56700 Lights Out? The Outlook for Energy in Eastern Europe and Central Asia Key Messages1 countries in the region had begun to experience difficulties with supply; however, the crisis has reduced The countries of Eastern Europe and Central demand and created some breathing room. It has also Asia (ECA) could face an energy crunch created a window of opportunity to take action to within the next five to six years. mitigate the impact of the anticipated energy crunch. But The financial crisis has created some countries need to act now. Mitigating actions are breathing room and a window of opportunity required on both the supply side and the demand side to mitigate the impact of the anticipated and will require significant investments (about $3.3 crisis. Mitigating actions are required both on trillion in 2008 dollars over the next 20 years, or about the demand and supply side. 3% of cumulative GDP) if the region wants to meet all its anticipated energy needs. This level of investment Significant investments will be required (3% cannot be provided by the public sector alone and of cumulative GDP between 2010 and 2030) measures will be required to create a climate that appeals and the public sector alone won't be able to to private sector investors. provide this level of investments. Countries need to take action now to create a Background to the Energy Crisis climate that is attractive for investments in this sector. Following the break-up of the Soviet Union, the countries of Central and Southeastern Europe (CSE) and the Commonwealth of Independent States (CIS) Introduction experienced six years of dramatic economic decline before a vigorous recovery, starting in 1999, enabled this On January 22, 2006, the district heating system in region to become one of the most economically dynamic Alchevsk, a city of 120,000 people in southeastern in the world. With the onset of the financial crisis in Ukraine, collapsed. The winter was very cold, with 2008, the region's economic performance went into temperatures dropping to -30 Celsius, and the collapse of reversal again and suffered significant decline. the system, following a boiler failure, made the city rapidly dysfunctional. About 4,500 children and elderly This economic performance was closely reflected in the had to be evacuated, leaving Alchevsk largely deserted region's energy sector; the initial economic decline saw until the spring. Subsequently, the entire district heating a sharp reduction in both the production and the system had to be replaced. The incident illustrates the consumption of energy. Primary energy production impact that a lack of energy supply can have on dropped steadily through 2000, to about 70% of its 1990 countries in ECA, and also highlights the region's level, before increasing again to reach 99% (of the 1990 vulnerability to failures of aging energy infrastructure. level) in 2008. Consumption fell off even more sharply, dropping to 70% of 1990 levels in 1999, before It is very likely that an energy crunch could hit several increasing again as economic activity resumed. But, countries in ECA in the next five or six years. Before given improvements in the level of energy intensity, it the financial crisis of 2008, several electricity-importing was still at only 80% of 1990 levels in 2008. This resulted in a steady growth in exports of primary energy 1 The information provided in this Knowledge Brief is based on Lights Out? (largely oil and gas), following an initial decline at the The Outlook for Energy in Eastern Europe and Central Asia, World Bank, beginning of the transition period. 2010. These trends suggest that the region should be amply Where Will Additional Supplies Come From? endowed with energy supply. However, during the economic decline in the early part of the transition At the beginning of the transition period, the energy period, maintenance and upgrading of what had come to sectors of the various countries were heavily inter- appear to be oversized infrastructure stock became an dependent. The energy exporters (the Russian Federation early investment casualty. Consequently, there was a and the Central Asian countries) relied on the energy- steady deterioration in this stock of assets. Concerns importing countries in the region as outlets for their about the impact of this deterioration were increasingly primary fuel exports and, in a number of cases, as transit apparent right before the financial crisis hit. routes to access markets in Western Europe. The energy importers, in turn, were heavily dependent on Russia The World Bank and the European Bank for and, to a lesser extent, the Central Asia exporters for Reconstruction and Development (EBRD) conduct a their primary energy supplies. Business Environment and Enterprise Performance Survey in the region every three years. The last was Figure 1: Actual and Projected Gas Exports from the conducted in 2008, right before the onset of the financial CIS/CSE Region 2005-2030 crisis. It showed that electricity is a major concern to businesses throughout the region (Table 1). In addition, 500 it revealed a dramatic increase in concerns about 400 (billion cubic meters) electricity supply since the previous survey in 2005. In 300 every country surveyed, the percentage of firms that considered electricity supply a problem rose. 200 100 Table 1: Percentage of Firms that Consider 0 Electricity a Problem in Doing Business -100 Sub Region BEEPS BEEPS 2005 2010 2015 2020 2025 2030 2005 2008 ECA 17 47 Imports of OECD Europe (non-CIS/CSE) Net CIS/CSE exports, base case EU-10 (Central Europe) 11 41 Net CIS/CSE exports, optimistic case Southeastern Europe 26 48 Source: World Bank staff calculations CIS North 9 58 CIS South 21 51 Following the break-up of the Soviet Union, the focus Source: World Bank and EBRD 2008 steadily switched from an emphasis on optimization of energy production and distribution at the regional level Table 2: Average Annual Growth Projections for to an emphasis on greater self-sufficiency at the GDP, Electricity Consumption, and Primary Fuel individual country level. However, while countries did Consumption in the Region, 2005-2030 Annual begin to diversify their supply sources, the established energy infrastructure has dictated some continuing GDP 4.4 Percent reliance on historic supply channels. This is particularly Electricity Consumption 3.1 Percent the case for gas supplies. While it is relatively easy for Primary Fuel Consumption 1.9 Percent consumers to replace oil supply sources, it is far more Source: World Bank staff calculations difficult to replace gas supply sources given the nature of the supporting infrastructure. The reduction in economic activity that has accompanied the financial crisis has eased some of these immediate The Russian Federation is a major supplier of gas to the concerns, but the respite is only temporary. While the European Union, meeting some 25% of its overall gas region, as a whole, is not expected to recover to the level demand and some 40% of its import requirements. It is of 2008 output until 2013, there are reasonable prospects also a key supplier to the region's gas importing that it can expect the resumption of long-term average countries located west of the Caspian Sea. However, it economic growth of almost 5% a year after 2011. This has not been investing in the upstream gas sector at a translates into an average growth rate for the period level that would allow it in the longer term to sustain, let 2005-2030 of 4.4% a year. The assumption of a 4.4% alone increase, existing production levels. Russian gas growth rate results in an expected annual increase in production has the potential to be increased to about 900 electricity consumption of about 3.1%, and an annual billion cubic meters a year, but to do so will likely increase in primary fuel consumption of about 1.9% require investments of about $20 billion a year; simply (Table 2). This translates into about a 90% increase in maintaining production at current levels over the next 20 electricity consumption relative to 2007 and about a 50% years would require investments to the order of $15 increase in primary fuel consumption. billion a year. However, between 2001 and 2008, only $36 billion was invested in the upstream gas sector - far less than would be required to sustain production. Absent a significant upturn in investment or actions to vehicles, and in enforcing them. In order to set an limit demand growth (an aggressive program of energy example, governments should undertake energy efficiency is one example of how this could be efficiency programs in the public sector, inform the achieved), the outlook for exports post-2020 looks rather public on energy efficient technology options, and bleak, with a very real possibility that the region overall design cities with alternative means of transport. could become a net importer of gas by 2030 (Figure 1). The outlook for electricity supply is of even greater Investments Required in Energy Production and concern than the outlook for gas and other primary Infrastructure energy supplies. Nearly 80% of the power plants were built before 1980 and most thermal plants have been Over the next 20 years, the projected investment operating well beyond their design life. This adverse requirements in the power sector amount to $1.5 trillion situation has been compounded by the lack of major in 2008 dollars, and the total requirement for the sector maintenance in the 1990s, a situation that is recurring in is about $3.3 trillion or about 3% of cumulative GDP the current financial crisis. Also, investment in new (Figure 3). capacity since 1990 has been negligible. As a result, the region is now confronting the effects of decades of Figure 3: The ECA Region Will Face Significant neglect and needs significant investments for Investment Needs Over the Next Two Decades rehabilitation of existing capacity and the installation of Projected Energy Sector Investment new capacity if the expected generation capacity Sector Required by 2030 requirements are to be met (Figure 2). (billions of 2008 dollars) Electricity 1,500 Figure 2: Projected Power Generation Capacity Crude Oil 900 Additions, Rehabilitations and Retirements in the CIS/CSE Region 2005 - 2030 Heating 500 250 Gas 230 200 Coal 150 150 Refining 20 (Capacity, GW) 100 Total 3,300 50 Source: World Bank staff calculations 0 Although the public sector in these countries will clearly -50 have to finance a portion of these investments, it will not have the capacity to meet the full investment needs. The -100 2006-10 2011-15 2016-20 2021-25 2026-30 countries in the region will therefore need to call on the financial depth and technical know-how of private sector Additions Rehabilitation Retirements investors and energy companies. Although the current Source: World Bank staff calculations financial crisis is a serious impediment to private sector investment in any activities or countries seen as high Energy Efficiency: Untapped Potential risk, as the financial crisis passes, the prospects for such investment will improve. However, in order to attract Investing in energy efficiency achieves three goals these investors, countries will need to create attractive simultaneously and at least cost: lower greenhouse gas investment environments that provide secure ownership emissions, better energy security, and more sustainable rights, are subject to the rule of law, foster transparency, economic growth. An additional $1 invested in energy and enable reasonable risk mitigation. In addition, efficiency may avoid more than $2 in production individual sectors will have to be viewed as financially investment. But much potential remains untapped and commercially viable. because of the many obstacles to investments in energy efficiency, including inadequate energy prices and lack In order to create an attractive environment for of payment discipline, a lack of information on the latest investment, countries will need to adhere to ten key technologies, too few contractors and service companies, principles (Box 1). Although these principles are not and financing constraints. equally important, all have significant bearing on perceptions of the overall climate for investment. Governments have a major role to play in energy Government actions that are consistent with these efficiency, not only in allowing energy tariffs to reflect principles will go a long way toward creating an costs, but by being proactive in setting and updating attractive and competitive investment climate in the energy efficiency standards for homes, equipment, and energy sector. Box 1. Dos and Don'ts for Creating a Better Figure 4: Weighted Average Electricity Tariffs for Investment Climate Residential Consumers in 2008 1. Don't impose a punitive or regressive tax regime. 25 2. Do introduce an acceptable legal framework. 20 US$ cents / KWh 3. Do provide supporting regulations administered by an 15 independent and impartial regulator. 10 4. Do create an environment that facilitates assured nondiscriminatory access to markets. 5 5. Don't interfere with the functioning of the market 0 Bosnia and ... Ukraine UNMIK Kosovo Romania Armenia Moldova Croatia Latvia Poland FYR Macedonia Slovakia Bulgaria Montenegro Turkey Serbia Georgia Russia Albania Kazakhstan Estonia Hungary Azerbaijan Lithuania Kyrgyz Republic place. 6. Don't discriminate among investors. 7. Do honor internationally accepted standards. 8. Do abide by contractual undertakings and preclude the Source: ERRA Tariff Database use of an administrative bureaucracy to constrain investor activities. 9. Do prevent monopoly abuses. Addressing Climate Change 10. Do ensure that the sector is kept corruption-free. Securing the funding to meet the region's future energy needs is clearly a key priority. However, the countries of the region also need to ensure that in developing their energy strategies and in implementing their investment One of the most critical elements in creating an attractive programs they act in an environmentally responsible investment environment is ensuring the financial and fashion. Relative to GDP, carbon emissions in the region commercial viability of the sector. Some of the are among the highest in the world. In 2005, Russia was important concerns are payment discipline, excessive the third largest carbon dioxide emitter in the world after losses and tariffs that are below cost recovery levels. the United States and China. Other countries in the There has been progress in all three areas and electricity region, however, also have significant emission levels. collection rates, for example, have increased from an These high emission rates reflect the region's reliance on average of 75% in the mid-1990s to 93% by 2008. abundant domestic coal, low energy efficiency and However, recent reviews of tariff levels indicate that outdated technology. If emissions are to be held down, there is still much to be done to ensure financial viability focused efforts will be required to reduce emissions in several countries in the region. Assuming gas prices in associated with the use of fossil fuels--in particular coal. the range of $250 to $300 per thousand cubic meters, the These efforts should include the use of carbon financing long run marginal cost of generation from new gas fired and consideration of measures such as carbon taxes to combined cycle power plants will be to the order of 6.5 constrain emission levels. to 7.5 cents/kWh (excluding costs associated with transmission and distribution). In conclusion, the region faces a potential energy crunch. The financial crisis has provided some breathing room to In 2008, most of the countries in Eastern Europe were address the potential energy constraints, but countries covering their long run marginal cost of generation. As a need to act quickly to take advantage of this window of result, these countries were able to attract both foreign opportunity by promoting an attractive climate for and domestic investors. In contrast, tariffs in many of the investment. At the same time they need to ensure that former Soviet Union countries did not appear to the energy strategies they pursue are perceived as being adequately cover long run marginal costs although, in responsive to environmental concerns. several countries - notably Russia - domestic tariffs for gas were well below international parity levels and hence short-run marginal costs were substantially lower than in countries in which gas was priced at full international levels (Figure 4). Nonetheless, these countries will need to bring their tariffs up to levels that will cover long run marginal cost if they are looking to attract investors. "ECA Knowledge Brief" is a regular series of notes highlighting recent analyses, good practices and lessons learned from the development work program of the World Bank's Europe and Central Asia Region http://www.worldbank.org/eca