Strategic interdependence in the East-West gas trade : a hierarchical Stackelberg game approach

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Abstract
The current and potential benefits of the East-West gas trade are enormous for all participants. Realizing those benefits requires significant upfront investments. But the new, more complex structure of the gas transit system that has emerged following changes in Eastern Europe and the former Soviet Union has created uncertainties that bear on the expected benefits from investment. The authors argue for the existence of stable contracts that would create an environment more conducive to investments and allow all participants to benefit from expansion of the gas trade. As a guide to formulating incentive-compatible, transparent, flexible contracts, they propose a framework based on a Stackelberg game, with three players (a supplier, a transiter, and an importer) under Russia's leadership. They use this framework to analyze the contract modifications that would ensue from changes affecting the gas trade. They concluded that: (a) increased competitiveness of the transiter and supplier through cost reductions would improve the payoffs to all players (the transiter's and supplier's profits and the Western importer's welfare). Strategic behavior on the part of the supplier and transiter would ultimately reduce the price to the importer, enlarging gas demand and reducing costs. If increased competitiveness is the outcome of more costly gas from sources other than Russia, both the supplier's and the transiter's payoffs would improve but the importer's welfare would deteriorate. The supplier and transiter would have leeway to strategically raise their price and transit fee, respectively, while gaining market share. But the importer would face rising costs for gas imports and would lose welfare; (b) an increase in the scope for the importer to substitute between alternative sources of gas improves welfare for all three players. The perception by the supplier and transiter of increased threat of competition leads to a preemptive move not to lose market share. The transiter and
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