NABUCCO VERSUS SOUTHSTREAM - ETH Z · ^Nabucco was the first attempt at forging a common energy policy to reduce *the EUs+ dependence on Russian gas. The basis of Nabucco is to bring

NABUCCO VERSUS SOUTHSTREAM A GAME THEORETICAL VIEW ON THE RACE OF GAS PIPELINES

DRAFT

Energy Economics and Policy

Spring Semester 2011

Term Paper

Patrick Haas

ETH Zurich Energy Economics and Policy

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Table of Content

1. INTRODUCTION .................................................................................................................................... 4

2. BACKGROUND: EVOLVING RIVALRY OVER CASPIAN GAS PIPELINES ............................................................... 5

2.1. EUROPE’S INCREASING GAS DEMAND AND THE NEED FOR DIVERSIFICATION .............................................. 5

2.2. NABUCCO – A STRATEGIC PROJECT FOR THE EU .................................................................................... 7

2.3. SOUTH STREAM – THE REACTION OF THE RUSSIAN ENERGY GIANT ........................................................... 8

3. A GAME THEORETICAL VIEW................................................................................................................ 10

3.1. SIMULTANEOUS-MOVE GAME .......................................................................................................... 10

3.2. SEQUENTIAL-MOVE GAME .............................................................................................................. 11

3.3. SEQUENTIAL-MOVE GAME WITH ENTRY DETERRANCE AND FIRST MOVER ADVANTAGE ............................ 12

3.4. A ZERO-SUM GAME? ..................................................................................................................... 13

4. CONCLUSION ..................................................................................................................................... 14

5. REFERENCES ...................................................................................................................................... 15


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1. INTRODUCTION

Who supplies Europe with natural gas in the future? And in which way? The struggle for power in

European gas supply is in full play, as the continent will become substantially more dependent on

imported gas. Reasons are a decline of domestic gas output combined with an increasing demand.

European gas production is supposed to have peaked around 2004 (Burchett, 2010), with proofed

reserves lasting for only 14 years at current gas consumption level (BP, 2010). At the same time, EU’s

environmental legislation boosts the demand for natural gas; a trend which is reinforced by the

expected economic growth of Eastern Europe.

Higher imports suggest growing dependence on importing countries. In case of the EU, Russian state

enterprise Gazprom currently satisfies more than a quarter of the overall gas demand or 40%

(EurActiv.com, 2007) of all imports. To overcome the Russian gas import monopoly, the common

European energy policy strategy aims at a diversification of gas suppliers and delivery routes.

Planned construction of a southern gas export corridor should “enable European access to gas from

the Caspian Sea region and also from the Middle East” (Loskot-Strachota, 2008). The strategic and

EU-backed gas pipeline project Nabucco decreases the dependence on Russian oil and minimizes

transit risks. Simultaneously, Russia wants to reinforce its dominant position in the European market

and limits access for competitors. EU’s intention to build the Nabucco pipeline is contrary to

Moskow’s interests and led to the setup of a competitive project under the leadership of Russian’s

quasi-state enterprise Gazprom. South Stream will supply the same European markets as Nabucco

“and is a counter-proposal to the concept of the export of Caspian gas to Europe independently of

Russia” (Loskot-Strachota, 2008).

A simplified economic assessment of the Race of the Pipelines can be found in the Term Paper of

Deniz (2011). Using his outcomes of different pipeline construction scenarios as a basis, this paper

applies approaches from game theory to model the current strategic interaction of the EU and

Russia, who compete on the implementation of their gas pipeline projects. The situational analysis

from a game theoretical perspective enables the derivation of some thoughts for possible future

developments. Indications for player actions are given on an economical, but also on a political level,

respecting the inherent limitation of both Deniz’ and my model.


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2. BACKGROUND: EVOLVING RIVALRY OVER CASPIAN GAS PIPELINES

2.1. EUROPE’S INCREASING GAS DEMAND AND THE NEED FOR DIVERSIFICATION

Europe’s demand for natural gas is steadily increasing. Projections foresee a doubling of European

gas demand from 1990 to 2030, reaching a level of 800 billion cubic metres per year by then

(Rutherford, 2011). The share of gas in the overall energy consumption in the EU will rise from

today’s 20% (Burchett, 2010) to approximately xx% in 20xx (tbd), establishing natural gas as the

second most important energy source after oil.

One of the main reasons for a growing gas demand is the environmental legislation of the EU. The so

called Emission Trading System (ETS) attaches a price to emissions of CO2 and created a market,

where electricity producers can trade “emission allowances”. The trading system encourages the

construction of gas-fired power plants, because they emit less CO2 than comparable coal-fired plants

(see fig. 2). The Emission Trading System implies a raise of the overall European gas demand, and the

trend is further reinforced by ongoing modernisation and expected economic growth of the Eastern

part of the EU (Dieckhöner, 2010).

Figure 1: Future European Gas Supply Creating Concerns (Rutherford, 2011)

Figure 2: CO2-Emissions in Electricity Generation (Rutherford, 2011)


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At the same time, indigenous European gas production appears to have reached its maximum level

around 2005, and is declining since (see fig. 3). A comparably low amount of proofed domestic gas

reserves enforces the assumption that Europe will have to import increasing quantities of gas.

Figure 3: Domestic European Gas Production in BCM (1970 - 2005) (Burchett, 2010)

Sitting at the other end of the bargaining table, Russia is the largest global gas supplier and owns the

world’s biggest volume of proofed gas reserves. It probaly also owns the wold’s most pro-

governmental non-state enterprise: Gazprom. Ties between politics and the company are strong and

numerous. Latest highlight: the former charmain of the supervisory board is currently Russia’s

president: Dmitri Medwedew. The giant company bears almost a quarter of Russia’s national budget

via taxes. It is almost redundant to say that Gazprom’s goals are therefore the Kremlin’s goals, and

vice versa.

However, a quarter of Europe’s gas demand is covered by Gazprom. European policy makers

perceive the dominant market position of Russia’s energy giant as a threat: Gazprom, “considered

opaque and corrupt” (Bruchett, 2010), could be used as a foreign policy tool to meet political

interests of Russia. The fear is justified: Ukrainian-Russian gas crises in the winters of 2006 and 2009

clearly demonstrated the willingness of the Kremlin to use Gazprom’s power to enforce political and

economical goals. Disputes over gas prizes, depts and payment led to a repeated interruption of

Russian gas supplies to Ukraine. The supply cut severely hit several European countries, as 80% of

Russian gas exports are transported through Ukraine. Western countries accused Moscow of using

the quasi-monopolistic import market power of Gazprom in the European energy sector as a political

bargaining chip. The crises illustrate the inseperability of energy resource economics and the political

environment, in which the resources are used. Even more, “political and organizational forces often

determine actual outcomes in oil, gas and electricity markets much more than pure economic or

technological imperatives” (Victor, 2011). Gazprom and Russia serve as a paramount example, but

various other countries and energy companies could be named as well.


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The tight coupling of energy policy and energy economy will also shape the future European gas

market and answer the crucial question of who will supply the continent with natural gas. At the

moment, contrary initiatives are taken by the two main players in the market: the EU tries to

diversify gas suppliers and delivery routes to decrease the dependence on Russian oil and minimize

transit risks. In the meanwhile, Russia wants to reinforce its dominant position in the European

market and limits access for competitors. The clash of the two opposing strategies is evident when it

comes to construction of the new pipelines. Both parties set up and support projects to build a

southern gas corridor which provides access to gas from the Caspian See region (Azerbaijan and

Central Asia). In what can be described as the Race of the Pipelines, the EU-backed Nabucco project

competes with the Russia-backed South Stream project. Both initiatives are shortly presented in the

upcoming sections.

2.2. NABUCCO – A STRATEGIC PROJECT FOR THE EU

“Nabucco was the first attempt at forging a common energy policy to reduce *the EU’s+ dependence

on Russian gas. The basis of Nabucco is to bring gas to Europe from new suppliers”, stated the EU

Energy Commissioner Andris Pielbags in 2007 (Finon, 2009). As early as 2003, the Nabucco pipeline

project is considered as one of the priority infrastructure projects of the EU. Triggered by the

Russian-Ukranian gas conflicts in 2006 and 2009, Nabucco became EU’s most important pipeline

project which enables a diversification supplies for natural gas. The project is an element of the

overall goal of improving energy security for Europe. However, the largest unresolved issue is the

lack of guaranteed supplies. Only Azerbajian has so far commited to deliver gas via the new pipeline

to Europe. The secured amount is by far not enough to fill the pipeline and further supplier need to

be contracted. This is not easy, as some countries, like Turkmenistan, do not have enough secured

gas resources and hold additional long-term contracts mainly Russia (yes, the same Russia with the

world’s largest gas resources), who then resells the gas and further strengthens its market position.

Furthermore, political instabilities and democratic deficits (a nice word to describe the unopposed

violation of human rights) in countries like Iran, Iraq and Kasachstan hamper or avoid intense

business relations and supply contracts. Although the EU intensifies efforts to increase the feasibility

of Nabucco, the project remains vulnerable. The multinational character of the EU as well as of the

project additionally complicates cooperation and decision-making. Political Europe therefore left

room for compromise and officially recognized the possibility of coexistance of the two projects

Nabucco and South Stream.


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2.3. SOUTH STREAM – THE REACTION OF THE RUSSIAN ENERGY GIANT

“One of the key factors which complicate the implementation of Nabucco is the fact that its

existence per se is contrary to the interests of Russia” (Loskot-Strachota, 2008). Nabucco aims at

supplying Russia-dominated markets in South and Central Europe with non-Russian gas. Gazprom

therefore started to act on different levels to minimize the probability of Nabucco’s implementation.

Signed gas trade agreements with Central Asian countries intend to limit the availability of natural

gas which could otherwise fill the European pipeline. To additionally lessen the demand in the

downstream market, long-term contracts with Southern and Central European countries were

negotiated. The South Stream project, launched as recently as in 2007 by Gazprom, ultimately and

directly torpedoes the Nabucco initiative. The fact that the Italian based energy company ENI acts as

partner of Gazprom in a project trying to maintain Europe’s energy dependency, illustrates the lack

of mutual consent in the European (Dis)Union and the difficulties of establishing a common energy

policy strategy within Europe. This directly or indirectly weakens every pan-European initiatives, such

as the Nabucco project. In turn, Russian energy giant Gazprom, with the blessing of Moskow, exhibits

all his market power to fight non-complying European energy initiatives. The South Stream project

benefits from a guaranteed and huge resource base, but is still less advanced than the competing

Nabucco pipeline.

Nabucco South Stream

Total length [km] ~4000 ~3700

Capacity [bcm/year] 31 63

Construction Cost [bEur] 8-14 19-24

Partners OMV, MOL, Transgaz,

Bulgargaz, BOTAS, RWE

Gazprom, Eni

Goes through Turkey, Bulgaria,

Romania, Hungary,

Austria

Russia, Bulgaria, Greece,

Italy, Serbia, Hungary,

Croatia, Slovenia,

Austria

Destination Austria Italy, Austria

Table 1: Data for Nabucco and South Stream (Deniz, 2011)


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Figure 4: Proposed Route of South Stream and Nabucco (BBC News, 2009)

Generally, it is difficult to determine the current status of the two projects and impossible to predict

if one or even both pipelines will be built. Propaganda, political games or simply different

assumptions about future developments result in various, sometimes contradicting information

about the competition of the two projects. In addition, the world’s economic crisis reshaped also

energy markets, giving a more pessimistic outlook to the near future. Impacts remain unclear and

although both initiatives suffer delays, the parties keep restating that their pipelines will finally be

constructed.

Keeping in mind the complex reality, I am going to assess a simplified situation from a game

theoretical perspective in the following chapter.


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3. A GAME THEORETICAL VIEW

The tool for analyzing settings with strategic interaction is Game Theory. In order to model the Race

of the Pipelines, I assume for simplicity that there are only two players: EU and Russia. They both

represent the respective consortium of firms and countries participating in and/or profiting from the

construction of one of the corresponding pipelines. Actions the players can take, i.e. strategies they

can choose, are simply building or not building the pipeline. I am applying non-cooperative game-

theory, because it is likely that the welfare of one player depends on the behaviour of the other

player. The game-theoretical assessment is based on a simple economic model and derived payoffs

have economical validity. It should trigger thoughts on how players could or should react in certain

situations or what it means from a game theory perspective, also taking economical and political

actions and constraints into account.

3.1. SIMULTANEOUS-MOVE GAME

As an initial approach, the situation is seen as a simultaneous-move game and presented in normal

form:

- Set of players: {EU, Russia}

- Strategy set of players: EU: SEU = ,Build Nabucco, Don’t Build Nabucco-

Russia: SRussia = ,Build South Stream, Don’t Build South

Stream}

- Four possible strategy profiles: (sEU, sRussia)

o (Build Nabucco, Build South Stream)

o (Build Nabucco, Don’t Build South Stream)

o (Don’t Build Nabucco, Build South Stream)

o (Don’t Build Nabucco, Don’t Build South Stream)

Each player’s payoffs are derived from the model of Deniz (2011). For the payoff of player EU, the

profit of the domestic supplier, simply called “Europe” in the model, and the profit of the Nabucco

pipeline are added. Similarly, the payoff of the player Russia equals the profit of the gas supplier

Russia plus the profit of the South Stream pipeline. These profits are computed as follows:

Profit = Revenue – Cost = Price*Delivered Quantity – Cost = p*Q – (Q + 0.05 Q2)


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The model directly outputs prices and delivered quantities; the cost function represents the

antiderivative of the marginal cost function defined in the model. The assumption of no fixed cost in

the long run justifies the omitted constant of integration.

The derived profits have only economical validity, as the model does not take into account any

political or other factors. The final payoff numbers are relative and give an indication on how much

economical welfare the player is receiving, given a certain scenario. A graphical representation of the

game is shown in the payoff matrix below.

EU

Build Nabucco Don’t Build Nabucco

Russia Build South Stream 148, 125 162, 112

Don’t Build South Stream 120, 155 133, 140

Table 2: Payoff Matrix

Although the underlying model is analyzing a highly simplified situation, the results seem to

strengthen some basic assumptions. The worst case for the EU and at the same time the best for

Russia implies the construction of the South Stream pipeline and the abandonment of the Nabucco

project. The same is true vice versa, although the relative gap between the two payoffs is not equally

large. The strictly dominant strategies for both players are “Build”, which results in a Nash

Equilibrium where both pipelines are constructed. From a player’s perspective, the best response is

always to construct the pipeline. This seems reasonable only if the demand is large enough to

balance initial costs, which are not considered in the model. The question can only be derived by a

sophisticated business case.

What is noticeable: the increase in payoff for one player when building the pipeline brings down the

payoff of the other player by approximately the same amount, what is the characteristic of a zero-

sum game.

3.2. SEQUENTIAL-MOVE GAME

As the competition of the two pipeline projects involves player choosing actions over time, the

situation must also be modeled as a dynamic game with sequential moves. I assume complete and

perfect information. Illustration happens in extensive form (see fig. 5).


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In a sequential move game, players can look ahead and reason back. For the Race of the Pipelines,

this implies that the beginning player can accurately forecast, what the other player will do, given his

own action of building or not building the pipeline. In this case, the first player – whoever it is – will

build the pipeline, as the final payoff will always be higher. The second player will also always choose

the strategy to build the pipeline.

This approach gives not much further implications, but serves as a basis for the next, more

sophisticated approach, which takes into account additional concepts to model the situation more

accurately. Payoffs initially gave some implications, but are not considered anymore.

3.3. SEQUENTIAL-MOVE GAME WITH ENTRY DETERRANCE AND FIRST MOVER ADVANTAGE

I reconsider a sequential move game, this time with entry deterrance. The game is usually illustrated

by the situation, where an entrant (Firm E) is trying to decide whether to enter an industry in

competition with a dominant player, i.e. an incumbent monopolist (Firm I) (see fig. 6). The initial

Nash equilibrium is {In, Accommodate}. However, the incumbent firm can change the game to its

own advantage by threatening the entrant firm with a possible price war. If the threat is credible, the

incumbent firm will stay out of the market; the new equilibrium is {Out, Price War}.

Transferring this to the pipeline battle, it has to be determined first, who will be the dominant player.

It will be the one who is the first “in the market”, i.e. who starts first with the construction of the

pipeline. The advantage of the first mover is obvious, as he has then the possibility to change the

Figure 5: Extensive Form (tbd)


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outcome of the game in his favour. Regarding this, one could see actions of the EU or Russia, such as

ceremonial summits, as attempts to convince the competitor of having “moved first”, i.e. of having a

decisive advance in the Race of the Pipelines. The Energy Policy Blog1 of March states that the

Nabucco consortium “decided on February 2010 to order the steel to forge the 3000km of future

pipe”. This action, whether simply communicated or really done, is also an attempt in this direction.

The problem is, that “credible commitments are difficult to make, because they require that players

threaten to act in an unprofitable way – against their self interest” (Froeb, McCann, 2010).

Figure 6: Illustration of a Sequential Move Game with Entry Deterrance

The aim is obvious and needs no game theoretical knowledge: once a player is convinced that his

opponent has moved first, the second mover will reconsider the implementation of his project. The

question can also be raised, what determines the “first move” in reality: the start of construction,

contractual obligation with supplier or consumer, etc.

Alternatively, we could look at Russia being already the dominant player in the game, because of its

structural and economical advantages. The attempts of Gazprom to negotiate long-term contracts

with possible suppliers and customers of Nabucco (see Section 2.3.) can then be seen as activities to

increase the entry costs for Europe, as it becomes more difficult to fill the Nabucco pipeline with

enough gas; the probability of profit decreases.

3.4. A ZERO-SUM GAME?

Latest considerations about the European gas market imply that the Race of the Pipelines has

become a zero sum game. The worldwide recession and diluted environmental commitments reduce

the European demand for gas, and new gas extraction methods might reinforce domestic supply.

“Nabucco and South Stream have become engaged in a ‘winner-takes-all’ contest to supply Europe

1 www.energypolicyblog.com


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with gas (Burchett, 2010). If this is true, decisions in the game become even more crucial, as every

reduction of welfare is associated with an increase in welfare of the competing player. This will finally

lead to an intensified rivalry over the two gas pipeline projects.

4. CONCLUSION

The game theoretical assessment of the two competing gas pipelines Nabucco and South Stream

gave some insights on the mechanisms of strategic interactions. Starting from basic approaches, the

model of a sequential-move game with entry deterrance and first mover advantage seems to be an

adequate model for the current situation in the Race of the Pipelines. Game theoretical concepts like

threatening the other player to change his strategy and the game’s payoff function could be mapped

to real world action.

For further information about the model of Deniz (2011) and the way it is used for economic

assessment of different pipeline construction scenarios, please refer to his paper.


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5. REFERENCES

Loskot-Strachota, Agata. 2008. Nabucco vs. South Stream – Rivalry over Balkan Gas Pipelines. CES

Commentary. Issue 3 (March).

Deniz, Canay. 2011. The Economic Impact of Two Pipelines on the European Gas Market. Term Paper.

Energy Economics and Supply.

Burchett, Kash. 2010. South Stream Steals a March on Nabucco. European Energy Review. 31 August.

BP. 2010. Statistical Review of World Energy June 2010.

Rutherford, Thomas Fox. 2011. ETH Course: Energy Economics and Policy. Lectures 1b, 7a.

Dieckhöner, Caroline. 2010. Simulating scurity of supply effects of the Nabucco and South Stream

projects for the European natural gas market. University of Cologne. Institute of Energy

Economics.

Victor, Prof. David. 2011. Stanford University Course: Political Science – The Political Economy of

Energy Policy. Course Description.

Finon, Dominique. 2009. The limits of the EU direct foreign gas policy – Autopsy of the stillborn

Southern corridor project Nabucco. Centre International de Recherche sur l’Environnement et le

Développement.

BBC News. URL: http://news.bbc.co.uk/2/hi/8360629.stm. Access: 19 April 2011.

Froeb, Luke. McCann, Brian. 2010. Managerial Economics. South Western, Cengage Learning.

Documents

NABUCCO VERSUS SOUTHSTREAM - ETH Z · ^Nabucco was the first attempt at forging a common energy policy to reduce *the EUs+ dependence on Russian gas. The basis of Nabucco is to bring