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The Sakhalin saga.

In early autumn 2006 the Western media carried headlines proclaiming that Shell and its Japanese partners in the Sakhalin Energy Investment Company (hereafter Sakhalin Energy) were victims of a Kremlin-orchestrated campaign to seize control of the project and hand it over to the state-controlled gas monopoly Gazprom. (1) The Russian Ministry of Natural Resources was alleging that Sakhalin Energy - a consortium developing the Sakhalin-2 oil and gas project - had breached various environmental regulations; and it was threatening to revoke the State Environmental Expertise Review that governed the project (the Russian equivalent of an Environmental Impact Assessment). Such action would have brought construction on the project to a standstill, resulting in billions of dollars of extra costs and further delay to a project that was already behind schedule and costing twice its original budget of $10 billion.

The immediate reaction of governments in the US, Europe and Japan was to cry foul and accuse the Kremlin of dirty play. The complaints went unheeded, however, the Kremlin feeling that it had legitimate concerns. President Putin later described the original Sakhalin-2 agreement as 'a colonial treaty that has absolutely nothing to do with the interests of the Russian Federation'. Throughout the autumn of 2006 pressure mounted, as Russian government representatives threatened billions of dollars in fines, and even criminal actions, against Sakhalin Energy. Much of the evidence used by Russian officials was obtained from a global campaign waged by the environmental movement, which was targeting the international financial institutions that were considering funding the project. Eventually, on 21 December 2006, the heads of Shell and their Japanese partners gathered in the Kremlin, in the presence of President Putin, to sign an agreement that handed over 50 per cent plus one share of the project to Gazprom, for a cash payment of $7.45 billion. The price was considered below market value by industry analysts, but this was an offer the companies could not refuse. Subsequently, the Kremlin leaked a confidential agreement with the foreign shareholders that further improved the financial terms of the project for the Russian government.

These actions marked a turning point for foreign investors in Russia. Not long afterwards Gazprom obtained TNK-BP's share of the Kovytka gas field in East Siberia, and legislation was enacted that favoured the two state champions, Gazprom and Rosneft. These two companies have been given exclusive rights to develop Russia's offshore oil and gas potential; and many now wonder what role foreign companies can play in the future development of Russia's oil and gas industry. While it is clear that Russia's state champions will in future have a controlling share, there are questions about their capacity to develop new production. And this is not just a domestic matter: Russia is the world's second largest exporter of oil, and its largest exporter of natural gas; and Europe is its largest customer. In 2006 Russia accounted for 43.3 per cent of the natural gas imports of the EU and 30.3 per cent of its oil imports. (2) The Sakhalin saga is a story that demonstrates the complex interplay of the political, economic and environmental concerns that now shape the global oil and gas industry. This article explores these complexities, and considers the wider lessons that can be learnt.

A brief background to Sakhalin-2

The Sakhalin region comprises the island of Sakhalin and the Kurile Island chain (which is subject to an unresolved territorial dispute with Japan). It is strategically located next door to some of the world's fastest growing energy markets. Chekhov famously described Sakhalin as 'hell', and from 1896 to 1908 the island was a penal colony; but for most of its more recent history it has been a neglected resource periphery, of strategic significance but limited economic importance. Its economy is focused on onshore oil and gas production, coal mining, forestry and fishing, and suffered steep declines during Russia's economic crisis in the 1990s. Its population declined by 28 per cent between 1990 and 2007, falling to 521,000. In recent years, however, Sakhalin has become one of Russia's fastest growing regions. It is now simultaneously one of Russia's most deprived regions, and one that receives more foreign investment than any other region apart from Moscow. This paradox is the direct result of the arrival of the international oil industry in the mid-1990s.

Offshore exploration dates back to the 1970s, when, following the first oil shock, the Japanese government advanced credits to the Soviet Union to finance oil and gas exploration in return for future supplies of oil and gas. In 1975 a Japanese company SODECO (Sakhalin Oil and Gas Development Company) was created, and two promising structures were identified: Odoptu and Chayvo (see map on p59). The project then became victim to deteriorating East-West relations, and Japan's involvement ended in 1983. However the local oil company, Sakhalinmorneftegaz (SMNG), continued to explore, and eight oil and gas fields were eventually identified; but by now the Soviet economy was in crisis, and it lacked both the capital and technology necessary to develop Sakhalin's offshore potential.

After the Soviet Union opened its economy to foreign investment in the late 1980s, Sakhalin attracted renewed attention. The Odoptu and Chayvo fields were still linked to the SODECO project of the 1970s - which later became Sakhalin-1 - but a second project was created around the Lunskoye and Piltun-Astokhskoye fields - which became known as Sakhalin-2 (see map). The fields are approximately fifteen kilometres offshore, northeast of Sakhalin, and are covered with ice for six months a year. In May 1990 a tender was announced for Sakhalin-2, but it was not awarded until early 1992, during which time the Soviet Union collapsed and Sakhalin's continental shelf came under the jurisdiction of a newly independent Russian Federation. The tender was awarded to a consortium comprised of US companies Marathon Oil and McDermott International (both of whom later left the project) and the Japanese company Mitsui. By year-end they had been joined by Shell, and a second Japanese company, Mitsubishi.

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In the early 1990s the Russian government was desperate to attract foreign investment to an economy that was in crisis, but Russia was politically unstable and the oil price was below $20 a barrel. Foreign oil companies demanded reassurances that their investments would be secure. This came in the form of a Production Sharing Agreement (PSA). According to Sakhalin Energy, a PSA is 'a contract between the investor and the state, which enables large-size, long-term and risky investments to be made by the investor'. The purpose of the PSA is 'to secure a set of terms and conditions applicable to the development of the resource by replacing the regular tax and license treatment with contractual provisions remaining in force throughout the lifetime of the project'. (3) On 22 June 1994 the Sakhalin-2 PSA was signed between the Russian Federation and Sakhalin Energy. The terms of the PSA are confidential, but a Shell executive working as the CEO of Sakhalin Energy later admitted they were 'the best PSA terms that you'll ever get in Russia, certainly in the future'. (4) One of the more peculiar aspects of the PSA was that the Russian party was to get no share of production until 100 per cent of the investors' costs had been recovered. Analysis of the Sakhalin-2 PSA commissioned by a group of environmental non-governmental organisations concluded that the particular terms of the Sakhalin-2 PSA were not typical of those incorporated in most PSAs throughout the world: 'The Sakhalin-2 PSA is particularly disadvantageous to the Russian party, and it is surprising that the Russian party agreed to these terms.' (5)

Russia has enormous oil and gas potential and much of its territory remains unexplored. Current oil and gas production is concentrated in West Siberia, in fields that have been producing since the 1970s and are now in decline. For Russia to sustain production and meet surging domestic demand and hungry export markets, it must invest in the development of more remote fields in Siberia, and in offshore developments in the Arctic and Sea of Okhotsk. Such development will require vast amounts of capital, and new technologies to deal with extreme operating environments and a fragile ecology. The foreign oil majors see themselves as having access to the necessary capital and technology to open Russia's new energy frontier. At the same time the oil companies are having problems in accessing new oil and gas fields, as over 80 per cent of the world's oil reserves are now controlled by states that favour their own national oil companies. The major oil companies today control a mere 5 per cent of the world's oil reserves (compared to 70 per cent in the 1970s). If they are to continue in business they therefore have to develop the more remote regions, such as the Arctic offshore, often in more risky geopolitical and/or environmentally sensitive situations; or develop non-conventional sources, such as oil sands. Oil company executives refer to this situation as 'the end of easy oil'.

In this wider context, the Sakhalin-2 project represents the future for the International Oil Companies (hereafter IOCs) - a large integrated oil and gas development project costing billions of dollars, to be implemented in challenging environmental conditions and a risky economic and political climate. The project is seen as a test case for future foreign investment in Russia. In the 1990s the IOCs were hoping that the Sakhalin PSAs would pave the way for large-scale foreign investment in Russia on their terms. However Sakhalin-2 has become a model far from what the IOCs originally envisaged.

Sakhalin Energy and the question of accountability

In the 1990s international financial institutions were called to account by NGOs for the environmental and social impacts of their lending. In response, the development banks, led by the International Finance Corporation, developed procedures to assess the impacts of the projects that they were being asked to finance. It is now common practice for large-scale developments seeking project financing to have to produce an environmental and social impact assessment, and an action plan that addresses how any negative impacts will be managed. The International Finance Corporation environmental health and safety guidelines were first introduced in 1998, and in 2003 they were extended to cover the provision of export credits by OECD member states, through the 'Common Approaches'. The IFC also launched the 'Equator Principles', aimed at commercial banks, to provide a basic framework for the management of social and environmental risks in project finance in the private sector. By May 2008, 60 of the major international commercial banks had signed up to the Principles and in 2007 some 71 per cent of total project financing for emerging market economies was governed by them. There is now strong conditionality attached to project finance for the extractive industries. When oil companies seek project financing, the IFC guidelines - which are seen as the benchmark of international best practice - now provide the global environmental movement with a means to hold them to account.

For Phase Two, Sakhalin Energy has sought over $5 billion in project financing. As a result, it has been the focus of a global campaign involving at least 146 NGOs in 22 countries. The local Russian NGO, Sakhalin Environmental Watch, has been at the centre of the campaign, supported by the California-based Pacific Environment and the UK-based Friends of the Earth and World Wildlife Foundation. Other specialist NGOs, such as the Oregon-based Wild Salmon Centre and the UK branch of the International Fund for Animal Welfare, have focused on specific issues such as the impact of the project on Sakhalin's salmon fishery, which is a major economic activity and source of sustenance on the island, and the status of the endangered Western Gray Whale, which has its summer feeding grounds in the area that is being developed.

Sakhalin Energy and its shareholders sought project financing not just to spread the political and economic risk, but also because the involvement of organisations such as the European Bank for Reconstruction and Development provides proof that the project is being developed to international standards in relation to the management of environmental and social impacts. However, though this reduces the reputational risk of the partners in Sakhalin Energy, it displaces some of that risk onto the potential lenders. In a letter to the Governor of the Japan Bank for International Cooperation the NGO coalition stated:
  Given the project's many irreparable policy breaches and Sakhalin
  Energy's chronic unwillingness to correct repairable damage,
  financing by JBIC will eviscerate your Bank's environmental and
  social credibility, increase risks to the Japanese government and
  damage the larger international effort to maintain ecological
  safeguards through the OECD Common Approaches and the Equator
  Principles. (6)


In 2003 the EBRD had declared the Environmental Impact Assessment for Phase Two unfit for purpose, but Sakhalin Energy had subsequently worked closely with the bank to address key areas of concern. In December 2005, announcing that the impact assessment process was now 'fit for the purposes of public consultation', the EBRD began a 120-day consultation process on the project, with public meetings in London, Moscow, Sakhalin and Sapporo, Japan. The NGOs had by this time produced a large amount of on-line material evaluating various aspects of Phase Two, making the case that it was clearly in breach of the IFC lending guidelines, as well as the Equator Principles.

The international NGOs tended to focus on the more charismatic elements of the impact, namely the plight of the Western Gray Whale, while the locally based NGOs and general public were far more concerned with the impact of onshore pipeline construction on the salmon fishery. The pipelines cross over a thousand watercourses, many of which are important salmon spawning rivers. Sakhalin Energy made an effort to address the EBRD's concerns: it re-routed the offshore pipelines to avoid the known whale feeding grounds, set up an independent Western Gray Whale Advisory Panel, developed an Indigenous Peoples' Action Plan, and revised its river-crossing strategy to reduce the potential impact on the fishery.

All of this activity contributed to the doubling of the cost of the project - from 'over $10 billion' to 'over $20 billion'. However, none of this additional cost was required by Russian state regulators: from a Russian perspective the increased costs simply served to delay the point of cost recovery, after which Russia would get a share of the project's production.

In early summer 2006, while Sakhalin Energy and the NGO community were still waiting for a decision on financing from the EBRD and its partners (the UK's Export Credit Guarantee Department, the US EXIM Bank and Japan's JBIC), the Russian Ministry of Natural Resources started to make accusations that the project did not comply with its own national legislation. The EBRD acknowledged that compliance with host country legislation was a prerequisite for making a loan, but argued that it also had its own decision-making process, which was independent of the Russian government. In September, after criticism of this response from the NGO community, the EBRD announced that no decision would be made until the project's position vis-a-vis Russian legislation was clear. Then, shortly after the Gazprom takeover of a majority share was agreed in December, the EBRD released a statement saying that it was no longer considering funding for Sakhalin-2. It claimed that this was because of changes in the project's ownership structure; and it noted, rightly, that it was its involvement that had forced Sakhalin Energy to make improvements to the project.

The EBRD had avoided a difficult decision, but had left exposed the other financial institutions involved. The UK Export Credit Guarantee Department has been the subject of a freedom of information case by the Corner House and Friends of the Earth-UK, which alleges that the Department agreed to support Sakhalin-2 before a proper Environmental Impact Assessment had been conducted. (7) In autumn 2007 Sakhalin Energy claimed that an independent assessment of the Health, Safety, Environmental and Social Action Plan of the project, prepared for potential lenders by consultants AEA Technology, showed a 'high level of compliance'. However the NGOs accused Sakhalin Energy of misrepresenting the report's findings, arguing that in fact it demonstrated 'widespread non-compliance'.

In March 2008, Sakhalin Energy announced it was withdrawing its request for funding from the ECGD, and from the US EXIM Bank, on the grounds that the project was 90 per cent complete and the timeframe for reaching a decision on further funding no longer made sense. This was interpreted by the NGOs as a victory: 'This announcement is a triumph for local environmental groups that have formed a coalition with national and international environmental organizations to block billions of dollars in public and private financing due to the chronic environmental impacts of the project'. (8) But it is likely that there had also been reluctance by the UK and US governments to provide financial support to a project that was now controlled by Gazprom, who in turn are controlled by the Russian Government.

Whatever the reasons for it, the victory was short-lived. In June 2008 Sakhalin Energy announced an agreement on financing with the Japan Bank for International Cooperation and a consortium of international banks, JBIC providing $3.7 billion and the banks $1.6 billion. The banks involved are Japan's Bank of Tokyo-Mitsubishi, Mizuho Corporate Bank, Sumitomo Mitsui Banking Corporation and France's BNP Paribas. At least one of these is an 'Equator Bank' and JBIC is bound by IFC guidelines. However, the reality is that energy security takes priority over concerns about the environment, and Japan will be the major recipient of Sakhalin-2's energy exports.

State control of Russia's resource wealth

Up until the summer of 2006 the bulk of the campaign against Sakhalin-2 had taken place outside of Russia: Moscow had seemed unconcerned by what was happening. But the origins of the changes in policy that came to a head in 2006 can be seen in Putin's policies from immediately after he became President in March 2000. Under Putin major changes started to take place in Russia, both in the locus of power and influence, and in the role of the state in the energy sector.

President Putin inherited an economy recovering from the 1998 financial crisis, but a federation that was fragmented. He quickly set about re-establishing what he called the 'power-vertical', firmly reasserting central control over Russia's regions. On Sakhalin this meant that the Governor and his administration lost influence over the development of the offshore projects, and the oil companies had to reorient themselves towards Moscow. At the same time, the state made moves to regain control over the country's oil and gas industry. This started with the Kremlin regaining a controlling share in Gazprom. After the attack on the private Russian oil company Yukos its production went into the hands of the state owned company Rosneft; and Gazprom purchased Sibneft, Roman Abramovich's oil company, for $13 billion. In 2000 the state controlled about 16 per cent of Russian oil production, but by 2006 this had risen to over 40 per cent. In explaining this strategy, much is made of a dissertation supposedly written by Vladimir Putin in 1997 at the St Petersburg Mining Institute. The central argument of the dissertation was that mineral wealth would be the basis of Russia's economic recovery and that, while the market would prevail, the state would play an important role in this process; it would regulate the resource sector and promote the formation of large vertically-integrated companies that could compete with Western multinationals. (9) Whatever the influence of the dissertation may have been, this strategy has certainly gained momentum: Gazprom and Rosneft now determine the future of oil and gas in Russia.

Sakhalin-2 was an obvious target for the Kremlin. It was Russia's largest new oil and gas project and was building Russia's first Liquified National Gas plant and developing a new energy relationship with Asia-Pacific, but it had no Russian involvement. Shell was well aware of this vulnerability and in 2005 had tried to negotiate a deal to give Gazprom a 25 per cent share; but this had failed when Shell announced the doubling of the project's costs. It was after this that Russian officials successfully used the arguments put forward by the NGOs concerning environmental impacts to attack the project. The Kremlin also maintained that the Production Sharing Agreement had not been a good deal for Russia and demanded a renegotiation of terms. Ultimately, it was the NGO campaign that enabled Gazprom to seize control of Sakhalin-2. But since Gazprom's arrival the problems with the Ministry of Natural Resources have disappeared.

Lessons learnt

The twists and turns of the Sakhalin saga, and the complex interplay it represents between different lobby groups and national and international interests - which have themselves changed over time - has not been well understood by western media commentators and politicians. What lessons can be learnt?

First, there were and are significant negative environmental impacts associated with Sakhalin-2. The charges about environmental damage were not manufactured. Rather, those concerns have 'disappeared' since Gazprom took control, which necessarily leads to a questioning of the integrity of the Kremlin's actions. However, had not Sakhalin-2 fallen foul of the state's existing domestic regulators - which can perhaps be seen as a consequence of too much attention having been originally paid to the concerns of potential international lenders - none of this could have happened. Furthermore, Shell and Sakhalin Energy have now been accused of 'stage managing' the autumn 2007 independent assessment made by AEA Technology, which was instrumental in paving the way for their financing deal.

Second, without the generous terms of the original PSA there would be no Sakhalin-2 project at all. But with the benefit of hindsight the Russian government clearly felt that those terms were too disadvantageous. Given the subsequent actions to correct the situation, the foreign partners are probably relieved that they still have a share in what remains a very profitable project. Gazprom also paid them for its controlling stake: the project was not nationalised without compensation. The wider lesson for the oil companies and energy-importing countries is that it is the governments of oil and gas rich countries that now dictate the terms of access, ownership and profit. This poses a fundamental challenge to their business models.

Third, while one would hope that Shell would have learned to better manage the environmental and social impacts of its activities, the real lesson learned, unfortunately, is to avoid project financing. Exxon-Mobil's Sakhalin-1 has been virtually immune to NGO pressure, largely because the consortium is using its own money to fund the project. That said, the fact that Sakhalin Energy still in the end got its financing suggests that some banks and financial institutions are willing to ignore their own guidelines in the increasingly intense competition for energy.

Fourth, although ultimately unsuccessful, the NGO campaign clearly demonstrates how the conditionality attached to project financing can be used to hold oil companies to account. Many improvements were made to the project in response to concerns that were first raised by the NGO campaign. Unfortunately, the unintended outcome of their campaign is that Gazprom is now in control, and is unlikely to listen to their concerns in the future. Rather, Moscow's desire for profit and influence will take precedent.

Finally, the Sakhalin saga points to the nature of future conflicts over oil and gas development. Oil companies such as Shell and Exxon-Mobil see Sakhalin as a testing ground for future exploitation of the Arctic. (The irony is that climate change is resulting in increased accessibility to potential oil and gas reserves in the Arctic.) A recent estimate by the US Geological Service suggests that 10 per cent of the world's known conventional petroleum resources are located in the Arctic, and 84 per cent of that is expected to be found in offshore areas. Shell recently purchased rights to explore in the Chukchi and Beaufort Seas offshore of Alaska, but has not started exploration due to outstanding legal actions by NGOs. For Shell and the global environmental movement, the Sakhalin saga may be over. But the battle to protect the Arctic is only just beginning.

Notes

(1.) 'Cynical on Sakhalin' was the headline in the Financial Times on 19.09.06.

(2.) Source: Eurostat, May 2008. The figures include totals for Bulgaria and Romania, which actually joined the EU at the beginning of 2007.

(3.) Sakhalin Energy, 2006 Annual Overview, Yuzhno-Sakhalinsk, Russia, 2007.

(4.) This is a quote from Steve McVeigh, then CEO of SEIC, in Rawi Abdelal, 'Journey to Sakhalin: Royal Dutch/Shell in Russia', Harvard Business School Case Study 9-704-040, 2004.

(5.) Ian Rutledge, The Sakhalin II PSA--a Production 'Non-Sharing' Agreement, Sheffield Energy & Resource Information Services, 2004, p3.

(6.) This letter and associated documents can be found at: Banktrack's website: www.banktrack.org. Select Sakhalin Oil and Gas Project under 'Dodgy Deals'.

(7.) For details visit: http://www.thecornerhouse.org.uk/.

(8.) 'Environmental Victory: Sakhalin-2 announces that it cannot get financing from US and UK Export Credit Agencies', Joint Press Release from Pacific Environment, Sakhalin Environment Watch and WWF-UK, 4.3.08.

(9.) Harley Balzer, 'Vladimir Putin's Academic Writings and Russian Natural Resource Policy', Problems of Post Communism, 53, 2006, 1. This article includes a translation of an article written by Vladimir Putin on 'Mineral Natural Resources in the Strategy for Development of the Russian Economy', originally published in Russian in 1999.

Michael Bradshaw

Michael Bradshaw discusses the complex interplay of interests that has shaped the history of the Sakhalin-2 project.
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Date:Dec 22, 2008
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