28.04.23 Sanctions Analytics

Irrecoverable losses: how sanctions have hit Russia’s most competitive industries the hardest

Re: Russia
Re: Russia
Although the Western sanctions introduced in response to Russia’s invasion of Ukraine did not lead to a complete collapse of the Russian economy, they have caused significant, irreversible damage, pushing industries which had achieved significant success on the international market towards demodernisation. A prime example of this is the Russian timber industry, which has lost its foothold in the European market. A perfect storm has been unleashed onto this sector of the economy; declining profitability, loss of high-quality equipment suppliers, and the suspension of international certification for environmental standards. To compensate for the loss of its premium markets, the industry has been forced to export products at lower prices and with lower added value, while increasing deforestation. This has effectively thrown the lumber industry back to the state it was in fifteen years ago.

From triumph to nightmare

More than a year has passed since international sanctions were introduced against Russia as a response to its full-scale invasion of Ukraine. During this time, the Kremlin has been referring back to the old Russian joke of ‘Yes, horror, but not horror-horror’ to frame the perceptions of the Russian public, the country’s elites, and its expert community. The authorities have heralded the failure of sanctions to throttle the Russian economy as evidence of its victory. This intention behind this framing was to convince ordinary Russians and a segment of the elites to accept the significant economic losses that have been incurred as a result of the irrational decision to invade Ukraine. The losses in question not only include the country’s loss of potential GDP (the difference between the economy contracting by 2.1% and its potential growth of 3.5-4%), but also investments into transportation and industrial infrastructure, as well as the modernisation of both production and technological standards. However, the more successful a sector of the economy was in terms of its international competitiveness, the more severely it has been affected by the invasion and retaliatory sanctions, with a direct correlation between its success and the level of irrecoverable losses. A striking example of this has been the timber industrial complex, which had been undergoing a successful modernisation process over the last two decades as a result of its focus on and success in European markets.

According to an analytical review by the forestry consulting company What Wood, 2021 was the most successful year in the entire history of the Russian forestry industry. Russian timber enterprises experienced a 32% boost in revenue, reaching a value of 2.9 trillion rubles, with their net profit tripling to 460 billion rubles. Their share in the country's GDP reached 2%, while export revenue also grew, from $11.7 billion in 2020 to $16.7 billion in 2021. Additionally, at the end of 2021, the forestry sector achieved a significant milestone with its first-ever IPO on the Moscow Exchange. Segezha Group, a timber holding company that performs a full cycle of timber harvesting and advanced wood processing operations, was able to raise 30 billion rubles during its initial public offering. Further, the company's securities were included in the First Level quotation list.

Before last year, European countries had been one of the primary international markets for the Russian timber and wood-processing industry. The industry's success on the European market was largely thanks to the rapid rise in timber prices globally, well-established supply chains, and the possession of international certificates of quality by Russian companies. Many companies in this sector had ambitious plans for 2022, including the purchase of expensive imported equipment to expand their productivity, entry into new foreign markets, and the acquisition of environmental certifications in accordance with international standards.

On the contrary, 2022 turned into a nightmare for the Russian timber industry. On April 5, the European Union adopted its fifth sanctions package in response to the Russian invasion of Ukraine and the massacre in Bucha. From July 10, EU countries were prohibited from importing various products from Russia (including plywood, wood-based panels, fuel pellets, all items under the foreign economic activity code 44, and several items from the pulp and paper industry). The eighth package of EU sanctions, which was adopted on October 6, introduced a complete ban on the import of Russian pulp and paper products. Additionally, both the United Kingdom and the United States cancelled Russia’s most-favoured-nation status for trade in forest products and implemented restrictive import duties on Russian timber goods.

Moreover, nearly half of the record export earnings achieved in 2021 were generated by countries that have since imposed sanctions on Russia. The volume of lumber shipped to European buyers plummeted from 4 million cubic metres of softwood and around 0.4 million cubic metres of hardwood in 2021, to only 1.76 million cubic metres of total lumber exports in the first 11 months of 2022. In other words, the export volume fell to just 40% of last year's level. Specifically, the UK, Germany, and Ireland reduced their imports by 76%, 58%, and 75% respectively, while Japan decreased its imports of Russian lumber by 11%. Consequently, the industry has been in a state of crisis, experiencing a 10% contraction in output.

The road to the past

Despite losing access to Western markets, the export revenues of the Russian timber industry decreased by only $3.07 billion over the year, which was lower than the $4-6 billion reduction that had been forecast by experts in the spring of 2022. The industry was largely able to maintain their earnings by increasing exports to other regions. Shipments to North Africa and the Middle East rose by almost 18% to 1.2 million cubic metres in 2022. Exports to the UAE, Iraq, Jordan, Iran, Singapore, Tajikistan, Turkey and Turkmenistan also increased. China accounted for more than half of Russia’s total lumber exports. As a result, overall lumber exports from Russia fell by 21% in 2022.

However, this reorientation towards other regions has also led to profound structural changes in the industry. Some of the aforementioned countries have increased their purchases of Russian wood products for onward resale to Western markets. Since the cost of lumber is lower in these countries than in Europe, Russian forestry enterprises have seen a marked decrease in profitability, as most of their profits have been transferred to these intermediary countries. This has meant that, among other things, Russian enterprises have had fewer available resources to comply with environmental standards and invest in expanding their production.

Sanctions have had the most significant impact on businesses located in the northwest of Russia. In December 2022, Vladimir Butorin, the owner of ULK Group, announced the closure of a pellet plant in the Novgorod region and plans to halt operations at other plants. The company had to lay off 30% of its workforce last year, and its revenue decreased 2.5-3 times. The company was also forced to halt construction on a wood processing complex in the Arkhangelsk region due to its inability to import the necessary equipment from Europe. The situation was exacerbated by the refusal of European suppliers to refund the advance payments made for equipment and machine tools. This equipment, which is extremely important for the Russian timber industry, has also fallen under sanctions. Butorin has estimated the losses of ULK Group at 10 billion rubles.

Compressed wood pellets made from forestry waste are known as fuel pellets, which are classified as biofuels in the EU. In Germany, they are used for heating private homes, government buildings, and even schools, and the German government subsidises the installation of energy-efficient boilers that use these pellets. Russia used to be the primary supplier of fuel pellets to Europe, but as of February 2023, Russian pellets were only being exported to South Korea and Turkey. Over the past year, Russian pellet exports have fallen by 70%, and continue to decline.

​​The Eastern Siberian timber industry, which used to sell valuable wood types to Europe, has also encountered difficulties finding new buyers for its products. Because lumber made from Siberian larch is not popular in China, its producers have struggled to find alternative markets. Further, transportation costs have increased and there is a shortage of trucks and railcars.

All of these issues have resulted in rising systemic costs. According to Important Stories, due to the loss of access to the European market, which requires compliance with high environmental standards, Russian companies are no longer obliged to adhere to principles of sustainable land use. As a result, in 2022, Segezha Group abandoned the moratoriums on deforestation set in place in Karelia, Komi, Krasnoyarsk Territory, Irkutsk and Arkhangelsk regions, affecting approximately 1.5 million hectares of forest. Last year, Segezha Group cut down 680 hectares of valuable forest in Karelia. This was not only an attempt to compensate for the company’s falling profits, but also the result of the suspension of international environmental certification within Russia. Companies used to spend a significant amount of money to obtain this certification, as it is a necessary requirement in order to sell wood products legally in Europe at market prices.

Ultimately, the timber industry has become a perfect illustration of the technological and economic regression that was forecast as a medium-term consequence of sanctions for the Russian economy. Russia has ceded the premium European market and the profits associated with it to other countries. It has become a secondary supplier to countries that have supplanted it within premium markets, and its timber industry is now experiencing a process of demodernisation. The losses to the Russian economy as a result of the invasion of Ukraine and the resulting sanctions will not be limited to 2022, but may potentially last for a decade or even longer, resulting in lost profits, wasted resources, and decreased market potential for the country’s most advanced industries.