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3.83 Table 3.15 summarizes the assumptions in this Chapter on the expected tariff growth for gas and electricity. In the most radical scenario, the real gas tariff would be 25 percent higher than in 2002, while the electricity tariff would be increased by one-third. It is worth noting that our macro assumptions provide for a considerable real ruble appreciation (in excess of 40 percent) for the period 2003-04. This means that dollar energy tariffs would almost double. In particular, the gas tariff would be higher than US$33 per 1,000 cub m, while in 2002 it was less than US$19.

Table 3.15: Real Growth in Energy Tariffs for Households in 2006 Relative to 2002, Depending on Scenario In US$ terms In rbl terms Power gas power gas Scenario 1 slow reforms, low oil prices 1.02 1.10 1.45 1.Scenario 2 advanced reforms, low oil prices 1.19 1.16 1.70 1.Scenario 3 slow reforms, high oil prices 1.05 1.16 1.49 1.Scenario 4 advanced reforms, high oil prices 1.34 1.25 1.91 1.Assumptions on the elimination of cross-subsidization 3.84 Given the considerable volume of cross-subsidization, merely increasing the average HUS tariffs to achieve full cost recovery would be insufficient. In addition, a considerable tariff rebalancing is needed to ensure that tariffs reflect the costs of service delivery for particular consumer groups. Such tariff restructuring would result in a considerable additional growth in residential tariffs relative to their average expected growth for the economy (see Table 3.16).

Table 3.16: Additional Growth in Residential Tariffs to Ensure the Elimination of Cross-Subsidization Additional growth in residential tariffs Electricity 1.Gas 1.Water 1.Heating 1.Housing maintenance 1.Average for the sector 1.Sources: IUE, staff estimates.

Assumptions on potential efficiency gains 3.85 The Russian housing stock is quite inefficient and there is considerable room for energy savings. For instance, the water consumption of Russian urban households is estimated to be more than 70 percent above the Western European level (World Bank, 2003a). However, the realization of most of these efficiency gains requires fundamental institutional changes in the sector, which could not be achieved in the short to medium term.55 In the period up to 2006, under the most optimistic assumptions about the pace of sectoral reforms, only a small portion of these gains could be realized. This is due to the existing institutional and technological constraints that would hamper the introduction of energy and resource saving technologies, especially at the household level. The situations regarding heating, water, and electricity are discussed immediately below.

3.86 Heating. Considerable savings in heating are technically possible but would require a major change in how Russian multi-apartment housing units are managed. In short, most savings could be achieved at the building level but not at the apartment-level. To realize these savings, apartment owners must (i) transform the current means of housing management into condominiums or similar, (ii) be capable of contracting and supervising efficient managing companies for their multi-unit buildings, and (iii) invest in the proper metering of delivered heat. The experience of the past 10 years suggests that the introduction of new management arrangements has been quite slow.

3.87 Water. The situation with water metering, which is a pre-condition for incentives to save water, is even less advanced than that for heating. And, because of technical constraints, water metering at the apartment level is not cost efficient. The efficient solution for metering has to be at the building level, which has the same limitation related to the need to introduce a collective form of housing management such as condominiums. In addition, water utilities in most cases are not interested in the installation of meters, because the current billing is based on norms that usually exceed actual household consumption. The introduction of meters would reduce the revenues of water utilities.

3.88 Electricity. In contrast to water and heating, households have better opportunities for savings in electricity. Most housing units have power meters and it is much easier for households to save electricity than to save heat or water. Thus, the price elasticity of See also Eismont et al. (2003).

electricity demand is higher than that for other utilities. Still, at the household level we do not expect substantial electricity savings for the period up to 2006. This is due to the following:

Expected growth in the ownership of household appliances, driven by the continuation of a fairly strong growth in real household incomes Growth in the installation of electrical ovens, especially in new apartments Improved quality of the maintenance of the housing stock (better lighting, etc.) 3.89 Overall, a combination of two opposite factors energy savings due to increased tariffs and growth in demand due to higher real incomes would keep the absolute level of electricity consumption in the residential sector basically constant.

3.90 Therefore, it is assumed in the scenarios with advanced reforms that most efficiency gains in the HUS would be realized not within the household sector but by service providers in heating and water supply. In particular, it is expected that by 2006 it would be realistic to achieve the following main improvements:

As a result of investment in network modernization and improved management, the current level of water losses could be reduced by 25 percent Investments in energy savings could reduce unit electricity consumption in water supply by 12 percent The reduction in heat losses in heating distribution could reach 10 percent Improved energy efficiency in heat generation (mostly through replacement/modernization of boilers) could amount to 10 percent 3.91 Overall, we assumed that owing to efficiency gains in the reform scenarios, by the total unit costs in the HUS could be reduced by 10-12 percent. In the non-reform scenarios, however, it is assumed that no reduction in unit costs would take place because of the efficiency gains.

Table 3.17: Effect on Costs of Efficiency Gains in Reform Scenarios Percent in decline in real unit costs due to energy savings Scenario 2 advanced reforms, low oil prices Scenario 4 advanced reforms, high oil prices Source: IUE.

Assumptions on the effect of delayed inflation (under-financing) 3.92 In our simulations we also assume that the non-energy part of housing costs should be adjusted upwards additionally to compensate for the period of the de facto tariff freeze in the late 1990s. It is assumed that this compensation would amount to a quarter of the gap between CPI growth and HUS tariff growth in 1998-2002.

Summary of the assumptions for HUS costs 3.93 Based on the above, we quantified four scenarios for the different cost dynamics of service delivery in the Russian housing sector, reflected as changes in the real costs of maintaining and servicing an average 1 sq. m of residential housing. Figure 3.1 presents a comparison of housing and utility cost increases under the different scenarios. It suggests that by 2006 in the most advanced scenario--scenario 4costs to residents would increase by almost 50 percent. It is worth noting that even in the inertial scenarios without reforms (scenarios 1 and 3), housing costs would also be growing in real terms, reflecting the continuation of the (although slow) domestic energy price adjustment.

Figure 3.1: Housing and Utility Costs to Consumers under Different Scenarios in 2006 (real growth relative to 2002) Growth in costs relative to 1.1.1.1.0.0 0.5 1.0 1.5 2.Scenario 1 slow reforms, low oil prices Scenario 2 advanced reforms, low oil prices Scenario 3 slow reforms, high oil prices Scenario 4 advanced reforms, high oil prices 3.94 This expected growth in HUS costs is a combined effect of the following four core factors (Table 3.18): (i) an increase in domestic energy prices (gas and electricity), (ii) an increase in non-energy costs related to the need to compensate the sector for a period of suppressed information, (iii) the elimination of cross-subsidization, and (iv) the realization of some efficiency gains.

Table 3.18: Various Factors of Growth in Unit Housing Costs, Accumulated Growth for the Period Relative to CrossScenarios Total costs Power Gas Non-energy Savings subsidization 1 1.02 1.00 1.03 1.00 1.00 1.2 1.40 1.17 1.08 1.32 1.15 0.3 1.04 1.03 1.08 1.00 1.00 1.4 1.47 1.32 1.17 1.32 1.15 0.Source: Staff estimates.

3.95 In addition to accounting for these four factors, the implementation of housing and utility reforms implies that the existing tariff structure should be further adjusted to incorporate an adequate level of investment costs in the sector. Based on the analysis undertaken by the IUE, this would require an additional increase in average tariffs by percent. This would increase our estimate for the overall future growth in tariffs to cover all economic HUS costs in scenario 4 to 90 percent.

3.96 The latter estimate suggests that if the full reform package is implemented the total costs to consumers of the HUS (including budgets as a source of residual subsidies) of the HUS would increase from 4.8 percent of GDP in 2002 to about 9 percent of GDP in 2006.

Such a change would produce not only a major tariff increase but also a considerable change in the cost structure in the sector, in which maintenance fees and capital charges would play a more prominent role than they now play.

3.97 The important caveat to the above estimates derives from the fact that they do not reflect actual changes in HUS tariffs that have taken place in Russia since 2002. Meanwhile, according to Roskomstat, in the last two years actual tariff adjustment has been considerable - real growth in HUS tariffs was 23 percent in 2003 and is estimated to reach at least percent in 2004. Overall, the tariff growth in 2003-04 amounted to almost 40 percent (i.e. it made up half of the tariff adjustment that is claimed necessary to complete the reforms in the sector in 2006).

3.98 While the recent pace of tariff adjustments appears to be consistent with the medium term objectives of HUS reforms, there is a risk that recent tariff growth was not accompanied by adequate institutional changes in the sector. Without complementary institutional reforms, tariff and cost increases in the sector could become excessive. In this respect, the current weaknesses of municipal regulators are of special concern. If not addressed, these weaknesses may lead to a non-justified growth in the tariffs of local utilities, especially water and district heating providers. In addition, without institutional reforms, it would be difficult to expect that sectoral players may become capable of realizing any non-trivial efficiency gains.

I. MAIN SIMULATION RESULTS Scenarios for the continuation of the current policies 3.99 Table 3.19 presents the results of the simulations of the group of status quo scenarios that do not provide for any significant acceleration of tariff reforms in the housing and energy sectors. In particular, they assume the preserving of cross-subsidization in tariffs and a relatively low pace of adjusting domestic energy prices.

3.100 Among 12 different scenarios, the one in Column 10 is the closest approximation of the current government policies and ongoing macroeconomic trends: this is the scenario with high rates of economic growth and with an unchanged level of cost recovery in tariffs of percent.

3.101 Under such assumptions, the total explicit costs (excluding cross-subsidization) of HUS will grow by about 30 percent, to 6.2 percent of GDP from 4.8 percent in 2002.

Households will have to absorb practically all of these incremental costs. As a result, in households would pay 60 percent more in real terms for HUS (about 4 percent of GDP), while in 2002 they paid about 2.5 percent of GDP. Given the high growth of household real incomes in 2002-06 (45 percent for the period), this would increase the average share of housing costs in total population spending only slightly, from 8.5 percent to 11 percent.

Overall, the number of recipients of housing allowances would decline considerably, from the 7.5 percent benchmark to 3.7 percent.

3.102 Budget spending on HUS would basically remain at the 2002 level and would amount to 2.3 percent of GDP. However, the share of the budget in total HUS financing would decline from almost half in 2002 to less than 40 percent. The largest portion of these costs would be related to the continuation of budget investment support (capital rehabilitation).

3.103 However, the above estimates hide considerable longer-term implicit budget costs and liabilities that the sector would continue to accumulate in such a no-reform scenario. First, the volumes of quasi-fiscal financing (cross-subsidization) would remain significant (1.25 percent of GDP). Second, the incomplete tariff reform would delay changes in incentives in the sector, which would prevent the reduction of current inefficiencies, while the government would continue to accumulate considerable contingent liabilities associated with the deterioration of the municipal housing stock and the urban infrastructure.

3.104 In this group of scenarios, a further increase in cost recovery in tariffs to 100 percent (column 11) would shift additional costs in the amount of 0.5 percent of GDP from the government to the population. The share of budget spending in total sector financing would fall below 30 percent. The share of households that receive allowances would grow by percent but would still remain low (less than 5 percent).

3.105 Incorporating the capital repair charges into tariffs (column 12) would produce a major additional reduction in the budget financing of the sector: total budget costs would decline to 1 percent of GDP or to 16 percent of the total financing. In this case, the population would be expected to pay more than 5 percent of GDP in HUS charges (i.e. more than twice as much as in 2002). The number of housing allowance recipients would increase to 7.4 percent of the population.

3.106 The main conclusions drawn from simulating the continuation of the current policies could be summarized as follows:

The continuation of the current policies provides for only a gradual shift of responsibility for housing financing from the government to households, while keeping budget liabilities in the sector at the current level of about 2.3 percent of GDP.

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