctions on oil, and even Germany aims to phase out Russian gas (by 2024). But so far outright bans on oil or gas have been a step too far.

That is why clever alternatives such as import taxes or price ceilings are now a hot topic in Brussels. No less a policymaker than US Treasury secretary Janet Yellen called for caution on outright bans last week, in warning that an oil embargo could lead to higher world prices, and then “although Russia might export less, its price for its exports would go up”.

It is unclear — at least to me — how helpful Yellen’s intervention was, if it supports those in the EU who are holding back the effort to cut Russian energy imports. She did not elaborate on how she sees a withdrawal of western demand for Russian oil and gas leading to higher Russian revenue. It presupposes that Russia could sell enough elsewhere, where prices would go up due to relocated western demand (on which more below). But in any case, surely the greatest risk of the outcome she fears is that western countries do not cut demand but Russia cuts supply. Witness today’s situation in Europe, where Putin has withheld less than 10 per cent of its sales but caused prices to go up by 20 per cent, netting the Kremlin a nice windfall.

Be that as it may, ever since Putin sent his army into Ukraine, economists have been in overdrive devising schemes to maximise the damage to Moscow’s energy earnings while minimising the harm to European oil and gas users. That is presumably what any forthcoming “smart” sanctions will aim to achieve. How would they work? Let’s look at the mechanics of a tax on Russian oil or gas imports, which has received most attention from economic experts (other versions would be a price cap or a buyer’s cartel arrangement).

Daniel Gros and John Sturm both have good explainers of the economics of a special energy tariff. These are in essence based on the classic argument of the optimal import tariff for a country that can influence its own terms of trade. The main idea here is that insofar as Russia depends on the EU market to sell its oil and gas, it will not completely withdraw supply if it does not get the same price as before, but will accept some of the pain of a tariff in the form of lower (pre-tariff) selling prices to ensure buyers do not reduce their demand too much.

An important implication of this is that even if there were no geostrategic goals, the EU would have a commercial interest in imposing a tariff on Russian energy imports. It could be set so that customs revenue would be more than enough to compensate those who lose out from energy prices (inclusive of tariffs) going up. Gros puts this economically optimal tariff level at 30 per cent, and at double that if the EU values the loss of income to Russia as much as it values its own price paid.

Going further than this, Ricardo Hausmann proposed right after Russia’s invasion a punitive tax of 90 per cent of the purchase price, with the purpose of expropriating the natural resource rent enjoyed by the Russian state (the price paid over and above Russia’s low costs of extraction).

Again, all this depends on the degree to which Russia would keep delivering oil or gas even if the price it received fell. And that in turn depends on technological, economic and legal factors.

Technologically, things look good. “Available estimates put average Russian crude oil production cost at between $20 to $30 per barrel,” says Laura Solanko at the Bank of Finland’s Institute for Emerging Economies. In addition, “some experts claim that a very large share of Russian oil wells is geologically difficult to shut and reopen. Therefore, Russian producers are likely to favour producing even if [the] price level is below $30/bbl. This has indeed been the case in the past as well.”

Similar points can be made for natural gas — it is not straightforward to manage a reservoir’s pressure if you are going to turn the gas on and off regularly. So Russia probably needs to offload its oil and gas because it cannot easily cut production by a lot in the short term. Could it take it to other markets if it stopped selling to Europe? Not gas — there is no capacity for years to send current pipeline gas elsewhere. As for oil, this is easier — but tanker capacity would need to be found, and the steep discount at which Russian oil is currently trading shows there is quite a bit of “self-sanctioning” going among buyers and/or shippers.

But oil can at least be shipped elsewhere. An oil embargo would withdraw demand for Russian oil in Europe but increase demand for non-Russian substitutes. By itself this would create a huge incentive for a carousel trade shipping Russian oil to non-sanctioning markets, and redirecting their previous supply from non-sanctioned producers to the EU. Russian exports are a tenth or so of global exports, so this should be possible. The result would drive up oil prices by the added transport costs everywhere, but they would still be similar around the world and Moscow’s bank accounts would not be appreciably lighter than now.

But here is where the legal elements come in. To avoid the result Yellen warns against, the west would in essence have to try to segregate the global markets for Russian and non-Russian energy goods. Anette Hosoi and Simon Johnson have shown how this must be done in an oil embargo. In addition to banning imports, the EU and its allies should also prohibit any tankers owned or controlled by people linked to their jurisdictions from transporting Russian oil and sanction any financing of the Russian oil supply chain.

Such auxiliary measures are essential to make any restriction on imports of Russian energy work as intended. But if the EU could do this, might it not as well go for an outright ban? The economic modelling of a tax or tariff, which concludes that Russia would lower prices to compensate, glosses over the mechanics of price adjustment. The way Russia would be “forced” to cut prices is that EU buyers would withdraw demand if they had to pay the full tariff. But the political resistance to import bans, as well as the claims that it is physically very hard to substitute away, suggest otherwise.

One advantage of a tax or tariff over the alternatives is judicial. Tariffs could be justified on the grounds of trade or energy policy, which may not require unanimity in the EU, unlike sanctions. But this may be a politically risky way to go if it is important to keep Germany on board.

In the end, then, a tariff and a ban look fairly similar. So they should best be thought of as steps in the same process. The best case for a tariff is that it can be introduced immediately and turned up over time. And crucially, if a steeply rising path of the tariff is agreed and announced today, companies will be given the best possible conditions to adapt. An immediate tariff, to be stepped up to reach prohibitive levels soon, and accompanied by further financial and shipping sanctions, is what the EU should now adopt.

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