72 years, is higher than any other significant producer except Saudi Arabia. Russia is also by far the world’s largest exporter of natural gas. In 2008, Gazprom exported about 154 BCM to Europe (including Turkey).

# **II. Optimal Export Prices**

It is in Russia’s interest to try to maximize its profits from exports of natural gas. Given the need to ship natural gas from Russia to Europe through a pipeline, Russia is able to “segment” the European market from the Russian market. Russia, in 2008, had a market share of approximately 28 percent of natural gas sales in Europe. In the year 2008, Europe including Turkey consumed about 547 billion cubic meters (BCM) of natural gas, while importing 154 BCM from Russia. This implies Russia has some market power in Europe<sup>.3</sup> The Russian government has given Gazprom exclusive right to use the pipelines for the export of natural gas to Europe.<sup>4</sup> In this situation, it is optimal for Gazprom to price above long run marginal cost to exploit this market power.

In more detail, given the significant role it plays in supplying the European market, Gazprom has market power.5 The extent of the market power, however, is tempered by the existence of competing sources of gas. In addition, Gazprom wants to benefit from being perceived as a reliable supplier that can be trusted to continue to deliver gas (potentially in increasing quantities) at a fair price to European markets.<sup>6</sup> In the long run, Gazprom faces risks that new competitors will erode its market share and those risks are greater the higher its markup over marginal costs.<sup>7</sup> Volumes for the next

> 3 The largest importers of Russian natural gas are Germany (36 BCM), Italy, (25 BCM) and Turkey (24 BCM). The next largest importers are Poland, Hungary, France and the Czech Republic, all of whom imported about 7-9 BCM in 2008. The other principal suppliers of gas to the European market are Algeria (through a pipeline across the Mediterranean), Norway, the Netherlands and the UK. See British Petroleum (2009)

> 4 Gazprom paid 685 billion rubles to the Russian government in taxes in 2008. At an average exchange rate of 25 rubles to the dollar for 2008, this was $27 billion. See http://eng.gazpromquestions.ru/?id=12#c337. Nemtsov and Milov (2008) argue, however, that due to gross inefficiency of Gazprom, Russia would be much better served with a state monopoly on exports, but competitive purchases by the state monopoly among competitive producers in Russia.

> 5 Based on data in the Europe market, in appendix 1 of Tarr and Thomson, we present our calculations of the Lerner index of market power. We find that it is significant in comparison with estimates of the Lerner index for other industries.

> 6 In the two episodes of suspension of gas deliveries to Ukraine, Russia was forced to resume deliveries to Ukraine, despite lack of resolution of its dispute with Ukraine, in order to supply its European customers.

> 7 Since higher prices will accelerate the entry of new competitors,  optimal dynamic pricing by Gazprom would result in a lower price to deter entry. If in the future, supplies from new competitors increase faster

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