However, the cost recovery level in Montenegro could be higher than the regional average, for example, if the country faces higher generation costs. The electric utility company in Montenegro (EPCG) is requesting the Regulatory Agency to approve an increase of the average residential electricity tariff to 10.7 c€/kWh and it has argued that an increase of this magnitude would be necessary to cover the rising labor costs and local communal taxes. This paper does not aim to resolve the debate of what is the appropriate electricity tariff level and argue in favor of a particular estimate of the cost-recovery level. Instead, we focus on an illustration of the anticipated poverty and environmental effects in several policy scenarios.

The Government of Montenegro faces an important policy dilemma. Residential electricity tariffs could more than double over the next four years if the regulatory agency approves the price increase requested by the electric utility company. Even a smaller increase in residential electricity tariffs to 7.0 c€/kWh is likely to be extremely unpopular. It could also give rise to environmental externalities from an increased reliance on fuelwood, the main alternative household energy source, as households switch away from electricity. However, the cost of maintaining residential tariffs at the current price level in the face of the rising cost recovery price, as our analysis shows, would be prohibitively expensive. Maintaining tariffs below cost recovery levels would also undermine the government’s commitment to the development of a regional electricity market. To resolve this dilemma, the Government of Montenegro could evaluate a range of alternatives that combine the price increase with measures that would mitigate the effect of this dramatic price increase on poor and vulnerable households.

In this paper, we use the 2004 ISSP<sup>6</sup> household survey data to provide an overview of energy consumption patterns in Montenegro and examine the likely impacts of electricity tariff reforms on household welfare. There are legitimate concerns that higher electricity tariffs will significantly increase the share of energy expenditures of poor households, particularly during the cold winter months. We also evaluate the distributional and fiscal impacts of alternative electricity tariff mechanisms using benefit incidence analysis. Our focus is primarily on the impact of different tariff levels and structures on the poor and vulnerable households.

Throughout the welfare impact evaluation and benefit incidence analysis we assume that households do not switch to other heating fuels, but we relax this assumption in the analysis of household choice of a source of heating. Fuelwood is the main alternative to electricity for space heating and it is used by more than half of the population either as the only source of space heating or in conjunction with electricity. Higher electricity tariffs may result in increased demand for fuelwood, if an increase of electricity tariffs induces a significant number of households to switch to fuelwood for heating during the winter months. We investigate the potential impact of electricity tariff reforms on household heating fuel choice by estimating a fuel switching model. The switch to fuelwood for space heating could potentially have a negative impact on forest resources, particularly in the North, by inducing deforestation and on household health by increasing indoor air pollution. The evidence presented in this paper suggests that the impact of electricity tariff reforms on household choice of space heating fuels and the level of fuelwood consumption should be carefully monitored.

reported in Alam, A., M. Murthi, R. Yemtsov, E. Murrugarra, N. Dudwick, E. Hamilton, and E. Tiogson (2005), “Growth Poverty, and Inequality: Eastern Europe and the Former Soviet Union.” Washington, D.C., World Bank.

> 6 Institute for Strategic Studies and Prognosis (www.isspm.org)

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