# **I.    Introduction**

With growing concerns over energy security and climate change, policy-makers have increasingly come to realize that energy prices will have to rise in order to reflect the full cost of consumption. In developing countries, this involves removing subsidies to bring energy prices closer to market rates; in the developed world, the goal is to internalize environmental costs into energy prices. However, at the same time, there is concern that higher energy prices will create economic distress, particularly for the poor households.

Recent reforms in Turkey illustrate these issues. Turkish residential electricity tariffs remained constant during 2002-07, even though fuel costs increased. In 2008, a cost-based pricing mechanism was approved, raising the retail tariff by about 50 percent over one year. Pricing reform is one of the key measures of the electricity market reform launched in Turkey in 2001. It is considered essential for encouraging energy efficiency, attracting private investment, and improving the financial position of the state owned electric utilities. Nonetheless, the magnitude of the price increase was unprecedented. How it would affect households’ consumption and welfare has prompted public dialogue and policy debate.

The purpose of this paper is to present a partial equilibrium analysis of the welfare impact of the tariff reform in Turkey.<sup>2</sup> I estimate a short-run residential demand function for electricity which can be used to quantify the welfare effect of price increases on different income groups. By allowing price elasticities to vary with household income (in the cross section), the model reveals a highly differentiated distribution of demand elasticities in the population, with wealthy households three times more responsive in adjusting consumption to price changes than the poorest, _ceteris paribus_ .

This result has noteworthy welfare implications. Because poor households are less adaptable to rising tariffs, they suffer a disproportionately larger welfare loss. Although this issue has received attention in the literature, few studies have addressed it in a systematic way.<sup>3</sup> The model also indicates a smaller aggregate price elasticity of demand than a model ignoring the heterogeneity in households’ price elasticities, suggesting that a homogeneous estimator will both neglect the variance and underestimate the aggregate impact on the population.

I estimate the demand model using disaggregated consumption data for a representative sample of 18,671 Turkish households from the 2008 and 2009 Household Budget Survey (HBS) of the Turkish Statistical Institute. The dataset provides rich detail in appliance ownership, dwelling

> 2 It should be noted that although electricity reform may result in price increases, it also provides opportunities that would not otherwise exist to improve quality and reliability of power supply, and to re-direct public resources more transparently to the poor.  Analyzing the broader impact of electricity pricing reform is beyond the scope of the paper.

> 3  Previous studies have noted that poor households devote a larger proportion of income to energy, and therefore, carry a disproportionally higher burden of rising energy prices.  However, few (if any) studies have estimated the differences in the welfare loss (measured by changes in consumers’ utility) between the poor and nonpoor.

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