Publication: Eurasia Daily Monitor Volume: 3 Issue: 199

Russian energy projects governed by production sharing agreements are now facing environmental scrutiny, possibly indicating Moscow’s unhappiness over the terms of deals made almost a decade ago.

Russian officials went as far as threatening to shut down the country’s largest production sharing agreement (PSA) project, Sakhalin-2. Last week Natural Resources Minister Yuri Trutnev issued a warning: “If Russian laws are violated and the environment is damaged, then we will take measures to stop the project” (Interfax, October 20).

Trutnev said Sakhalin Energy, the Sakhalin-2 project operator, would present a plan to rectify any environmental damage. He said the ministry had received a letter from Sakhalin Energy CEO Ian Craig, in which the company reportedly conceded environmental violations and pledged to solve the problems (RIA-Novosti, October 20).

Rosprirodnadzor, the Russian Federal Service for the Oversight of Natural Resources, has been leading the charge against Sakhalin-2. Oleg Mitvol, deputy head of the agency, accused Sakhalin Energy of committing ecological violations during the construction of an 800-kilometer pipeline that runs the length of Sakhalin Island.

Rosprirodnadzor has already ordered the suspension of construction of onshore pipelines and sought a criminal probe against a contractor working for the project. The Russian authorities have threatened to sue Shell, which holds a majority stake in Sakhalin Energy, if it fails to suspend work on the pipeline.

In the meantime, Rosprirodnadzor has said big oil firms in Russia could be subject to environmental inspections. On October 18, the agency announced that it would investigate Gazprom’s oil unit, Gazpromneft. Rosprirodnadzor said it would also look into perceived violations by Lukoil and Rosneft. However, these latest moves to investigate Russian energy firms are merely a pretext to target the PSAs, particularly Sakhalin-2.

The Russian government signed the Sakhalin-2 PSA with the Sakhalin Energy Investment Company in 1994. That investment group consists of Shell Sakhalin Holding (55%), Mitsui Sakhalin Development (25%), and Diamond Gas Sakhalin (20%). The deal was Russia’s first PSA, and it became effective in 1996. The project has been producing oil since 1999, and participants are planning to build the world’s largest liquefied natural gas (LNG) plant in the Russian Far East.

Now Russian officials complain that production-sharing agreements such as Sakhalin-2 offer investors too many tax breaks, as the deals were drafted in the 1990s when oil prices were much lower. Under existing agreements, Russia will start receiving its share of profits only after investors have recovered their costs. Russia’s three existing PSAs have so far brought state coffers only about $700 million in indirect revenues, according to Russian estimates.

Russian officials have not disguised their reluctance to accept what they view as an unfair division of profits within the Sakhalin-2 deal. “For Russia, the efficiency of the Sakhalin-2 project has been going down, thus [we are] questioning the need to continue using production-sharing agreements,” said Viktor Orlov, head of the Federation Council’s committee on natural resources and environmental protection.

Moscow was particularly upset by Shell’s move to double the cost estimates for Sakhalin-2 from $10.3 billion to $19.9 billion. Cost overruns cut Russia’s share of profits, Orlov argued. “In 2005 expenses totaled $4.055 billion as compared with the original estimate of $2.514 billion,” he said. Orlov also accused Sakhalin Energy of slow work, inflated costs, and failure to employ enough Russian nationals (RIA-Novosti, October 20).

However, government officials have been sending mixed messages regarding Sakhalin-2. For example, on October 17 Industry and Energy Minister Viktor Khristenko said that the PSA could only be revoked or changed if both sides agreed.

There is no logic in shutting down the project, because Russia would have to compensate Sakhalin Energy for all losses resulting from a stoppage, said Andrei Dementyev, deputy industry and energy minister. However, he claimed that the economic terms of the Sakhalin-2 agreement are “the worst of the three PSAs,” Dementyev also said the state-controlled overseas oil projects operator Zarubezhneft would be invited to conduct an independent audit of the rising Sakhalin-2 cost estimates by early December (RIA-Novosti, October 20).

Russian media outlets commented that economics were behind the regulatory assault on Sakhalin-2. Environmental probes into Sakhalin-2 operations were caused by a desire by the Russian authorities to influence the project without being involved in international arbitration, Kommersant daily commented. Russian officials, including Trutnev, have conceded that such arbitration would be very costly for Russia (Kommersant, October 21).

Russia’s Environmental watchdog Rosprirodnadzor has launched a two-pronged attack, using regulatory pressure and unfavorable publicity to put pressure on the PSA projects. Rosprirodnadzor’s Mitvol led a team of environmentalists and journalists to Sakhalin in late September.

Mitvol’s activism quickly backfired, when an apparent link between the agency and the project was revealed. On October 18 Russia’s organized crime police seized documents, including airplane tickets and hotel bills, related to a recent trip by Rosprirodnadzor officials to the Sakhalin-2 project. However, it remains unclear whether the police raid came as a fallout of Mitvol’s criticism of the Sakhalin-2 or Russian energy majors.

Therefore, the environmental probe into Sakhalin-2 has been seen as a strategy aimed to press investors into re-negotiating terms of the original deal. Meanwhile, the subsequent police investigation of Rosprirodnadzor appeared to come as an indication of the government’s indecision on how to deal with the PSAs. It remains to be seen whether the forces advocating a tougher or a softer line regarding the PSAs will win out.