Azerbaijan 2021

Energy Policy Review

Aerial View Of Baku Azerbaijan

About this report

Oil and gas continue to dominate Azerbaijan’s economy and provide most of its export and government revenue. While these resources have sharply raised the country’s living standards since the late 1990s and remain plentiful, the long-term outlook for this economic model is uncertain. Oil production is declining and major oil and gas importing countries have pledged to reduce greenhouse gas emissions to net-zero by mid-century, implying little demand three decades from now for oil or gas without carbon capture and storage.

This report assesses the energy sector and related economic challenges facing Azerbaijan. It proposes several ways to respond by increasing the efficiency and diversity of domestic energy supply and use. The overriding recommendation is a gradual transition to competitive markets with significant private sector participation and energy prices that reflect the cost of production. The withdrawal of subsidies should be accompanied by support measures for those most in need. Such a transition would attract new market entrants and new investments, helping to develop Azerbaijan’s significant solar and wind potential, and limiting greenhouse gas emissions.

These recommendations are in line with efforts already underway in Azerbaijan. Prompted by the oil price shock in 2014-15, the government has recently drafted proposals for electricity and gas market reforms, as well as laws on energy efficiency and renewable energy. The country’s first specific energy strategy is also nearing completion. The report encourages Azerbaijan to move swiftly to adopt all these proposals and implement them effectively to ensure secure and sustainable energy in the future.
Executive summary

Oil and gas exports continue to dominate Azerbaijan’s economy and provide the majority of government revenue. Although they are plentiful, the long-term outlook for fossil fuel resources (and therefore for government revenue) is becoming uncertain in light of recent commitments by major importing countries to achieve net-zero greenhouse gas (GHG) emissions by 2050.

This report proposes several ways to increase the efficiency of domestic energy supply and usage to respond to this challenge. In essence, it recommends that Azerbaijan transitions gradually from its current system – which is government-owned and -operated, vertically integrated and subsidised – to competitive markets with significant private sector participation and cost-covering energy prices. Of course, subsidy withdrawal would need to be accompanied by support measures for financially vulnerable citizens. Such a transition would help diversify the economy away from oil and gas exports while attracting new market entrants and new investments, including in renewable energy. These measures would also help reduce GHG emissions.

These recommendations actually support efforts that are already under way. Prompted by the oil price shock of 2014-2015, the government recently drafted several reform proposals, and many new laws are awaiting approval. Laws governing the electricity and gas sectors since the 1990s will be revised, and specific legislation on energy efficiency and renewable energy will be introduced. In addition, the country’s first specific energy strategy is nearing completion. The government has furthermore decided to diversify foreign direct investment away from oil and gas and towards infrastructure and industry, and it has already taken steps to improve Azerbaijan’s investment climate.

Scaling down the long-term importance of oil and gas

Oil and natural gas bring in around 90% of Azerbaijan’s export revenues, and they finance around 60% of the government budget. They also supply 98% of primary energy and more than 90% of the country’s electricity. Oil and, more recently, gas have been largely responsible for the remarkable rise in living standards in Azerbaijan since the late 1990s.

Azerbaijan has succeeded in creating a stable upstream oil and gas investment climate and has become an important and reliable oil and gas exporter. A major achievement of international significance is the recently completed Southern Gas Corridor (SGC) that supplies gas from Azerbaijan’s Shah Deniz 2 field to Europe through Turkey. The SGC gives Azerbaijan a new source of gas export revenues while helping Europe diversify its gas supply routes and improve gas security as its domestic production continues to to decline. The IEA expects European gas import demand to rise by around 45 billion cubic metres per year (bcm/a) by 2025.1 With capacity increases, the SGC could transport twice the 16 bcm/a production of the Shah Deniz 2 field, which could lead to Azerbaijan becoming a regional gas hub.

Although oil and gas will remain major sources of wealth for Azerbaijan in the short and medium terms, two factors in particular indicate a less important role for them in the long term. The first is that oil production, which dates to the mid-19th century, has been in decline since 2010. Although natural gas production, which became significant in the 2000s, continues to increase, total export revenues are falling due to lower oil production. The oil price shocks of 2014-2015 and 2020 highlighted the risks of short-term fuel price fluctuations and strengthen the case for further long-term efforts to diversify the economy.

Second, the emerging global push for clean energy will inevitably affect oil and gas demand. Several of the world’s largest energy importers (the European Union, Japan and South Korea) have recently pledged to reduce GHG emissions to net-zero by 2050, and China is aiming for the same by 2060. These targets therefore imply little demand for oil or gas without carbon capture, utilisation and storage (CCUS) three decades from now. Technology breakthroughs and policy changes may further accelerate this transition, and competition for export opportunities among producing countries may well intensify, increasing the risk of many oil and gas assets becoming stranded.

Managing the costs of new developments is crucial to Azerbaijan’s future success as an internationally competitive producer, and reducing the carbon footprint of production is also likely to be necessary. The State Oil Company of the Azerbaijan Republic (SOCAR), the country’s national oil company, is targeting to eliminate gas flaring completely in 2021 and is also successfully working to reduce methane emissions. The potential of using CCUS to enhance oil recovery and produce hydrogen from natural gas should also be studied. The IEA encourages the government to continue working closely with the leading oil and gas sector companies operating in the country to reduce sectoral emissions.

The government has recognised the need to reduce economic dependence on oil and gas exports. Efforts to modernise and increase oil refining and petrochemical production have been successful and continue to produce improvements. SOFAZ, the State Oil Fund of the Republic of Azerbaijan, could stimulate further diversification. 

A path to a more efficient, dynamic and sustainable energy system

It is critical to increase efficiency, attract new entrants and investments, and diversify the energy supply in Azerbaijan’s current energy system in which gas, electricity and heat are supplied by financially burdened monopolies at strongly subsidised prices. Policy responses should therefore include energy tariff reform, electricity and gas market reform, greater renewable energy use and higher energy efficiency.

The level of energy prices is central to attract investment and encourage citizens to use energy efficiently. As part of the country’s social policy, the government sets domestic end-user prices for electricity, natural gas and oil very low, often below the full cost of supply. The IEA estimates that in 2019, Azerbaijan’s implied subsidies for oil, natural gas and decline.

The tariff system includes cross-subsidies between consumer groups and energy carriers as well as direct subsidies from the state budget. The low price of natural gas in particular creates distortions. For example, it discourages the use of renewable energy for electricity production and, as it favours individual gas boilers for space heating, it inhibits the use of potentially more efficient system solutions such as district heating and cooling, electricity and heat pumps. Low oil prices meanwhile encourage the use of large, inefficient cars that are often acquired second-hand, and the effects of this may intensify as car ownership becomes more common.

Subsidised tariffs do not encourage residential and industrial consumers to use energy more efficiently, even though it would make economic sense for the country as a whole. Tariff reform should therefore be central to Azerbaijan’s energy sector reform efforts. The oil and gas saved through improved efficiency or through substitution by renewable energy could be exported at much higher prices or turned into higher-value-added petrochemicals. Furthermore, the GHG emissions avoided would help the country meet its Paris Agreement climate target (see below).

To reduce subsidies in the longer term, more emphasis should be placed on explaining to the public that blanket energy subsidies are a highly regressive measure that benefits mainly the well-off. These subsidies should be phased out gradually and replaced by support mechanisms that protect vulnerable groups.

Gas and electricity market reform

Azerbaijan would also benefit from more dynamic, efficient and environmentally and financially sustainable electricity and gas markets. The IEA therefore strongly encourages the government to intensify efforts to unbundle monopoly operations, increase competition and attract private investment to build new infrastructure and modernise the existing system. Reforming the tariff system and phasing out gas subsidies to enable cost recovery and fair competition across all power and heat technologies is essential. To ensure that reforms are socially acceptable, this complex task requires careful action to protect vulnerable consumers. It also requires continuous education and training efforts to guarantee that enough people have the planning capabilities and skills necessary to deliver the reforms efficiently and effectively. A campaign to improve public awareness of the reasons for energy policy changes and the benefits of future reforms is also needed.

Electricity demand in Azerbaijan is set to grow in the years and decades ahead. The whole population has access to affordable electricity, and wider electrification is expected to raise demand considerably from the currently low 2 500 kilowatt hours (kWh) per capita per year. The country needs a more dynamic electricity sector, and investments in new and more efficient generating capacity and electricity grids are essential. The IEA welcomes the government’s determination to reform the electricity system and gradually move from a state-dominated, vertically integrated system to a more dynamic, efficient and environmentally sustainable one. The challenge now is to deliver it.

Azerbaijan’s 2016 Strategic Roadmap recognised the need for electricity reform, and several reform proposals have been drafted. These include the draft laws on electricity, on the role of the regulator in energy and public utilities, and on the use of renewable energy in electricity generation. The IEA urges the government to adopt the pending legislation and proceed to implement an ambitious electricity market reform for the benefit of the country and its economy.

The government should first focus on the issues of governance and financial viability. Tariffs and subsidies should be reformed to enable full cost recovery and encourage investments in power sector development, which should help reduce operating costs and improve generation, transmission and distribution efficiency. To enable the energy sector to allocate resources more efficiently, the IEA furthermore urges the government to reform and gradually abolish subsidies for natural gas in electricity generation. The government should also focus at the outset on setting specific policy objectives for a secure, efficient and clean electricity system. Although Azerbaijan has enough gas resources to generate all the electricity it needs for decades to come, it is also in the enviable position of having hydropower and significant solar and wind power potential. As solar and wind technology costs have declined dramatically in recent years, tapping into their potential would allow the country to save its natural gas for export at the same time as reducing domestic GHG emissions.

In this context, the IEA welcomes the government’s ambition to raise the share of renewable energy in total generating capacity from 16% in 2018 to 30% in 2030, and congratulates it on its first power purchase agreements (PPAs) for a 240‑megawatt (MW) wind farm, signed in late 2020, and 230 MW of solar power capacity, signed in early 2021. When the time comes for the government to consider renewable energy targets beyond 2030, it should take account of both the economic potential of renewable energy and the scope for other policies and measures to meet energy policy goals. Cost-effectiveness should be a key criterion for choosing among policy options: for example, it may be less costly to meet longer-term energy policy goals by increasing energy efficiency than by building new generating capacity.

To meet electricity market reform objectives, policies and measures must provide for unbundling, third-party access to grids, transparent wholesale markets, and partial privatisation of monopolies. It follows that Azerenergy’s generating assets should be effectively unbundled from its transmission grid ownership and grid operations. At the same time, transmission and distribution tariffs should be separated from energy supply tariffs to enable the use of performance-based incentives, while electricity generation should be opened up to competition and wholesale and retail markets created. There is a strong case for undertaking such a broad and complex reform gradually. The first step should be to remove entry barriers for new participants and begin to institute unsubsidised cost-based economic dispatch of power plants to increase efficiency. This should be quite feasible, since – aside from autoproducers – almost all generating capacity is owned by Azerenergy.

To increase competition, some of Azerenergy’s generating assets could be privatised. The emphasis should be on privatisation as a means of increasing competition and operational efficiency rather than as an end in itself, with full privatisation unlikely to be necessary to achieve the desired goals. For example, in many European countries the state remains the majority shareholder in electricity generators that operate in competitive wholesale markets. New entrants could be entirely private or based on public-private partnerships, provided that barriers to market entry are removed. An important point to consider relates to raising the share of variable solar and wind power capacity. As the government plans to attract investment through long-term PPAs, a mechanism should be designed to integrate PPAs into the future wholesale market.

The establishment of the regulator in 2017 was a major step in electricity market reform. Since the Azerbaijan Energy Regulatory Agency (AERA) remains closely overseen by the Ministry of Energy, just like the electricity sector monopolies Azerenergy and Azerishiq, it will be essential to grant it the legal right to take binding decisions and issue recommendations. This also applies to its work in natural gas and district heating. 

Securing larger electricity supplies

Having an uninterrupted supply of electricity is critical for a modern society. In their efforts to ensure electricity security, many IEA member countries have found it useful to put in place a comprehensive framework, supported by laws, regulations, policies and measures that address generation, transmission, distribution and supply challenges. The IEA urges Azerbaijan to consider a similar framework approach that takes account of electricity infrastructure needs and long-term network development. The government should ensure that it has sufficient personnel qualified to carry out the tasks required under the framework. It should also organise emergency response exercises, as they have proven effective in boosting preparedness and response capability in other countries.

An electricity security framework should cover the areas of fuel security, resource adequacy, operational security and governance. Azerbaijan’s fuel supply appears secure, as the country has significant natural gas resources and is about to diversify by investing in renewable energy generation. Resource adequacy is supported both by generating capacity that is set to expand and is already able to meet twice the peak demand, and by cross-border connections. In addition, efforts to modernise networks are under way to keep up with growing network demands. The July 2018 blackouts demonstrated that several domains of operational security require improvement, as does the area of governance, including legislation, institutions and regulation. Furthermore, the electricity security framework should include targets and indicators that are regularly monitored and reviewed to measure progress and help ensure that electricity security is maintained and improved. 

Using energy more efficiently

As other countries with legacy infrastructure and subsidised energy prices, Azerbaijan has plenty of scope to improve its energy efficiency. The IEA strongly encourages the government to recognise that greater energy efficiency can benefit the economy, reduce pollution and create additional jobs, and to rapidly adopt the laws, strategies, policies and measures needed to realise this potential. Strong policies on energy efficiency will become increasingly relevant because more buildings will be constructed, more appliances and equipment sold, and more vehicles purchased in the years and decades ahead. A long-term approach is therefore needed to keep the country on an environmentally sustainable energy pathway.

Instead of subsidising energy use for everyone, the government should focus social policy measures on those in real need while gradually switching to more efficient energy use. As part of its targeted support measures, it could, for example, launch programmes to replace the least efficient household appliances (refrigerators, washing machines, etc.) with new, highly energy-efficient models, offering subsidies for the least well-off.

As renovations to improve the energy efficiency of the existing building stock, especially residential and public buildings, would also save energy while benefitting citizen health, the case for introducing financing mechanisms for energy-efficient housing is strong. The government should also ensure that residential buildings comply with energy efficiency regulations. In many IEA countries, compliance is verified by public sector building inspectors, which is an approach Azerbaijan’s government should consider.

Experience in IEA member countries shows that minimum energy performance standards are among the most effective and cost-efficient energy efficiency policy instruments. The government should therefore introduce stringent standards across all sectors to cover buildings, vehicles, appliances and equipment. These standards should be underpinned by an effective energy efficiency audit mechanism. It should also update the standards regularly and, when applicable, accompany them with energy labelling.

Azerbaijan’s population, half of which still lives in the countryside, is expected to continue growing, urbanising and becoming wealthier. The country will thus need to build more urban infrastructure in the coming decades, including new heating systems. Space heating is currently based on individual boilers that burn subsidised gas. However, modern district heating and cooling (DHC) systems, combined with more efficient electricity generation, heat pumps, waste heat use and thermal storage, could offer a solution that is more efficient and cost-effective while reducing CO2 emissions.

As transport sector oil use more than tripled between 2000 and 2018, energy and climate considerations should be integrated into long-term transport and urban development policies so that Azerbaijan does not become locked into inefficient and energy-intensive private car-dominated urban structures. For example, if private car ownership in Azerbaijan were to increase to the current European Union (EU) average, the country’s car fleet would expand almost fourfold to five million. Expansion of the Baku metro in recent years has improved public transport availability, but further replacement of private vehicles with public transport, walking and cycling would improve air quality and reduce noise and congestion, especially in the Greater Baku area, which is home to almost half the population and half the country’s vehicles.

Tackling the rise in transport fuel demand (unrestrained by prices or taxes) and the hike in natural gas use (subsidised in all sectors) is also necessary for Azerbaijan to achieve its Paris Agreement goal of reducing net GHG emissions by 35% from 1990 to 2030. In 2018, the latest year for which data are available, net GHG emissions were 2.5% above the 2030 target. Cutting GHG emissions from oil and gas production would also reduce total GHG emissions considerably.

Energy research, development and innovation merit additional effort

Energy research, development and innovation (RDI) is necessary to help Azerbaijan maintain and improve its economic competitiveness, and to enable diversification away from oil and gas. For these reasons, the IEA encourages the government to step up its energy RDI efforts significantly.

Further energy data improvements

Reliable data is the basis of sound policymaking. The IEA congratulates the State Statistical Committee of the Republic of Azerbaijan (SSC) for improving energy efficiency data collection and monitoring, and it encourages the SSC to further develop national energy statistics to improve data coverage and quality and to inform policy decisions.

Key recommendations

The government of Azerbaijan should:

  • Finalise laws and plans for which approval is pending as soon as possible, and ensure their effective implementation based on clearly designated responsibilities and accountabilities, with adequate resources.
  • Diversify the domestic energy mix to gradually reduce oil and gas dependence.
  • Institute further structural energy reforms in a phased manner to develop competitive markets based on prices that reflect the full energy supply cost, and to ensure transparent and non-discriminatory grid access; support reforms by measures that guarantee the energy regulator’s independence and capacity, and aid the most vulnerable citizens.
  • Take steps to increase the efficiency of energy supply and use, and incorporate energy and climate considerations into long-term urban development and transport plans to limit energy demand growth.
  • Develop an integrated long-term strategic plan for energy and climate change that incorporates and builds on reform measures to date, and that aims to deliver the country’s nationally determined contribution (NDC) under the Paris Agreement, including through the use of renewable energy.
  1. IEA (2020), Gas 2020.