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# Box I - What constitutes "efficient pricing?"

Long run marginal cost pricing has sometimes been taken as _the_ benchmark for setting prices in the energy sector. Several characteristics of the energy sector in central Europe raise questions about the appropriateness of using LRMC (Gray 1995). Underlying the LRMC approach is an assumption that energy demand is growing and that future investment needs can be reliably forecasted. Neither is fully the case in the transition socialist economies.

_Energy intensities,demandprojections and investment needs._ Energy demand is hard to predict in central Europe because there is so much room for improved efficiency in consumption. Energy intensity (energy consumption per unit of GDP) in central Europe is three to six times that of industrial or developing economies, and in Poland it is:seven times higher than West Gennany's (Meyers, Schipper and Salay, 1989). Energy consumption has declined in response to the sharp decline in GDP in the last few years, falling 24.7% from 1990 to 1993, similar to the decline in GDP (Box Table 1). Energy intensity has also declined since 1992. In Poland energy consumption has declined 23.2%. since. 1990, substantially reducing energy intensity. The main reason energy consumption decreased more than GDP in Poland is because of the fall in industrial output -- industry being the most energy intensive sector.

The continued contraction of energy intensive heavy industry and ongoing improvements in energy efficiency are expected to reduce energy intensity and further reduce growth in energy demand. These trends mean investment requirements for new capacity are likely to be small. Central Europe is thus different from other regions such as East Asia, where power demand is growing much faster than supply (Gray 1995. pg. 29).

Box Table 1: Percent change in energy consumption and GDP in transition economies

|||<br>1990|1991|1992|1993|Total|
|---|---|---|---|---|---|
|ISE Encrgy Consumption|-7.0|-9.0|-8.5|-2.7|-24.7|
|TSE GDP|-7.5|-10.0|-4.7|1.3|-21.7|
|Poland Energy Consumption|-19|-2|-4|0.8|-23.2|
|Poland GDP|-11.9|-7.6|_1.5_|3.8|-14.2|

ources: tor all 'ISEs: Gray 1995; for Polan 1990-1991: Meyers, Schipper, Salay (1995 forthcoming), for Poland 9921993: Energy Infonnation Center.

_Environmentaland rehabilitation investment._ While central Europe may not need large new capacity investments, investment is needed to rehabilitate existing facilities and to make energy production environmentally cleaner. But, that timing is uncertain, depending e.g. on demands imposed by countries importing the transition economies' goods, and the implementation of stricter "European" environmental standards in TSEs (Gray, 1995).

In short. uncertainty about new capacity requirements and about when westem environmental standards will be implemented makes it diflicult to discem w%hat investment costs LRMC price increases should in fact incorporate. What _is_ certain is that utilities need to recover costs, including some "best guess" of future investment needs.

# 9/(...continued)

extent to have the mines survive longer; (iii) local retail prices do not reflect the full environmental costs of coal production. A study has estimated environmental costs to represent about 10% of present production costs; finally, (iv) local prices to households do not reflect the environmental costs of buming coal, as small users are not subject to standards, let alone fees or fines. Overall, the indirect subsidy on coal to retail (household) users may not be small.