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VoxEU Column Environment Politics and economics Energy

Cutting Russia’s fossil fuel exports: Short-term pain for long-term gain

In response to the invasion of Ukraine, most OECD countries have announced punishing sanctions against Russia. But the sanctions have so far failed to target Russia’s primary source of foreign exchange – exports of fossil fuels. This column argues that while the short-term impact of restricting Russia’s fossil fuel exports on EU households’ real income would be non-trivial, the longer-term cost would be more modest and would be offset by considerable environment co-benefits. Meanwhile, the adverse impacts on the Russian economy would be overwhelming.

On 24 February, Russia launched an unprovoked attack on Ukraine, invading its territory on multiple fronts, including from neighbouring Belarus. As the entire Ukrainian nation has entered a fight for democracy and the country’s independence, most of the countries of the OECD, including the US, Australia, Canada, South Korea, Japan, the UK and the EU, have announced punishing sanctions against Russia. These include restrictions on financial transactions, freezing assets of Russia’s major banks and selected individuals, banning exports of high-tech equipment to Russia, as well as closing the airspace for Russian flights. Notably absent at the time of writing this column is one of the most painful items for the Russian economy – restrictions on the export of fossil fuels. This is the country’s primary source of foreign exchange.

This exception is hardly surprising. During 2019, the EU and UK imported over US$118 billion worth of fossil fuels from Russia, with Germany, Netherlands (largely re-exports), Italy, Poland and France among the top destinations (Figure 1). During earlier periods with higher energy prices, the corresponding import flow was even larger. Indeed, the value of this import flow exceeded $181 billion in 2014.

Figure 1 Value of fossil-fuel imports from Russia during 2019 (selected countries)

 

Note: Due to instability in the 2021 trade data, we have opted to report these data for 2019 instead.
Source: UN (2022).

Based on Eurostat data,1 the share of EU’s imports from Russia ranges from 26.9% for crude oil to 41.1% and 46.7% for natural gas and solid fuels, respectively.

The EU27 and UK together account for over 63% of Russia’s fossil fuel exports and, when combined with selected other countries that have imposed sanctions against Russia, such as the US, Turkey and Japan, the share of Russia exports increases to 80%.

If these revenue flows were to be cut off, this could have a tremendous impact on the Russian economy, which relies heavily on energy exports for financing its government budget, as well as supporting its military operations. At the same time, such an embargo would also hurt the EU economy and other energy importers imposing import restrictions. Some believe that such adverse implications could be substantial, thus preventing policymakers from considering this step. But apart from the pure financial aspect there is another dimension at stake – environmental quality. 

The recently announced the EU Green Deal sets ambitious mitigation goals and establishes a target of reducing greenhouse gas emissions by 55% by 2030 relative to the 1990 level. To reach this goal, a major reduction in fossil fuel consumption will need to take place in the coming years. This enhancement in mitigation ambition could be achieved through a mix of mechanisms and policy measures, including carbon pricing, energy taxes, energy efficiency improvements or changes in behavioural patterns. Restrictions on the imports of fossil fuels from Russia adds another option to this list, which could allow the EU to achieve additional reductions in greenhouse gas and air pollutant emissions, as well as reduce energy dependence. But the question is at what cost?

A potential scenario of rapid import reduction

To answer this question, we use a state-of-the-art global computable general equilibrium model – ENVISAGE (van der Mensbrugghe 2019).2 We first develop a baseline scenario of macroeconomic, energy, and emission profiles that is based on the continuation of current trends until 2030.3 We then simulate a scenario whereby the EU and other high-income countries4 impose restrictions on imports of fossil fuels from Russia starting from 2022. These restrictions are implemented in a form of tariff barriers that increase over time5 and cover natural gas, crude oil, coal, and petroleum products. While our model estimates the impacts for all represented countries and regions of the world, here we focus on the EU27, as this region accounts for over 54% of total Russian fossil fuel exports (UN 2022). The predicted reduction in imports of fossil fuels by the EU ranges from 40% to 60% in 2022 and reaches 70-90% in 2024 (relative to the baseline). 

We find that such restrictions could come at a very modest long-run cost to the EU. The cumulative reduction in real income is less than 0.4% in 2030. This translates into a slowdown in the income growth rate of only 0.04% per year – instead of growing at 2.18% per year, the EU’s real income would be growing at 2.14% per year over the period 2022-2030. 

At the same time, we find substantial environmental co-benefits of such a move. CO2 emissions drop by 3.1% in 2022 and the reduction reaches 5.5% in 2030 compared to the baseline. We also find major health co-benefits that come from reductions in the air pollutant emissions, such as fine particulate matter (PM2.5 and PM10), sulphur dioxide (SO2) and nitrous oxide (NOx). The decline in emissions of these substances ranges from 2.0% to 4.2% in 2024. During 2019 alone, at least 178,000 premature deaths could have been avoided if all EU Member States had reached the World Health Organization’s new air quality guideline (EEA 2022). Achieving such emission reductions would be a major contributor to reducing premature mortality in the region.

Figure 2 Impacts of restrictions of Russian fossil fuel exports by the EU and other OECD countries on the economies of Russia and the EU

 

Notes: Estimated by authors using ENVISAGE model. All changes are reported relative to the baseline scenario.

By contrast, such a move would be a major burden on the Russian economy, slowing economic growth, reducing government budget revenues, and substantially decreasing the country’s ability to finance military operations. The immediate reduction in real income would be almost 6% relative to baseline (in 2022) and would reach 8% percent by 2030.6 Our estimates also suggest that by 2030 the cumulative loss in real income for Russia would exceed $1.1 trillion, while cumulative export revenue losses from reductions in fossil fuel exports would amount to almost $1.4 trillion. 

Short-term risks for the EU

The Russian invasion of Ukraine has already put significant pressure on global energy markets. Brent crude oil prices have been pushed well over $110 per barrel – levels that have not been seen since 2012.7 To address these significant market and supply disruptions, International Energy Agency member countries have committed to release 60 billion barrels of crude oil from strategic reserves,8 but the pressure on gasoline prices continues to mount. The natural gas price on the Dutch TTTF Gas Futures has increased by over 90% relative to pre-war levels,9 adversely impacting the residential and industrial users in the EU. Further major restrictions on Russian energy exports, coupled with limited opportunities to switch energy suppliers in the short run, could place a further burden on consumers. In the results discussed so far, we have focused on the medium- and long-term impacts of fossil fuel import restrictions, but have not addressed the more immediate risks of such a move.

To account for the potential short-term implications of banning Russian fossil fuel imports, we explore a set of sensitivity scenarios, where we limit the trade substitution possibilities and impose more substantial restrictions on fossil fuel imports from Russia.10 The predicted reduction in imports of natural gas by the EU ranges between 79% and 90%, while for the case of crude oil the reduction is between 68% and 82%. Under such scenarios, real income in the EU decreases by 0.3-0.6% relative to the reference case, while energy prices for EU households on average increase by 6.7-8%. 

The magnitude of the short-term impacts would largely depend on the reaction OPEC, which could alter production plans to compensate for the lost Russian share of global supply. But even if OPEC and other energy exporters proceed with an output increase, it will likely take some time for EU to adjust the supply routes and substitute import sources. 

The bottom line

The immediate impacts (during the first few months) of restrictions on Russia’s fossil fuel exports are likely to be non-trivial. EU households’ real income could drop by 0.3-0.6% (relative to the reference case), with energy prices growing by 6.8-8%. On average, the poorest EU households spend 11.3% of their income on energy and transport fuels (European Commission 2020). This share substantially varies across countries, being as low as 6% in Sweden and exceeding 23% in Slovakia. Addressing the adverse impacts will require additional adaptation and diversification efforts from EU member states and implementing policies that reduce the economic burden on the most vulnerable. 

Note that we are focusing here on the markets for fossil fuels. However, the economic impacts of the conflict are likely to be more extensive – notably on the market for cereals and fertilizers, that will have ripple effects on global food security, as well as spillovers from the significant and multiple sanctions placed on the Russian economy.11 

At the same time, in the medium and long run, such restrictions could come at a modest cost for the EU economy, resulting in substantial environmental co-benefits through reductions in CO2 and air pollutant emissions. These mitigation costs are comparable to – and likely lower than – further increases in the EU Emissions Trading Scheme (ETS) carbon pricing. 

References

Chepeliev, M (2020), “GTAP-Power Data Base: Version 10”, Journal of Global Economic Analysis 5(2).

EEA – European Environmental Agency (2022), “Cleaner air could have saved at least 178,000 lives across EU in 2019”.  

European Commission (2020), “Energy prices and costs in Europe, Part II: Energy Costs for the economy, households and industry”, Commission Staff Working Document, COM(2020) 951 final.

IMF – International Monetary Fund (2021), World Economic Outlook: Recovery during a Pandemic—Health Concerns, Supply Disruptions, Price Pressures. 

Riahi, K, D P van Vuuren, E Kriegler et al. (2017), “The Shared Socioeconomic Pathways and their energy, land use, and greenhouse gas emissions implications: An overview”, Global Environmental Change 42: 153-168. 

UN – United Nations (2022), UN Comtrade Database.

van der Mensbrugghe, D (2019), “The Environmental Impact and Sustainability Applied General Equilibrium (ENVISAGE) Model. Version 10.01”, Center for Global Trade Analysis, Purdue University.

Endnotes

https://ec.europa.eu/eurostat/cache/infographs/energy/bloc-2c.html

2 The global economy in the model is represented by the following countries and regions: China, Indonesia, Philippines, India, Russia, Turkey, Egypt, Morocco, Brazil, United States, EU27, Rest of East Asia and Pacific, Rest of South Asia, Rest of Europe and Central Asia, Rest of Middle East and North Africa, Rest of Sub-Saharan Africa, Rest of Latin America and Caribbean, High-income Asia, Rest of High-income countries. A key data input to the model is the GTAP-Power 10 Data Base (Chepeliev 2020). The economy of each region is divided into 36 economic activities.

3 To represent GDP growth rates by countries we rely on the World Economic Outlook 2021 (IMF 2021) forecast to 2026 and the Shared Socioeconomic Pathways Database SSP2 scenario post-2026 (Riahi et al. 2017). 

4 We assume that restrictions are imposed by the following countries and regions: EU27, United Kingdom, United States of America, Turkey, Canada, Japan, Australia, New Zealand, South Korea, Honk Kong, Taiwan, Singapore, Switzerland, Norway, Iceland, and Liechtenstein. 

5 In 2022 we implement a 50-percentage-point increase in import tariffs for all covered commodities. In 2023 import tariffs increase by another 25 percentage points and in 2024 a cumulative increase reaches 100 percentage points, staying at this level until 2030.

6 Though it is still relatively early in the conflict, analysts are adjusting their 2022 forecasts for the Russian economy. For example, Oxford Economics has a scenario with a contraction of 3.1% in 2022 (https://blog.oxfordeconomics.com/content/a-darker-economic-scenario-from-russias-war). Goldman Sachs is projecting Russian GDP to decline by 7% in 2022 (https://www.ft.com/content/47121812-621a-404a-b60f-e2a7f62c5236). 

https://www.cnbc.com/quotes/@LCO.1

https://www.iea.org/news/iea-member-countries-to-make-60-million-barrels-of-oil-available-following-russia-s-invasion-of-ukraine    

9 https://www.theice.com/products/27996665/Dutch-TTF-Gas-Futures/data?marketId=5360399&span=1

10 To represent these scenarios, we use a static version of the ENVISAGE model with the trade elasticities reduced by half. Using this framework, we explore scenarios with a 100 and 150 percentage point increase in import tariffs for all covered commodities.

11 See for example Krugman in the New York Times (https://www.nytimes.com/2022/03/04/opinion/russia-ukraine-sanctions-economy.html?referringSource=articleShare).