How to solve Europe’s Russian gas conundrum with a tariff

Daniel Gros 30 March 2022

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Editors’ note: This column is part of the Vox debate on the economic consequences of war.

The search for additional sanctions is intensifying in view of the ongoing suffering of the civilian population in Ukraine under Russian bombardment of cities.  One idea which is often discussed is for the EU, or individual Member States, to ban imports of Russian gas. The economic consequences of such a step would be very severe in the short run.1 But there is another, more gradual way which would minimise economic disruptions and which would have a strong impact on the revenues flowing to Russia. The EU should simply impose a special import tariff on Russian gas.  

Such a move would of course be against WTO rules. But under these special circumstances, it can be justified with the exemption under Article XXI for national security.  Moreover, Russia has imposed for a long time an export tax of 30% on gas.  The EU can claim that its import tariff just compensates for this distortion.2

The key point of departure is that Russian gas is provided to Europe by one supplier, Gazprom, with a near monopoly on exports of gas.3 At the same time, the EU accounts for about 70 % of overall Russian pipeline gas exports (about 140 billion cubic metres).   Other customers are unlikely to be able to compensate fully for the EU market.  China takes already substantial amounts of gas from Russia and will not want to become dependent on Russia for its energy.  As the biggest buyer, the EU has considerable ‘monopsony power’, but this has so far not been used.4

Standard economic analysis implies that Gazprom, as a monopolist, will not simply charge its marginal cost to European consumers, but will restrict its supplies to the point where its marginal cost equals the marginal revenue from the last cubic meter sold. This gives Gazprom a considerable monopoly rent (which flows ultimately into the coffers of the Russian government).

If the EU imposes a tariff, Gazprom will increase its price, but only by a fraction of the tariff because otherwise it would lose too much revenue.  The tariff thus eats into the rent of Gazprom.  Figure 1 in the annex shows the equilibrium resulting from a tariff. The welfare of European consumers thus suffers from higher prices, but the tariff revenue would be higher than their loss, at least up to a certain level of the tariff.

In Gros (2022b), I develop this standard formal analysis5 further and show that there is a tariff rate which is optimal for the EU because it would maximise the difference between the tariff revenue and the losses of European consumers.  In a simple linear model, the optimal tariff turns out to be roughly 30% (of today’s price) – by chance equal to the Russian export tariff. Moreover, this tariff would cut Gazprom’s revenues from sales to Europe by one half.

The optimal tariff argument thus implies that a tariff on imports of Russian gas would be appropriate even without having any intent to sanction. Such a tariff would thus have been appropriate already in the past. At present, the EU is searching for ways to reduce Russia’s export revenues. This intent can be added to the analysis by assuming that the EU is willing to forego one euro of benefits for itself if this cuts Russia’s export revenues by one euro. The result is then that the EU should impose a tariff of roughly 60% on imports of Russian gas.6 This would then cut Gazprom’s revenues to less than one fourth of today’s level.

European consumers would of course suffer more under the higher, sanctioning tariff.  But the model suggests that the tariff revenues would still be sufficient to compensate them because the higher tariff would also take away a larger proportion of the (remaining) rents of Gazprom.7

Sanctioning Russia via a high tariff on Gazprom’s exports to the EU would thus represent the ultimate ‘smart’: it would severely diminish Russia’s revenues and would impose no economic burden on the EU.

The political advantages of a tax on imports of gas from Russia are also clear.

First of all, it would counter, at least partly, the moral argument that, by importing gas from Russia, we are financing Russia’s war of aggression.  Those who still buy Russian gas would then also contribute to financing our reaction to this war and the tariff would provide them with a strong price signal to diversify over time.  Those who have alternatives will do so immediately.  The demand for Russian gas in Europe will fall, slowly at first, but at an accelerating rate.

Second, it would yield substantial revenues (which also play a key role in the economic analysis).  At the present high global natural gas prices, a 30% tariff on the value of Russian gas could easily reach €30–50 billion (on an annual basis) at the level of the EU.  This would allow the EU to provide assistance to vulnerable groups being hit by higher gas prices, further assistance to the Ukrainian government, and help to Member States to defray the costs of caring for the millions of refugees we must expect.  If, as now unfortunately seems likely, 3–5 million Ukrainian have to seek shelter in the EU, the overall costs could also be in the order of dozens of billions of euros (counting over €10,000 per refugee for housing and living expenses).8 

A further advantage of this approach is that it provides a strong long-term incentive for the private sector to seek other supplies.  And these supplies would be forthcoming.  If the EU makes it clear that the tariff is going to stay as long as Russia’s aggression against Ukraine continues, other potential suppliers of gas around the world will take notice and start investing in finding new sources or exploit better existing ones. In Gros (2022b), I argue that in Asia there is considerable potential for energy savings and switching from gas to coal, thus liberating important quantities of LNG supplies for Europe.

One could of course object that Russia could react to the European import tariff by increasing its own export tariff. This might very well be the case. But Russia’s export tariff is of little importance. It determines only the domestic price level for gas (see Tarr 2004 on the reasons why Russia wants to keep dual pricing).  The lower that level, the more gas will be wasted inside Russia. Anyway, the domestic price level for gas inside Russia is fixed in roubles and has thus already gone down relative to the world market price level.  The Russian export tariff has thus de facto already increased.

As an alternative to a tariff, it has been proposed to simply put a cap on the price European importers would be allowed to pay to Gazprom. But this would raise several issues. 

First of all, it would not solve the problem that, for the European consumer, Russian gas should be more expensive than other gas. Moreover, even assuming that Russia accepts to deliver at a price fixed by the EU, at what price would/should the importers resell the gas to consumers?  

Second, at what level should the price be fixed? At marginal cost, trying to appropriate the entire producer surplus? In this case, Russia would no longer have an incentive to deliver. 

Third, if Russia continues to deliver (if the price has been fixed sufficiently above marginal cost), what quantity should the EU import?  

A price cap does not solve the fundamental problem that Russian gas has become politically toxic in Europe; it should now also be made expensive. 

Finally, one has to ask how Europe would achieve the aim of reducing gas imports from Russia without resorting to a tariff. The only alternative would be quantitative restrictions or outright orders to energy distribution companies not to buy Russian gas. The latter would be difficult to sustain from a legal point of view and the former would be equivalent to a tariff if the rights to import Russian gas are auctioned. If they are just distributed on political grounds this would result a massive distribution of rents.  The European Commission has recently presented ideas how the EU could substitute about two-thirds of today’s Russian gas imports ‘well before 2030’.  But the Commission document (European Commission 2022) describes only what sources could substitute Russian gas, not how or why private sector gas users should reduce their purchases of Russian gas.

At any rate, one has to keep in mind that any reduction in Russian gas imports – whether achieved through quantitative restrictions, licensing or a tariff – implies the same increase in gas prices (unless gas is rationed). The main difference a tariff makes is that the link between the reduction of gas imports and higher prices becomes more transparent.

Annex

Diagrammatical textbook exposition

The figure below illustrates the linear case used in the text.  MC denotes the marginal cost, D demand and MR is marginal revenue.  QFT denotes the quantity imported under free trade, and QT the quantity imported with a tariff (or rate t).

Figure A1

Source: International Trade: Theory and Policy, section 9.6 

The importing country gains if d > a+b+c, which will always be the case for a small tariff. 

References

Bachmann, R, D Baqaee, C Bayer et al. (2022), “What if? The economic effects for Germany of a stop of energy imports from Russia”, ECONtribute Policy Brief No. 028 (see also the Vox column here).

Brander, J A and B J Spencer (1984), “Trade warfare: tariffs and cartels”, Journal of international Economics 16(3-4): 227-242.

Gros, D (2022a), “When the taps are turned off: How to get Europe through the next winter without Russian gas”, CEPS Policy Insight No. 2022-07.

Gros, D (2022b), “Optimal tariff versus optimal sanction: The case of European gas imports from Russia”, forthcoming EUI Policy Brief 2022/19..

Hausmann, R (2022), “The Case for a Punitive Tax on Russian Oil”, Project Syndicate, 26 Feb February.

Johnson, H G (1968), “The Gain from Exploiting Monopoly or Monopsony Power in International Trade", Economica 35(138): 151-156.

Jones, R W and S Takemori (1989), “Foreign monopoly and optimal tariffs for the small open economy”, European Economic Review 33(9): 1691-1707.

OECD (2017), “Who bears the cost of integrating refugees?”, Migration Policy Debates No. 13, January.

Sturm, J (2022), “A Note on Designing Economic Sanctions”, manuscript, 16 March. https://drive.google.com/file/d/1DGY7BRJd8op4KvCx0-uw5cU7r7lQ4j2X/view

Tarr, D G and P D Thomson (2004), “The merits of dual pricing of Russian natural gas”, World Economy 27(8): 1173-1194.

Endnotes

1 For an estimate see Baqaee et al. (2022).

2 See Tarr (2004) for an economic analysis of Russia’s dual pricing in the WTO context.

3 For Russian gas one thus cannot apply the usual models which assume that foreign supply is provided by competitive firms (e.g. Sturm 2022).  

4 For the classic reference on monopsony power, see Johnson (1968) and Brander and Spencer (1984). Russia has some LNG export facilities, but they are close to being fully used and can thus not constitute a safety valve.

5 The model is based on Jones and Takemori (1989), who also discuss in detail what constellation of market segmentation would be required for a tariff to be possible. [1] This would be somewhat lower than the ‘punitive’ rate of 90% suggested by Hausman (2022).

6 It is assumed here throughout that there is one integrated European market in this model.  The price is the same for all countries, independently of whether they import their gas from Russia or sources (piped from Norway or Algeria, LNG from the Middle East). The impact of a higher gas price or a tariff on any individual member state thus does not depend on the amount of gas imported from Russia by that country, but only on its overall imports of gas.

7 See OECD (2017) for estimates of the per capita cost of refugees in OECD countries between $10,000 and $20,000.

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Topics:  Energy Politics and economics

Tags:  Russian gas, Russian sanctions, Ukraine war, gas tariff

Director of the Centre for European Policy Studies, Brussels

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