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The G7’s oil price cap is a perilous gamble

Johannes Nordin is a junior research fellow at the Institute for Security and Development Policy.

Right before Russia’s Gazprom completely stifled gas flows through the Nord Stream I pipeline, G7 leaders had agreed in early September to implement a price cap on Russian energy exports. By leveraging Europe’s central position in the global maritime insurance industry, these measures seek to lower Russia’s inflated energy income not just from sanctioning states but from third countries as well.

However, the eleventh-hour mechanism carries grave risks and unintended consequences that shouldn’t be ignored.

The G7’s price cap is meant to align with the European Union’s sixth sanctions package and seeks to preempt a price surge when the EU oil embargo takes effect. Not to be confused with separate proposals for an EU-wide gas price cap, the G7 initiative works through shipping and insurance premiums — instead of sanctioning buyers or transporters of Russian energy, causing an upward squeeze on global prices, it seeks to put downward pressure on Moscow’s oil income by charging energy shipments higher insurance premiums, unless they comply with a yet-unspecified price cap.

Set above Russia’s marginal production costs, yet below today’s inflated prices, this ceiling price can be inferred to be around $60 per barrel (bbl).

Given its technical complexity, short implementation deadline and low efficiency should other large consumers of Russian energy opt out, experts have remained wary of the vague proposal. Despite diplomatic efforts to court their support, thus far neither Turkey, China nor India — the three largest importers of Russian fossil fuels outside the EU — have responded positively to calls for joining any sanctions regime. In fact, all three have increased their Russian energy imports.

Additionally, while approximately 90 percent of the global oil shipping fleet is insured by the London-based International Group of Protection & Indemnity Clubs, China and India have already accepted insurance from the state-controlled Russian National Reinsurance Company after Russia’s forced exit from the International Association of Classification Societies.

In the meantime, Beijing has once again urged dialogue instead of sanctions, pointing to global energy security concerns. Ankara, meanwhile, went one step further, with Turkish President Tayyip Erdoğan jeering that Europe was “reaping what it sowed” with its “provocative” policies toward Russia. In contrast, Delhi pledged to study the proposal carefully, albeit recently invoking its “moral duty” to secure affordable energy.

Several South Asian countries already experience rolling blackouts, outpriced on global markets with their currencies sliding against the dollar. India’s External Affairs Minister S. Jaishankar has thus charged Western critics with hypocrisy, pointing out that the EU buys more Russian energy than all other countries combined and secondary sanctions by the United States still block alternative suppliers. Referencing Europe’s silence on various issues in Asia, he further rebuked the outdated mindset that “Europe’s problems are the world’s problems” but not vice versa.

Economic and historical ties with Moscow and mutual aversion toward unilateral sanctions certainly play a significant part in the overall equation. Yet, from the perspectives of Beijing and Delhi, their continued energy purchases have kept global prices from spiraling even further by not adding to the crowded bidding war for the same limited oil supplies.

Considering the Kremlin’s consistent willingness to retaliate against sanctions, there’s also a genuine concern of further escalation, and Moscow’s recent threat to halt energy exports to countries observing the price cap and the Organization of the Petroleum Exporting Countries’ (OPEC+) decision to reduce September’s oil production levels are unlikely to incentivize any reconsideration.

However, price cap proponents maintain the positive effects still outweigh the drawbacks.

They note indirect impacts, pointing to Russian energy producers who are rushing to negotiate discounted oil contracts to shield themselves against losses. A price cap could thus help non-participating countries negotiate deals at even steeper discounts.

Meanwhile, Russia’s top consumer, China, is unlikely to significantly scale up imports, given the high importance awarded to energy diversification. And price cap circumvention will still drive up transportation costs and erode Moscow’s profits.

Finally, proponents call bluff on Russia’s threat to cut supplies, stressing oil revenues’ outsized role in state finances, the country’s limited storage capacity and the potential infrastructure damages that could occur from halting production.

While the initial points appear sensible, the last one rests on the unproven assumption that Moscow — a strategic player particularly “adept at negative-sum games” — would necessarily prefer some income to none.

But given an extremely inelastic global oil demand, even a demand-supply imbalance of a few hundred thousand barrels per day can cause price spikes. And with U.S. emergency oil reserves at multi-decade lows, OPEC+ favoring high prices, and Iran and Venezuela still under sanctions, there’s little spare capacity left. Moreover, soaring natural gas costs are already driving significant gas-to-oil switching worldwide. So, the Kremlin could very well wager a strategically timed price shock to global markets would weaken Western resolve more than it would hurt Russia.

Factoring in the price cap and partial retaliations, Goldman Sachs forecast average oil prices surging to $125/bbl for Brent Crude in 2023. More alarmingly, JPMorgan estimates Russia could cut daily production by up to 5 million barrels without excessively damaging its economy, squeezing prices to $380/bbl in a worst-case scenario.

Given these systemic risks, experts have been pushing energy tariffs as a less complex alternative to a price cap, which would avoid the need to monitor, enforce and adjust sanctions over time.

A tariff-based approach requires less political capital to persuade recalcitrant countries, entailing less intra-EU friction. Tariff-inflated prices also suppress relative demand for Russian energy, and they buy time for securing alternative suppliers. Proceeds can then be rediverted to alleviate consumer price increases, as well as the Ukrainian war effort.

In contrast, Moscow’s energy income doesn’t automatically translate into greater war-fighting resources. While a combination of currency controls, falling imports and boosted energy income has so far saved the ruble, Russia remains the world’s most sanctioned nation, with severely restricted imports in both quantity and quality.

Thus far, the steps to wean Europe off Russian energy before adequate substitutes were in place — and Russia’s retaliations — have elevated global prices and fomented resentment among outpriced developing countries. Attempts at shaming unwilling nations into taking sides — as with India — and allusions to potential punishment for continuing non-agricultural trade with Russia — for example, in Africa — have only fueled historical grievances with perceived Western arrogance. And predictably, the Kremlin has seized upon such frictions in its disinformation campaigns about the war.

Meanwhile, elevated energy prices have paradoxically led countries to pay Russia more for fewer imports, with the ensuing energy crisis catalyzing the largest energy market intervention in EU history, and Moscow’s still on track for a 38 percent year-on-year rise in energy export earnings in 2022.

The loss of the European market will, beyond doubt, severely impair Russia’s fossil fuel economy medium- to long-term. But in the short term, these setbacks may have been entirely avoidable.

Unfortunately, politically speaking, it’s now too late for tariffs.

Unlike a price cap, tariffs can’t coexist with a full-on embargo, precluding the EU from saving “face by not backtracking” on sanctions. And amid growing public discontent and skyrocketing energy bills, European governments are understandably worried about the effects on EU unity, should the Pandora’s box of sanctions be opened for interrogation even slightly.

Given these political limitations, EU and G7 leaders must double down on their efforts to swiftly bring back alternative energy suppliers. They must also practice more humility toward those involuntarily caught in the sanctions crossfire.

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