# **1. Introduction**

Countries with former centrally planned economies in Europe and Central Asia are in the process of implementing structural reforms in the energy sector. In the past, electricity tariffs were very low in these countries, inducing inefficient electricity consumption. Furthermore, electricity tariffs did not cover the operation costs, leading to large subsidies to utility companies and thus imposing a heavy fiscal burden on the budget. In the 1990s governments in Europe and Central Asia started to implement market reforms, including restructuring energy utility companies, liberalizing energy markets, and raising energy prices to the cost recovery level. The main objective of these reforms was to reduce fiscal subsidies, improve operational efficiency of the utility companies and raise end-user energy efficiency. However, the substantial increase in energy prices in the region has had an adverse impact on poverty and the environment when pricing reforms were not combined with measures to mitigate the losses from a price increase on the poor households.

Contrary to most other transition economies, where energy intensity declined or remained stable in the 1990s, in Montenegro energy intensity per unit of GDP increased by as much as 60 percent. This significant increase was a result of low energy prices, a declining GDP level, and a lack of financing to maintain and upgrade energy infrastructure.<sup>1</sup> In order to improve energy efficiency and the financial situation in the energy sector the Government of Montenegro began implementing energy sector reforms, which include increases in electricity tariffs.

Further price increases are now under consideration due to recent developments in the regional electricity market. Along with the other countries in South East Europe, Montenegro recently signed a regional energy treaty, which commits the signatory countries to liberalize the non-residential energy market by January 1<sup>st</sup> 2008.<sup>2</sup> This treaty includes a set of measures intended to support the development of a regional electricity market, such as raising electricity tariffs to the cost-recovery level, enforcing payments discipline, restructuring energy companies, establishing an independent energy regulator, revising tariff methodologies, and putting in place social safety nets to offset the adverse impact of tariff increases on vulnerable households. In the next five years these reforms are expected to lead to a significant electricity price increase in the signatory countries.<sup>3</sup> This paper is an ex-ante analysis of the welfare impact of this price increase on households in Montenegro.

There is some debate about the appropriate cost recovery level that should be used as a benchmark in setting electricity tariff levels in Montenegro. By some estimates, electricity is no longer subsidized in Montenegro and the average residential tariff of 4.85 c€/kWh, including taxes, has reached the current short-run cost-recovery price level.<sup>4</sup> The long-run cost recovery level for the region is estimated around 7.0 c€/kWh and it includes the provision for investments in maintenance and upgrading of the infrastructure (Figure 1).<sup>5</sup>

> 1 See “Serbia and Montenegro. A Country Environmental Analysis.” The World Bank. Washington D.C. (2003). 2 Participating countries in the development of the power market in South East Europe under this treaty include Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Serbia, Kosovo, the Former Yugoslav Republic of Macedonia, and Romania. Turkey is also expected to sign the treaty at later date.

> 3 See Kennedy, David (2006), “World Bank Framework for Development of a Power Market in South East Europe.”

> 4 Personal communication with David Kennedy (World Bank). Information about the average residential tariff was provided by EPCG (Elektroprivreda Crne Gore), the Electric Company of Montenegro.

> 5 In the absence of specific data regarding the cost recovery price level for Montenegro and how much that is likely to vary given alternative new investment choices, we rely on regional estimates of cost recovery prices

1