# **3. The impact of electricity tariff reform on household welfare**

In most scenarios of the proposed electricity tariff reforms that are currently under consideration the price of electricity would increase substantially. How hard will it be for households to adjust their consumption of electricity if they face higher electricity prices? Ideally we would want to have data on household consumption of electricity at different price levels to estimate the demand for electricity. Then we could derive the price elasticity of electricity demand, which would indicate how responsive electricity consumption would be to the proposed electricity tariff reforms. Unfortunately, data on Montenegrin household electricity consumption at different electricity price levels are not available in the ISSP 2004 survey or from previous household surveys.

**_Estimating the welfare loss associated with higher electricity tariffs_** .<sup>10</sup> In the absence of electricity price variation to estimate a household demand function for electricity we calculate the welfare loss making different elasticity assumptions of household response to the proposed increase electricity price tariffs. The welfare loss is calculated as the loss in consumer surplus from the price increase, expressed as a percentage of total household expenditures. We assume three different electricity price elasticities. At one extreme, we assume that the price elasticity of electricity demand is zero and households do not change the quantity of electricity they consume when they face higher prices. This is our “worst case” scenario, in which household losses are the most significant. At the other extreme, we assume an elasticity of -1, which indicates that households’ response to electricity price changes is proportional to the magnitude of the price change. In this scenario, a 10 percent increase in electricity prices generates a 10 percent reduction in electricity consumption. A more realistic case is an intermediate scenario, which assumes an elasticity of -0.5. In this scenario household demand is inelastic but it is responsive to higher electricity prices.

**_Household welfare losses in different price elasticity scenarios._** Table 3 presents the results of the analysis of welfare losses associated with higher electricity prices. The analysis suggests the welfare losses of the poorest quintile are approximately twice as large as the welfare losses of the richest quintile. The welfare losses for the poorest households are larger because the poor spend a higher share of expenditures on energy than the non-poor. Assuming the initial reforms result in an increase of the price of electricity to 7 c€/kWh, the welfare loss of the poorest households would range from 2.66 to 3.41 percent of household expenditures. However, if households use only electricity for heating (and assuming they cannot switch to fuelwood), the welfare losses of the poorest households would range from 3.86 to 4.96 percent of household expenditures. The welfare losses are of course greater for higher electricity prices. The welfare losses assuming a zero elasticity are proportional to the price change, i.e. the welfare loss associated with a 50 percent increase in price would be twice as large as the welfare loss associated with a 25 percent increase in price. When demand is elastic, however, the rise in welfare losses is less than proportional to the price increase.<sup>11</sup>

> 10 We follow the approach used by Caroline Freund and Christine Wallich (1997) in” Public-Sector Price Reforms in Transition Economies: Who Gains? Who Loses? The Case of Household Energy Prices in Poland.” _Economic Development and Cultural Change_ .

> 11 The welfare losses estimated assume households do not make investments to improve energy efficiency and are thus best interpreted as short term welfare losses. Clearly, higher electricity prices

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