The strategic implications of the second Russia-China gas deal on the European gas market: insights from a Hotelling model in a game theoretical framework

At the end of 2014, Russia and China signed a framework for the second gas agreement. According to this agreement, Russia will supply 30 billion cubic meters (bcm) of gas to China over 30 years via the future Altai pipeline, which would connect Asian and European gas markets. This paper analyses the potential impacts of the second gas agreement on the European gas market. The analysis is based on an analytical and numerical Hotelling model. The core Hotelling model has been modified as follows: (i) three gas markets (Europe, China, and Russia) are considered; (ii) Russia is assumed to have market power in the European and Chinese gas markets; (iii) domestic gas prices are regulated in Russia; (iv) a finite planning horizon, which implies that agents plan for a finite future, is incorporated; and (v) a stock effect, which occurs when the marginal production cost is affected by the remaining stock, is introduced. In the numerical Hotelling model, the European gas market is depicted as oligopolistic competition in a game theoretical framework. The numerical Hotelling model is formulated as a mixed complementarity problem. The analysis leads to several interesting findings. Export netback gas prices for Europe and China should not necessarily be the same due to different degrees of market power, even if the resource constraint is binding. Gas exports to China will not necessarily result in re-optimisation of the Russian profit maximisation strategy in Europe, at least in the medium-term. Given the assumptions of a finite planning horizon and large gas reserves, Russia could face a non-binding resource constraint. In that case, Russia will continue to supply gas to Europe. Nevertheless, gas exports to China ultimately reduce the potential of Russia to supply gas to Europe in the long-term. Our results show that Russia could take a stronger bargaining position after 2050, when scarcity concerns could become more pronounced. Furthermore, in the presence of a stock effect, Russia could bargain with Europe for a higher gas price to compensate for an increase in the marginal production cost. Under a supply elasticity equalling unity, the stock effect could result in an annual reduction in the export supply of gas to Europe by 12 bcm. Nevertheless, scarcity concerns as well as adverse stock effects could be diminished if implicit subsidies on domestic gas consumption are reduced in Russia. The domestic gas market covers a large potential for gas exports. A 20% increase in the domestic gas price in Russia could potentially release 29 bcm of gas for export markets annually. We use a dynamic multi-region multi-sector CGE model. The Russia-China gas deal can lead to a substantial reduction in CO2 emission via a reduction in coal consumption. Furthermore, the average gas price in Europe can be increased because of reallocation of Russian gas from the European to the Asian gas market.