Following the collapse of communist regimes in the late 1980s, GDP in Central and Eastern Europe and the Commonwealth of Independent States (CIS) fell rapidly. In Central and Eastern Europe the economies were able to recover (or nearly recover): by 1999 real GDP in Poland was higher than it was in 1989; in Central and Eastern Europe (including the Baltic States) GDP was more than 95 percent of the 1989 level. In contrast, in the CIS the level of GDP in 1999 was only slightly more than 50 percent of the 1989 level.

There is a close relation between changes in GDP and electricity demand. Between 1989 and 1993, when output was falling, electricity sales and production levels also fell, albeit by much less than GDP. The fall in electricity output was largest in countries that experienced the largest declines in GDP (the Baltic states and the CIS).

With the revival of economic growth in Central and Eastern Europe in the mid- to late 1990s, electricity production also increased (table 1). Electricity production grew at about 2 percent a year in Bulgaria, the Czech Republic, and Hungary between 1993 and 1997. In contrast, in the CIS, in which GDP continued to decline, there was a continuing—and in some cases sharp—decline in electricity production.

A striking feature of these electricity markets over the past decade has been the change in the demand mix. The fall in industrial output (particularly heavy industry) exceeded the fall in GDP. The decline reduced both the absolute and relative level of demand for electricity by industry. In contrast, residential demand rose. Between 1989 and 1998 total residential consumption increased 8 percent in Poland, 20 percent in Slovenia, 56 percent in the Slovak Republic, and 84 percent in Romania.

The changing demand mix has significant implications for the industry and its reform. The relative increase in residential demand increases peak-load demand (during the evening and the winter, for example). In some countries (the Czech Republic, for example), winter peak demand is now significantly higher than it was before 1990. This changing demand profile for electricity creates problems. Most generating capacity in these countries has been designed to run continuously rather than to meet peaks in demand. Running base-load plants to meet peak demand requirements is very inefficient. Satisfying peak demand requires costly arrangements, such as importing electricity or new investment in peak load plants.

The shift away from industrial toward residential demand also has significant financial implications. In most countries in the region the average price paid by residential consumers is still below the average price paid by industry; elsewhere it is only slightly higher. In OECD countries, where prices reflect the relative costs of supply, average household electricity prices are about twice the level paid by industry. Industrial electricity consumers in Central and Eastern Europe—and particularly the CIS—are thus effectively cross-subsidizing residential consumers.

The reduction in industrial demand will create a financial shortfall unless residential prices are increased to compensate for the decline. In all transition economies household utility rates are low in absolute terms; in most of these countries the household price is 50 percent or less of the OECD average (figure 1). As a consequence, residential demand is higher than it would be if prices were higher, exacerbating the revenue shortfall of the utility companies.

Nonpayment of bills represents another serious problem. In 1997 total collection rates were just 50 percent in the Russian Federation and Kazakhstan, 80 percent in Ukraine, and 85 percent in Bulgaria and Lithuania. In contrast, in the Czech Republic, Estonia, Latvia, Romania, the Slovak Republic, and Slovenia overall collection rates were at least 95 percent. Noncollection is primarily an industrial consumer problem, causing it to have a disproportionately large impact on electricity suppliers’ revenues.

As electricity companies do not have good prospects of recovering their costs and earning a reasonable rate of return, new investment is an unattractive proposition, particularly to private investors, whether local or foreign. Overall, with significant excess capacity in both generation and transmission, the lack of investment could become a problem only in the medium to long run. But some areas require immediate investment. These include expanding generating capacity, especially for peak consumption; ensuring the safe and reliable operation of plants in Bulgaria, Romania, and the CIS, where considerable investment is required to maintain plants in operation; and reducing detrimental environmental impacts by reducing the use of coal-fired power stations and upgrading or decommissioning some major nuclear plants, such as Chernobyl in Ukraine and Kozlodui in Bulgaria, for example.

Not surprisingly, reform has proceeded most rapidly in the more developed Central European economies, particularly Hungary and Poland. But despite the importance to these countries of meeting requirements for EU accession, including the 1996 EU Electricity Directive, progress has not been rapid even there. Some impediments to reform include the following:

The limited progress in reform achieved so far is shown in the lack of competition, low levels of private sector investment and, in some Central and Eastern European countries, difficulties in privatization (at least at acceptable sales prices). In contrast, in telecommunications, private companies have made significant new investments, and privatization has proceeded relatively smoothly, at good sales prices.

The key difference is that consumer demand for telecommunications services—both for better existing services and for new services—has increased dramatically. Retail and particularly business consumers, among whom demand for high-value telecommunications services is growing rapidly, are willing to pay economic prices for telecommunications services. As a result, investors have the potential to earn an adequate return on their investment. This contrasts sharply with electricity, where price structures fail to allow a reasonable rate of return on capital.

To set free the liberalization process, the simple solution would be to readjust tariffs by increasing prices to residential consumers and removing cross-subsidies between industrial and residential consumers. However, the political difficulties associated with readjusting tariffs remain significant, impeding reform (see box). A positive byproduct of price readjustment would be that it would provide much stronger incentives for energy efficiency, which is very low in these countries.

Progress toward electricity industry reform in the region has been affected by the progress of general economic reform. Given the amount of legislation passed in the early 1990s, it was difficult to find the time and resources to develop and adopt the necessary laws in the power sector. Moreover, a limited legacy of well-defined and credible political institutions created uncertainty, which hindered regulatory effectiveness. This problem persists, particularly in the CIS. A related problem, particularly in the smaller Central and Eastern European countries and the poorer CIS countries, is the lack of people with the required skills to design, implement, and run regulatory institutions.

A clear divide has emerged between the Central and Eastern European countries (including the Baltic States) and the CIS—a divide that could well grow. In Central and Eastern Europe the prospect of joining the EU has created new incentives to pursue liberalization measures that comply with the EU Electricity Directive. Bulgaria, for example, finally passed its long-awaited energy law in August 1999. This act anticipates opening up the market in line with the EU directive, unbundling the national power monopoly’s core activities, and eliminating cross-subsidies and raising tariffs to increase to cover costs. In the Czech Republic residential prices are expected to have exceeded industrial prices by 2002 (with proposed household price increases of 14 percent in 2001, and 13 percent in 2002). Progress in these countries is being helped along by an increasing familiarity with democratic institutions and procedures, which is reducing legal and commercial uncertainty. In contrast, reform in the CIS is lagging behind. There has been little readjustment of tariffs, collection rates remain low, and political interference is prevalent. In Ukraine, for example, basic reforms to create a competitive market were initiated, but the government and Parliament want to maintain control of power generation and distribution. As in many other areas of reform in the transition economies, much remains to be done to create well-functioning electricity markets.