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Formation of fair-pricing model in the case of common energy market

Purpose – To develop proposes for creating a new fair-pricing model for use by countries entering a common energy market and analyze the countries that buy and sell energy, as well as reveal key issues overlooked.

Methodology – The methodological base for the research is dialectical method and system approach. The work employs such general scientific techniques and methods as scientific abstraction, analysis and synthesis, comparison, generalisation and descriptive analysis.

Originality/value – The topic is more relevant to Eurasian countries, because of political decision to establish a common economic market by 2020. But the question remains open on the mechanism of price and tariff agreements. This new model addresses key issues that are overlooked now: systemic and political risk inherent in counterparties, and human capital accumulation. These concepts are widely used in the financial industry, but are overdue in energy disputes.

Findings – The proposed model makes sense from the academic point of view. Authors propose to expand the discussion and to include new components – economic (systemic) risk and human capital, which has not been applied yet in theory in the context of energy disputes. The topic is more relevant to Eurasian countries, because of political decision to establish a common economic market by 2020. But the question remains open on the mechanism of price and tariff agreements. Proposed model will project the definition of fair energy prices in the common energy market of Eurasia. It will be possible to apply the model for the EU member states, and compare the results with the reality, to analyze whether the principle of fair pricing is applied and to determine the pressure of political influence. 

Introduction. Research Background

This article addresses an immediate need. In April of this year, the governments of Kazakhstan, Russia, and Belarussia signed an agreement to create a common energy market.

The treaty establishing EurAsEC was signed on October 10, 2000 in Astana and entered into force on May 30, 2001 after its ratification by all Member States. Members of the Eurasian Economic Community since its formation are the five states – Belarus, Kazakhstan, Kyrgyzstan, Russia and Tajikistan.

On January 25, 2006 the Protocol of Accession of Uzbekistan to the Organization was signed. In October 2008, Uzbekistan has suspended the participation in the work of the EurAsEC.

Since May 2002, the status of observers gained Ukraine and Moldova, in January, 2003 – Armenia.

Observer rights are also held by the Interstate Aviation Committee and the Eurasian Development Bank.

The main tasks for the Community are the following:

  • – completion of registration in full free-trade regime, the formation of a common customs tariff and a unified system of non-tariff regulation;
  • – the free movement of capital;
  • – creation of a common financial market; 
  • – harmonization of principles and conditions for the transition to the single currency within the Eurasian Economic Community;
  • – establishing common rules for trade in goods and services and their access to domestic markets;
  • – a common unified system of customs regulations;
  • – development and implementation of interstate target programs;
  • – creating equal conditions for production and business activities;
  • – establishment of a common transport market and the integrated transport system;
  • – formation of a common energy market;
  • – creating equal conditions for foreign investment in the markets of the Community;
  • – ensuring the free movement of citizens of the EurAsEC states within the Community;
  • – harmonization of social policies in order to create community welfare states, providing a common labor market, common educational space, coordinated approaches to healthcare issues, labor migration, and others;
  • – approximation and harmonization of national laws, ensuring interaction of legal systems in order to create a common legal space within the Community .

EAEC transformed to EurAsian Economic Union (EAEU) in 2013, it is a fundamentally new level of Eurasian integration. That’s why the key direction of integration work is the creation of a common market, in particular, the market of energy resources. In EAEU energy is one of the leading industries. Member states, of the union have long been cooperating in the field of mining, transportation and processing of energy resources, their energy sectors are closely intertwined. Therefore, the creation of a common energy market is the most important direction of the Eurasian integration, which ensures reliability and security of supply, attracts mutual investments, as well as provides a more efficient use of fuel and energy potential. In accordance with the Treaty on the EAEU our common electricity market will start operation by July 1, 2019, and the common market of gas, oil and oil products by January 1, 2025. The process of creation of the common market was divided into several stages. The initial stage involves the development and approval of the relevant concepts. The next stage is about the programme implementation and plan of actions, and ultimately – the establishment of the common market. Indeed, the main purpose of our integration is a synergistic effect. According to the EEC in 2030 the effect of participation in the Eurasian Economic Union can result in additional 13 percent of GDP growth for its member states. This is one of the main visible advantages of EAEU existence. To create a single electricity market, it is necessary to provide price transparency and to develop market mechanisms within the countries. It should be noted that last year the volume of mutual trade in electricity among EAEU amounted to about 6 billion kWh and decreased by 30% in comparison to 2013. In return the creation of the single market will improve the situation and double the volume of mutual trade in electricity. According to some reports, loading of generating capacity may also be increased by 7%. However, there may be some obstacles like diverse pricing policies and inconsistencies in legislation.

Our topic is relevant due to the fact that it discusses the settlement of energy conflicts that may arise between countries. The conflict between Russia and the EU Charter is an example to it. This example is indicative for Central Asian countries, since energy security is a key factor of industrial development of any country. Issues regarding access to gas and electricity are the most important for society.

Main Body.

In this paper we are going to consider an applicable model in determining transfer prices for gas taking into consideration the political influence of countries.

First of all it is necessary to find a theoretical framework for addressing these issues.

Theoretical Background

Usually academics consider two types of market: a perfect market and a monopoly market in various degrees. No need to explain that this classification is not entirely applicable for energy markets. P. Krugman (1979) focuses on the scale effect and shows that large enterprises may push smaller ones out of the market, and they gradually turn into a monopoly as a result of reliving tariff barriers [1]. Developing a simple model of monopoly competition, P. Krugman showed the economic consequences of the phenomenon.

Even if the market is formally monopolized (high concentration) simple models for concentrated markets will not work in this case, because they do not take into account the political and legal aspects [2].

In the literature, systematic risk definitions appeared during the 1990s. However, this term was globally using during the global financial crisis. The nature of systematic risk is coming from finance [3]. International Monetary Fund (2015) considers that systemic risk assessments based on measures of excess credit should be performed with different indicators at different stages of financial development [4].

Dow (2000) argues that this risk has several subspecies and has a macroor microeconomic effects [5]. Davis (1995) identifies this term asimbalnace between system [6]. As a system he considers financial intermediation Nier (2009) indicates that the growth of aggregate demand increases the possibility of this risk. Probability of financial institution's default is a systematic risk on micro level. In both cases the financial system is negative affected. The more precise studies of systematic risk on micro level is given by Viktor Todorov and Tim Bollerslev (2010) in their theoretical framework for sensitivities towards continuous and discontinuous systematic risks [7]. Their analyses based on the assumption there is no diversification policy to predict and avoid risk.

De Bandt and Hartmann (2000) differentiated a horizontal and vertical systematic risks. The horizontal view is limited to events in the financial sector alone (through the bankruptcy of financial intermediaries or the crash of financial markets). The vertical view focuses on systemic risk, in which the impact of a systemic event on output is taken to gauge the severity of such an event [8].

We continue to use Davis's idea and consider the systematic risk as a result of imbalance in a system. Our system is negotiation process of establishing fair prices for members of the economic integration in the stage of common market.

Thus, the term "integration" has entered the world of science to describe quite certain, specific process in international relations. In our view, economic integration is an objective process of development of strong economic ties between the national economies that cover the sphere of production and lead to the creation of regional economic complexes. From a scientific position, integration is a contractual association of sovereign states that join their resources to improve the effectiveness of the national economy and overcome some of the difficulties and contradictions of economic globalization. A common market can be considered the first stage of deep economic integration. Free mobility of the key participants in the process of production is its characteristic. In addition to goods and services, capital and people move freely inside a common market. The benefits expected consist of further gains in efficiency through a more appropriate allocation of resources: capital moves to where skills are and people move to where opportunities beckon [9].

Activity of modern integration unions can be characterized by moving them to the main groups: dominance, interdependence and cooperation. The first group is characterized by the spontaneous formation of alliances, by the creation of such alliances on a global scale. And a certain one-sided benefit, lack of the legislative framework, control of compliance with agreements on the part of the country is more interested in the interaction.

Determining a second group based on the states of integration:

  • the interdependence of countries – participants;
  • to develop mutually beneficial terms of cooperation;
  • establishment of joint bodies of control and regulation;
  • long-term cooperation agreement;
  • – protection of national interests.

For the relationship of the third group is characterized by the integration with the following conditions:

  • the prevalence of integration advantages over negative consequences;
  • mobilizing efforts to solve common problems;
  • the establishment of joint coordinating supranational bodies;
  • the presence of a single joint strategy of integration development.

Complex interaction of integration trends in the context of globalization is based on theoretical approach to explain the relationship with countries. The modern theory of international economic integration based on the classical theory that the basis for the creation and development of specialization is based on the competitive advantages of the country. In this case, some sectors of the national economy with an opportunity for further growth, while others are shrinking.

Despite the existing flow, the core of integration is to improve member countries, increasing competition and achieving social development. Under economic integration is considered a feature of the present stage of development of the world economy and at the same time aimed at achieving macroeconomic indicators not only one country but the entire region. Controversial issue is the achievement of regional goals to the detriment of individual countries. The solution to this problem lies in the essence of the phenomenon of economic integration, but the practical side is international experience and can be borrowed countries. This process of accretion of the economies of neighboring countries into a single economic complex is on the basis of strong economic ties between national actors. Level of integration can be determined by the following three criteria:

  • the number of interested and involved in the areas of integration;
  • the presence of supranational institutions;
  • the number of members of the participating countries.

International economic integration is a feature of the modern type of the global economy, aimed at accelerating the development of regional economies and improve the international competitiveness of countries members of the integration The notion of integration is not identical to the definition of the process of globalization, due to varying degrees of control allocation of factors of production. Thus, the integration basis is a recognized need of broad and comprehensive development of trade and economic cooperation, and cooperation in the future is creating a self-sufficient and secures the overall market. By pushing the need for the support of domestic producers and creating equal conditions for business activities on a single economic space.

According to one of the concepts of the theory of integration market is the principal instrument of governing the economy. In turn, state activity is considered as a source of disruption balance business environment. The impact of the state according to the followers of this concept applies not only in the domestic market but also in international politics.

In addition to the common external tariff that defines a CU and to ensure the viability of a CM, uniform regulations have to be worked out among the members regarding the movement of people and capital. This is a major task that requires, at least over time, agreement on qualifications and certifications of workers from different member countries [10]. .

For a CM to become effective, therefore, co-operation in decision-making is required in yet more areas. Non-tariff barriers have to be dismantled, structural adjustment policies have to be jointly reassessed, distribution policies will face harmonization pressures, and fiscal and monetary policies, as a dynamic consequence or by design, will show greater convergence. This convergence results from the increased economic interdependence among the members and necessitates that greater consideration be given to the effects of national policies on the welfare of CM partners.

Many economies depend on the volatility of energy prices. Countries that have energy resources (oil and gas) face the difficulty of selling their product to other countries. Energy markets are essentially monopolies and are characterized by a high margin. Energy is often bought and sold on wholesale markets before reaching the final consumer. To ensure the smooth functioning of these markets and prevent price manipulation, the EU [11] for example has enacted regulations which prohibit the use of insider information or the spreading of incorrect information concerning supply, demand, and prices.

For example, country A sells gas to wholesale buyer from country B at a price for country A, let’s say p1, where p1 is several times higher than the cost.

Country B sells the imported gas to other companies and also makes its own mark up, so p2 = p1 + delta (margin of a wholesale company in the country B). Markup = p2 c,

To meet the conditions of fairness in the distribution of markup, it is necessary to determine the level of sensitivity of two economies to the energy prices. Each country is characterized by its level of sensitivity: β1 for country A and β2 for country B. We can estimate the amount of energy price risk β, as a regression coefficient (1):


Note Constrain by author

Human Capital accumulation and destruction

Figure 1 – Human Capital accumulation and destruction

As we can see from the figure 1 green color is accumulation, red is destruction. The low equilibrium is stable. When green above red human capital accumulates faster until the steady state is reached. When green below red human capital is destroyed faster until H falls back to the steady state. When exogenous shock moves the human capital stock so that H>1 the economy enters a new growth path: green always above red, human capital grows

We define the amount of human capital with a scalar , where i is an identificator of a project and t – is a time period, and I model the relation between the survival probability and human capital as a linear function (formula 3):

The equation is a quadratic equation in respect to , which implies that the system has two stable equilibriums: with low and with high levels of human capital . If the system starts from low level of human capital it may stuck in the suboptimal equilibrium point without external help. Such help can come in a form of protective tariffs which increase the probability of business projects to succeed, and accelerate accumulation of human capital.

Practical value

The practical value of the proposed model will allow:

  1. Analyzing the countries that buy and sell energy to determine their level of sensitivity to delivery. This analysis can be done on the example of the EU member Compare the results with the reality, to analyze whether these parameters are taken into account or not.
  2. Projecting the definition of fair prices in a common energy
  3. Calculating the demand and coming to an agreement, thus removing the conflict (for example, "gas issue" in Ukraine).
  4. Developing a plan of action to implement the EAEU programme.

The proposed model makes sense from the academic point of view. We propose to expand the discussion and to include new components – economic (systemic) risk and human capital, which has not been applied yet in theory in the context of energy disputes. The topic is more relevant to Eurasian countries, because of political decision to establish a common economic market by 2020. But the question remains open on the mechanism of price and tariff agreements. Our model will project the definition of fair energy prices in the common energy market of Eurasia. It will be possible to apply the model for the EU member states, and compare the results with the reality, to analyze whether the principle of fair pricing is applied and to determine the pressure of political influence.



  1. Krugman Paul Increasing Returns, Monopolistic Competition, and International Trade // Journal of International Economics. – 1979. – № 9 (4). – pp. 469-479.
  2. Loktionov V. Does accounting quality mitigate risk shifting? – 2009. – P. 45.
  3. Todorov Viktor, Bollerslev Tim Jumps and betas: A new framework for disentangling and estimating systematic risks // Journal of Econometrics. – 2010. – № 157 (2). – pp. 220-235.
  4. IMF Working Paper African Department Systemic Risk Assessment in Low Income Countries – Balancing Financial Stability and Development. – 2015.
  5. Dow, What Is Systemic Risk? Moral Hazard, Initial Shocks, and Propagation // Monetary and Economic Studies, Bank of Japan. – 2000. – pp. 19-21. Davis Systems and Systemic Risk in Finance and Economics. – Systemic Risk Centre Special
  6. – 1999. – № 1. – January, 3.
  7. Arena, M, Bouza , Dabla-Norris E., Gerling K., Njie L. Credit Booms and Macroeconomic Dynamics: Stylized Facts and Lessons for Low-Income Countries. – IMF Working Papers. – 2015. – № 15/11.
  8. Caggiano G., Calice , Leonida L. Early warning systems and systemic banking crises in low income countries: A multinomial logic approach // Journal of Banking & Finance. – 2014. – № 47. – pp. 258-269.
  9. Claessens, , Ayhan Kose M. Financial Crises: Explanations, Types, and Implications. – IMF Working Papers. – 2013. – № 13/28.
  10. De Bandt, , Hartmann P. Systemic risk: A survey. Working Paper Series. – 2000. – № 35. – ECB, 13.
  11. De Nicolò, G., Favara, G., Ratnovski, L. Externalities and Macroprudential – IMF Discussion Note SDN/12/05, IMF, 7-10. – 2012.
  12. Rakhmatulina G. Impact of the Customs Union on the economic development Kazakhstan. Prospects for integration in the petroleum sector // Eurasian economic integration. – 2012. – № 1 (14). – 78-79.
  13. Mukhamedzhanov B. Perspectives of the Common Economic Space. – The Foundation of the First President of the Republic of Kazakhstan, Almaty, – pp. 20-27.

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